Digital Media

Yesterday, BoomTown wrote about AOL's efforts--including hiring investment bankers--to sell its ICQ instant-messaging unit.

But that's probably not going to be the end of the shedding of assets at the online site.

In fact, according to sources inside and outside AOL, one of the next candidates for sale could be its MapQuest online map service.

Purchasers of the service that provides mapping and directions, sources said, are likely to be other mapping giants, especially Microsoft.

But it is not clear if the software giant or anyone would fork over a huge sum of money for MapQuest.

That would include the $1.1 billion in stock that AOL paid for MapQuest in 1999.

AOL is set to spin itself off in less than a month from corporate owner Time Warner, and sources said selling off peripheral properties is part of becoming a smaller, more focused company.

MapQuest, like AOL's Bebo social-networking site, fits this description.

While it does have widespread distribution across the Web, reaching over 40 million users monthly, MapQuest lags well behind aggressive efforts being pushed by both Microsoft and Google.

Story Copyright (c) 2009 AllThingsD. All rights reserved.

AOL, which has already told investors that it will spend up to $200 million firing a good chunk of its staff, has now told its employees. It is looking for "up to 2,500 volunteers," CEO Tim Armstrong told his staff Thursday. That's a third of the company's payroll.

The voluntary layoff program begins December 4, a few days before the company spins off from Time Warner. If AOL doesn't get enough volunteers, it will ax people on its own.

This is lousy news for employees, who are faced with a "jump now or wait to be pushed" decision, but it is designed to cheer investors: AOL says the cuts will drop its annual operating expenses by $300 million. Through the first nine months of this year, AOL's operating expenses ran around $1.8 billion.

Meanwhile, AOL is looking to shed some parts of its business altogether. It has hired bankers to sell off its ICQ messaging service and is considering dumping MapQuest, among other assets.

Armstrong's (expensive) goodwill gesture: He is giving up his 2009 bonus, which was to be at least $1.5 million. His explanation to employees: "As a member of our team and the person who takes accountability for the results of the company, I am making the decision to forgo my 2009 bonus. That decision is a personal one and is not a sign for the future payout of the overall bonus plan for employees."

Here's the text of the company's filing with the SEC:

On November 19, 2009, AOL Inc. (the "Company") informed its employees of proposed restructuring activities as part of its continuing cost reduction initiatives aimed at aligning the Company's organizational structure and costs with its strategy (the "Restructuring"). The Restructuring is conditioned upon the successful completion of the Company's previously announced spin-off from Time Warner Inc. (the "Spin-off"), as well as the approval of the Company's new Board of Directors that will begin service in connection with the Spin-off. It is anticipated that, if approved, the Restructuring will include the reduction of approximately a third of the Company's current employee base, which will be conducted on a voluntary and involuntary basis. The goal of the Restructuring is to reduce ongoing annual operating costs by approximately $300 million. If the Restructuring is approved, the Company expects to incur restructuring charges of up to $200 million, substantially all of which is expected to be incurred from the date of the Spin-off through the first half of 2010.

Story Copyright (c) 2009 AllThingsD. All rights reserved.

AOL will officially be spun off from Time Warner on December 9, with trading to begin the next day.

Shareholders of record at 2 p.m. PST on November 27 will get one share of AOL for every 11 shares of Time Warner on the day of the long-expected spinoff of the Internet service.

At Time Warner's current market cap of $38 billion, that gives AOL an implied value of $3.2 billion--a fraction of Google's $20 billion valuation of the portal in 2005, when it invested $1 billion in the property. And it's even lower than the $5.5 billion valuation Google gave the company last January, when it wrote down its investment.

(Credit: All Things Digital)

AOL will trade on the New York Stock Exchange as "AOL."

Ironically, before it merged with Time Warner at the dawn of the new century, AOL previously traded on the NYSE.

AOL went public on Nasdaq on March 19, 1992, under the ticker "AMER," and moved to the NYSE on Sept. 16, 1996, trading as "AOL."

(Fun fact: BoomTown actually attended both the fancy dinner the night before AOL moved to the NYSE from Nasdaq and the AOL party on Wall Street the next day.)

If you want to get really technical, AOL common stock will begin trading on a "when-issued" basis--you really don't want to know the confusing regulatory details of why--on the NYSE under the symbol "AOL WI" beginning on November 24.

