September 4, 2000 5:00 AM PDT

Lawsuits dampen VCs' file-sharing enthusiasm

With song-swapping companies Napster, MP3.com and Scour mired in copyright lawsuits, file-sharing entrepreneurs may start singing the blues when it comes to landing venture capital funding.

Hearings began last week in a case that pits MP3.com against Universal Music Group. Meanwhile, Napster and Scour--which offer peer-to-peer technology that lets people search and retrieve files directly from personal computers--have been hit with similar lawsuits.

The 9th U.S. Circuit Court of Appeals said this week that a three-judge panel would hear the Napster case sometime between Oct. 2 and Oct. 6 in San Francisco. A verdict in the MP3.com case is expected as early as Wednesday.

The outcomes could unleash a flood of VC money--or slow it to a trickle. Many experts are bracing for judges to rule against the file-swapping companies, causing venture funding to dry up for other players in the risky niche.

Several high-profile venture firms have been conspicuously absent from the file-swapping movement, despite the surging popularity of the sites. Many venture capitalists say investing in the upstarts is too risky.

"There are too many deals around at the moment to invest in one in which there are legal issues," said Lise Buyer, a partner at Technology Partners.

It's easy to see why venture capitalists are handling peer-to-peer technology with trepidation: Negative court rulings could cost millions of dollars and put companies such as Napster out of business, draining the coffers of venture firms that back the plucky upstarts.

The Recording Industry Association of America (RIAA), which sued Napster last December, is seeking $100,000 for every copyright-protected song for which Napster facilitated trading. MP3.com could face damages in the millions of dollars, given previous estimates that the company paid $20 million each to four other major record companies to settle similar disputes.

Scour, which also allows for the swapping of full-length movies, faces the wrath of the RIAA and of the Motion Picture Association of America.

Venture capitalists who fund file-swapping businesses may face another risk far greater than losing their initial investment: They could be sucked into expensive copyright lawsuits because of "vicarious liability."

For example, the RIAA could show that a venture capital firm could have prevented copyright infringement but decided not to do so--and then profited from the infringement, said Kurt Opsahl, a copyright attorney with Perkins Coie in San Francisco. That would make the venture firm liable for financial damages.

Venture firms, which provide funding that technology start-ups require to grow, receive their payoff when a company goes public or is bought. Venture capitalists typically assume broad management powers inside the companies they fund, appointing key executives and crafting the companies' legal and business strategies--opening them up to the same lawsuits that the companies face.

The threat of vicarious liability has scared off many venture firms from the file-sharing arena.

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"We did look at Napster but didn't invest in them because of a variety of concerns--including that the downside was greater than simply losing our investment," said David Cowan, managing general partner with Bessemer Venture Partners.

One of the most publicized cases of vicarious liability involved Kleiner Perkins Caufield & Byers. The firm was named in a 1999 lawsuit over trade secrets because it was a major backer of Amazon.com and Drugstore.com.

Wal-Mart accused the e-commerce companies--and their venture firm--of luring away 15 employees who had knowledge of Wal-Mart's information systems. The case was settled last year, with no parties having to pay damages.

Despite the risks, not all venture capitalists are shying away from file-swapping start-ups.

Scour, which is seeking a second round of financing, received seed money from Hollywood power broker Michael Ovitz and the Yucaipa Companies, even though its lawsuits were already under way. Napster received an estimated $13 million from venture capital firm Hummer Winblad.

"Litigation doesn't necessarily mean a venture firm won't invest in a company. Both Napster and Scour received funding while they were in litigation," said Stewart Alsop, a partner with New Enterprise Associates. "The legal issues will be evaluated the same way as any other risk. It's just harder to judge a legal or regulatory risk."

Redpoint Ventures invested in online music-storage company Myplay.com last October, before Napster's RIAA lawsuit.

"We expected the lawsuit but invested in Myplay as a legal alternative to Napster," said Peter Gotcher, a partner at Redpoint Ventures. "Myplay has negotiated the functionality of the Myplay service with the RIAA from its inception."

But many venture capitalists remain highly skeptical of the business models of file-sharing services, irrespective of how the start-ups fare in the courtroom.

"There have been a lot of entrepreneurs looking for funding in the peer-to-peer music-sharing space," Cowan said. "But even if the activity is legal, we don't plan to fund any of them. We're skeptical of their business model. It's a business model in which they're paying their employees but no one is paying them. And that's not a good model."

 

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