Napster’s Collapse Nears as Funds Fade

Napster Inc., the Bay Area start-up that brought online music piracy to the masses, teetered on the brink of bankruptcy Tuesday as it struggled to transform itself from industry outlaw to ally. Company founder Shawn Fanning and two other top executives resigned, and the company told employees it was insolvent after a deal with global media conglomerate Bertelsmann collapsed.

Barring the arrival of any last-minute funding, people close to Napster expect the company to seek bankruptcy protection within days.

Napster’s demise would leave the major record labels and music publishers, which sued it for copyright infringement, trying to collect damages for the billions of unauthorized copies of songs that Napster users made. But the music industry wouldn’t be left empty-handed: It still has two appeals court rulings that effectively outlaw networks such as Napster’s.

Bertelsmann, which lent Napster at least $85 million to help develop a legitimate version of its service, might end up with the company’s assets if it goes into bankruptcy protection. And if it does, it’s likely to resurrect the Napster brand with a fee-based service that compensates the music industry for its works.

The bankruptcy filing appeared imminent after Napster’s board missed a Monday deadline to sell just its assets to Bertelsmann, a major investor in Napster said.

Ron Conway, whose investment fund has poured more than $1 million into Napster, blamed “self-serving, greedy, out-of-control egos” for the collapse of the latest talks.

Conway said the failure of the venture capitalists on the board to strike the deal meant not only that Napster’s shareholders would be stranded but that its 70 employees also would lose their jobs.

In the event of a bankruptcy, Bertelsmann isn’t guaranteed to walk off with Napster’s assets because the labels and publishers still want to be paid, said attorneys Carey Ramos and Jeffrey Knowles, who represented various music publishers in the lawsuit against Napster.

Tuesday’s developments were the latest in a series of setbacks for the Redwood City-based company, a pioneer in online file sharing that has yet to profit from the innovations of its 21-year-old founder. Fanning was 18 when he wrote the code that powers Napster.

The company’s free service skyrocketed in popularity two years ago, drawing tens of millions of consumers with easy-to-use software that let them copy songs from each others’ computers through the Internet. But the music industry’s copyright-infringement lawsuit eventually crippled the service, and Napster couldn’t win the licenses it wanted from the major labels to launch a legitimate subscription offering.

Napster’s demise won’t stem the rise of music piracy: Several other online file-sharing networks have emerged that are attracting even larger global audiences. Instead, it exemplifies how slow the major labels have been to fight piracy in the marketplace with fundamentally different approaches to distributing music.

Indicating that it had not given up hope of reviving Napster, Bertelsmann said, “We are hopeful that Napster’s brand and technology will be able to realize its potential as a compelling consumer proposition.”

Bertelsmann had offered to buy Napster for $16.5 million, but a dispute erupted among the closely held company’s shareholders over the price and over how the spoils would be divided.

Silicon Valley venture capital firm Hummer Winblad had the right to take more of the sale money out first under the terms of its May 2000 agreement to invest in Napster. Fanning’s uncle, John Fanning, who had incorporated the company the previous year and served as its chairman, rallied other investors to negotiate for a bigger slice of what Bertelsmann was willing to pay.

The elder Fanning ultimately lost that fight, with a Delaware judge ruling Tuesday against Fanning’s attempt to seize control of Napster’s board. In the meantime, however, Hummer Winblad’s representatives on the board rejected Bertelsmann’s offer to buy all the company’s stock, insisting that Bertelsmann indemnify them personally in case they were held liable for Napster’s past infringements, sources said.

Bertelsmann then offered to buy Napster’s assets and pay off some of its debts as part of a prepackaged bankruptcy plan that would have left Hummer Winblad and other shareholders empty-handed. When the board failed to act on that offer, Bertelsmann withdrew.

The board’s failure to accept either offer prompted Konrad Hilbers, Napster’s chief executive and a former Bertelsmann executive, to resign Tuesday, along with Jonathan Schwartz, its chief counsel.

The likely end of Napster Inc. as an independent company cuts short one of the most audacious experiments in the history of commerce. From its beginnings in Massachusetts, Napster was attacked as an illegal aid to those who wanted free music. Yet at the height of the Internet boom, it managed to attract more than $15million in funding from Hummer Winblad and other professional investors who saw the potential for a giant payoff if Napster withstood the industry’s assault or negotiated a compromise.

With that help, Fanning’s dorm-room inspiration became one of the fastest-growing Internet applications in history. But it also provoked a war that’s still raging between the entertainment and technology industries, with now routine skirmishes in courtrooms and on Capitol Hill.

The company wound down and eventually shut off its free service in response to federal court orders. Yet its successors learned from Napster’s experience, many of them basing themselves in other countries and using less centralized systems harder to shut down.

Before and after Bertelsmann’s investment, Napster came close to striking a deal with the major record labels that won round after round against it in federal court. Both sides blame each other for the collapse of the earliest talks.