On December 10, when-issued trading of AOL common stock will end and "regular-way" trading under the symbol "AOL" will begin.

After that, it will be up to CEO Tim Armstrong to make the long-suffering AOL into the little Internet company that could.

The separation of AOL and Time Warner is also symbolic, dismantling the most potent symbol of Web 1.0, when AOL essentially got control of the media giant, only to see the merger crash in disaster.

If at first you don't succeed...

Here's the full Time Warner press release on the transaction:

Time Warner Declares Spin-off Dividend of AOL Shares

Record and Distribution Dates and Final Distribution Ratio Announced

NEW YORK-(BUSINESS WIRE)-Nov. 16, 2009-Time Warner Inc. (NYSE:TWX) and AOL Inc. today announced the timing and details regarding the spin-off of AOL from Time Warner.

The Time Warner board of directors has approved the final distribution ratio and declared a pro rata dividend of the shares of AOL common stock owned by Time Warner that will result in the complete legal and structural separation of the two companies.

On the distribution date of December 9, 2009, Time Warner stockholders of record as of 5 p.m. on November 27, 2009, the record date for the distribution, will receive one share of AOL common stock for every eleven shares of Time Warner common stock they hold.

Fractional shares of AOL common stock will not be distributed to Time Warner stockholders. Instead, the fractional shares of AOL common stock will be aggregated and sold in the open market, with the net proceeds distributed pro rata in the form of cash payments to Time Warner stockholders who would otherwise be entitled to receive a fractional share of AOL common stock.

No action or payment is required by Time Warner stockholders to receive the shares of AOL common stock. Stockholders who hold Time Warner common stock on the record date will receive a book-entry account statement reflecting their ownership of AOL common stock or their brokerage account will be credited with the AOL shares. An Information Statement containing details regarding the distribution of the AOL common stock and AOL's business and management following the AOL spin-off will be mailed to Time Warner stockholders prior to the distribution date.

The AOL spin-off has been structured to qualify as a tax-free dividend to Time Warner stockholders for U.S. federal income tax purposes. Cash received in lieu of fractional shares, however, will be taxable. Time Warner stockholders are urged to consult with their tax advisors with respect to the U.S. federal, state, local and foreign tax consequences of the AOL spin-off.

Shares of Time Warner common stock will continue to trade "regular way" on the New York Stock Exchange ("NYSE") under the symbol "TWX" through the distribution date of December 9, 2009, and thereafter. Any holders of shares of Time Warner common stock who sell Time Warner shares regular way on or before December 9, 2009, will also be selling their right to receive shares of AOL common stock. Investors are encouraged to consult with their financial advisers regarding the specific implications of buying or selling Time Warner common stock on or before the distribution date.

AOL common stock will begin trading on a "when-issued" basis on the NYSE under the symbol "AOL WI" beginning on November 24, 2009. On December 10, 2009, when-issued trading of AOL common stock will end and "regular-way" trading under the symbol "AOL" will begin. The CUSIP number for the AOL common stock will be 00184X 105 when regular-way trading begins.

Time Warner and AOL have entered into a Separation and Distribution Agreement and several other agreements related to the AOL spin-off. The completion of the AOL spin-off is subject to the satisfaction or waiver of a number of conditions, including the Registration Statement on Form 10 for the AOL common stock being declared effective by the Securities and Exchange Commission ("SEC"), the AOL common stock being authorized for listing on the NYSE and certain other conditions described in the Information Statement included in the Form 10 and in the agreements filed as exhibits to the Form 10. The condition relating to the authorization of the AOL common stock for listing on the NYSE has been satisfied, and today AOL sent a letter to the SEC requesting that the Form 10 be declared effective. Time Warner and AOL expect all other conditions to the AOL spin-off to be satisfied on or before the distribution date.

Story Copyright (c) 2009 AllThingsD. All rights reserved.

Time Warner reported on Wednesday lower sales and earnings for its third quarter, with a drop in revenue across virtually all segments, including AOL.

Sales for the quarter dropped 6 percent to $7.1 billion from $7.5 billion in the year-ago quarter. Earnings fell to $661 million, or 55 cents a share, compared with $1.1 billion a year ago. Adjusted earnings per share was 61 cents, compared with analyst expectations of 53 cents, according to Thomson Reuters.

