NYT: Turmoil at Napster Moves the Service Closer to Bankruptcy

[TankGirl]

From New York Times:

Turmoil at Napster Moves the Service Closer to Bankruptcy

May 15, 2002
By MATT RICHTEL

SAN FRANCISCO, May 14 - The chief executive of Napster, its founder and several of its top executives resigned today, a move that may foreshadow the imminent bankruptcy of a service that became synonymous with the free exchange of music online.

The resignations followed the collapse of negotiations by Napster and the German media conglomerate Bertelsmann, which had sought to acquire the online music service. People close to the negotiations said that Napster's board - mired in its own infighting - had rejected Bertelsmann's latest offer and that the company had virtually no financing left to keep it operating.

People familiar with the company's plans said Napster might now be forced to file for Chapter 7 bankruptcy. Such a move would probably shut a company that just a year ago was one of the most popular services on the Internet.

By letting people exchange music at no charge, Napster exploded in popularity. That engendered the ire of the record industry even as Napster helped shape the early days of the Internet. By last spring, at the height of Napster's popularity, more than 80 million people had downloaded the software, which let them exchange music and store music files on their personal computers.

But Napster was confronted with two extraordinary hurdles: it needed to make money from a service it was providing free, and it had been sued by the major record companies, which asserted that the company had helped millions of people pirate copyrighted music. In February 2001, a federal appeals court sided with the record companies, ordering Napster to prevent users from exchanging copyrighted music owned by major record companies. Last July, seeking to overcome both hurdles, Napster went offline and sought to create a commercial service that
would charge users to exchange music and would compensate record companies.

But the service never got off the ground, even as new free services like Kazaa and Morpheus arose and the record companies started their own rudimentary commercial services. Napster argued that the record companies had refused to license music for use on Napster, and its executives even now blame that refusal for its current circumstances. While Napster fruitlessly negotiated for licenses, its finances dwindled, leading to a series of layoffs in the last six months at the company, based in Redwood City, Calif. About 70 employees are left.

In a letter to employees today, Konrad Hilbers, the chief executive, wrote that he was resigning because Napster's board refused to accept the latest offer from Bertelsmann. He said the deal would have allowed Napster to "keep the company's assets, including its employees, together in the long term."

"I am convinced that not pursuing the offer is a mistake," Mr. Hilbers said, "and it will lead the company to a place where I don't want to lead it."

He was joined in resigning by Shawn Fanning, who developed Napster's software as a college student and founded the company, and who was its chief technology officer; Jonathan Schwartz, Napster's general counsel; David W. Phillips, vice president for service and product management; and Milton E. Olin Jr., executive vice president.

In a statement, Napster acknowledged that negotiations had fallen through with Bertelsmann, and it suggested that its aspirations to create a commercial service had ended.

"We deeply regret we have been unable to find a funding solution that would allow Napster to launch a service to benefit artists and consumers alike," the statement from Napster said, adding: "We will be looking at additional steps in the coming week to further reduce expenses."

One departing executive, who asked not to be identified, said he had decided to resign in part because he thought that it was unethical to continue to work for a company that was so low on funds it would not be able to pay employees' salaries or give them vacation or severance pay should it fold. "Management team felt very strongly they didn't want to run cash reserves below a point where they couldn't pay employees out," the executive said.

The company now appears to be in the hands of its board, which consists of Hank Barry and John Hummer of the venture capital firm Hummer Winblad, which invested some $13 million in Napster, and John Fanning, Shawn Fanning's uncle.

Infighting on the board has complicated matters, and that discord coincidentally was the subject of a court decision today. A chancery court in Delaware ruled against John Fanning in a lawsuit that he brought to try to wrest control of the board from Mr. Barry and Mr. Hummer.

Bertelsmann, the parent of BMG music, one of the major record companies, has lent Napster $85 million to help it become a commercial service. Under a deal proposed some two weeks ago, Bertelsmann would have paid $16.5 million - and erased the previous debt - in exchange for gaining full ownership of Napster. Bertelsmann might have subsequently taken Napster into Chapter 11 bankruptcy protection and reorganized the company, people familiar with the negotiations said.

But Napster's board rejected the deal about two weeks ago. People familiar with the issue said a sticking point had been Bertelsmann's refusal to indemnify Mr. Barry and Mr. Hummer completely from further lawsuits that the record companies have threatened to file.

Shortly thereafter, Bertelsmann made a new offer, but one that was far less attractive, the sources said. The deal would have essentially paid $5 million to help erase Napster's debt to its unsecured creditors, which are owed about $11 million.

While Napster contemplated the offer last week, Bertelsmann was paying Napster $50,000 a day - money that let Napster keep going. On Monday, Bertelsmann stopped paying.

It is possible that Bertelsmann may wind up retaining some of Napster's assets, even if Napster goes into bankruptcy. As Napster's largest creditor, it would have to be outbid by some other suitor for Napster's assets, which would include its brand name and its software.

The apparent collapse of Napster is mixed news for the record companies. On one hand, they are watching the final spasms of an archnemesis, a company they assert cost them tens of millions of dollars in lost sales. And they do not have to face Napster in a full trial whose outcome was not certain.

On the other hand, the record companies do not now have a chance to collect any damages for copyright infringement, a chance they would have had at trial.

- tg