Time Warner also increased its full-year earnings per share outlook to at least $2.05. Previously, Reuters reported, the company had said the full-year figure would be similar to last year's $1.98 a share.

The company saw growth in its Networks unit, which includes Turner Broadcasting and HBO, with revenue climbing 5 percent to $2.9 billion. But sales fell in all other segments.

Lower movie ticket sales brought down revenue by 4 percent in the Filmed Entertainment division, while a decline in magazine subscriptions cut revenue by 18 percent in the Publishing segment.

Results were also weak at struggling AOL. The number of subscribers fleeing the service increased, while ad revenue decreased, contributing to a 23 percent drop in quarterly sales.

Time Warner sales fall in the third quarter. The figures above are in millions of dollars.

(Credit: Time Warner)

Back in May, Time Warner announced that it would jettison AOL by the end of the year, a goal that Time Warner CEO Jeff Bewkes reiterated Wednesday. AOL will spin off into a separate company led by former Google ad exec Tim Armstrong, who was appointed AOL's CEO in March.

The 2001 union between Time Warner and AOL never quite coalesced. AOL was supposed to be the high-tech jolt that would transform Time Warner. But almost from the start, AOL underperformed, running into financial setbacks less than a year after the merger.

As the Internet continued to take off, subscribers realized they didn't need AOL to hop onto the information superhighway. By the end of 2003, losses had mounted, many of the key players in the deal had left, and Time Warner had dropped AOL from its name.

Though Time Warner has been dragged down by most of its underperforming segments, especially its publishing division, the company is still hoping for a brighter future without AOL.

In preparation for its upcoming spin-off from parent company Time Warner, AOL has named nine members to its board of directors--and from what it sounds like, more additions to the board could be coming.

The current lineup includes former Amazon Chief Information Officer Richard Dalzell, Plainfield Asset Management partner Karen Dykstra, financial services exec William Hambrecht, Paley Center for Media Director Patricia Mitchell, former FCC Chairman Michael Powell, former CBS Chief Financial Officer Fredric Reynolds, former Procter & Gamble exec James Stengel, and ex-William Morris Agency CEO James Wiatt.

"AOL is very fortunate to have an exceptional group of proven leaders to serve on our board of directors," CEO Tim Armstrong, who took over the reins of the company this spring, said in a release. "AOL is on a mission to help create the future of media and content and the AOL board will play a central part in helping us focus the strategy and also operate the company with the highest ethical standards."

The majority of the board members don't hail from Armstrong's own Silicon Valley turf: the CEO served as Google's director of sales up until his hire at AOL. But most of them are veterans of traditional media, which presumably will give the onetime dial-up king an advantage as it attempts to shape itself into a digital-content power player--at least on the surface.

(Disclosure: One of AOL's new board members has a past affiliation with CBS Corp., which publishes CNET News.)

SAN FRANCISCO--Tim Armstrong is such a tease.

The AOL CEO, speaking at the Web 2.0 Summit on Thursday, didn't have any high-profile announcements like many of the other speakers at the conference. But instead, he hinted that one might be on the way.

"We have been working on something for the last three months that I think is a fairly substantial shift in our technology," he said. "When that's ready to announce, maybe we'll come back and talk to you about it."

Interviewer and conference organizer John Battelle tried to pry more information out of him, to little avail. But it sounds like it has something to do with the framework that powers AOL's network of blogs and content properties.

"It's a broader platform with more information around content and the creation of content," he said. "We see that platform evolving to a much higher scale."

Armstrong, who joined AOL in March after a stint as head of sales at Google, said that recently the company has increased its roster of journalists from 500 to over 3,000, and that over 3,000 pieces of content are posted every day to AOL properties. It's also now creating three to four times as much video as it was several months ago.

"We've hired people from places like The Wall Street Journal and ESPN," Armstrong said. "You're not just hiring a person, you're hiring the community they come with, and I think that has been an important part when you look at the network effects of that."

It's still not clear how AOL, currently in the process of being spun out from parent company Time Warner, will rake in profits from this huge investment in media content. Armstrong seemed unfazed.

"If you're not going to take risks and you don't think the future is bright," he said, "the Internet is probably not the right place for you."

AOL CEO and former Google sales exec Tim Armstrong.

(Credit: Google)

We get it, Tim Armstrong. We know the still relatively new AOL CEO is all about reinventing the once-mighty online access company into a digital publishing powerhouse. But that didn't stop him from really hammering the point home at The Atlantic's First Draft of History conference on Thursday morning.

"What is the future of the company?" Armstrong, who previously served as a high-profile sales executive at Google, said in his talk, which was streamed live online. "If I had to describe it in one word, I think it's content, and I think it's content because there's an opportunity to marry what the content's already done with what the content can do."

One of his goals at AOL, he said, is to evolve and simplify the display advertising industry in a manner inspired by the success of search advertising. "When you have millions of advertisers that can sign up online in 10 minutes and run a global search campaign," he explained, "the same thing needs to be brought to display."

Armstrong has reason to believe in content. AOL acquired a solid portfolio of blogs when it purchased publishing network Weblogs Inc. in 2005, and the titles it's launched since then have largely been well-received--even though Armstrong promptly did away with the "MediaGlow" branding that had been established for the company's content division soon into his reign as CEO.

AOL has reach: 100 million visitors in the U.S., and 275 million globally. It'll soon be wholly independent from parent company Time Warner. Plus, the traditional print publishing industry is so beleaguered that it's about time a digital power stepped up to the plate.

But there are still plenty of issues at stake. Armstrong said that the ultimate answer to one of the biggest controversies in new-media publishing--do you charge for it or not?--will be that the Web will gravitate toward a mix of free, ad-supported content and paid offerings.

"I think consumers are smart. I think that if the content is really good, people will pay for it," he said. "I do think there's cases where I think if you can add enough value to content, people are going to pay for it. I think The Wall Street Journal's a good example of this."

Meanwhile, Armstrong expects the digital advertising industry to continue to mature, despite the fact that revenue has still been dampened by the recession. "When I came from Google to AOL the first meeting that I did was in Baltimore, at our Advertising.com (offices)," he related, referring to the ad network that AOL acquired in 2004. "One of the employees said, 'How many ad campaigns do you think we should be running?' and I said, I don't know, 500,000, and the audience went blank."

He continued, "The number was a few thousand, and for me that was shocking because I came from a place where we went from having a few hundred customers to having a million customers. And why hasn't AOL thought in that direction and that scale?"

Part of achieving that scale, he explained, involves getting pretty deep into local advertising markets, something that AOL sees as an untapped resource for both audiences and ad dollars. At the Atlantic event, he showed off some visuals from Patch, the local-news start-up that he invested in prior to his arrival at AOL; AOL ultimately acquired it. The start-up is currently restricted to about a dozen towns, mostly in New Jersey, but a gradual expansion is on the road map.

"In the town we're covering every single thing that a consumer in that town should be concerned about," Armstrong said of Patch, which employs a professional journalist in each town as well as aggregates local news from other sources. "The thing you don't see from the surface here is (that) we built a massive structured database underneath this. We've digitized the entire town."

Microsoft's new Bing search service is the fastest-growing U.S. search engine among the top 10, according to a Nielsen report released Monday.

The total amount of searches on Bing rang in at 1.1 billion for the month of August, a leap of 22.1 percent over July, winning Microsoft a 10.7 percent share of the search engine market.

Google remained in the top spot with a commanding 64.6 percent share, accounting for 7 billion searches in August, a gain of 2.6 percent over July. Yahoo saw its search results drop 4.2 percent for the month to 1.7 billion, earning it 16 percent of the market.

(Credit: Nielsen)

Other players in the top 10 included AOL Search in fourth place with 333 million searches and Ask.com Search in fifth with 186 million searches.

Similar studies have also seen a boost in Microsoft's search business. An August report from ComScore discovered that Microsoft's share of the global search engine market lept 41 percent from July 2008 to July 2009. Bing was introduced in May, taking the place of Microsoft's Live Search.

Earlier this week, Microsoft showed off a "visual search" feature for Bing that returns thumbnail images for at least some search results. Microsoft reportedly will be debuting a Bing 2.0 sometime soon sporting a variety of new features.

The dot-com era had eToys, Webvan, and Pets.com. The digital-entertainment boom has SpiralFrog.

The day SpiralFrog likely reserved a corner in the pantheon of the Web's most noteworthy busts came on July 14, 2008. At 2 a.m. that day, an agitated Amir Khan, an executive at hedge fund 3V Capital Management, SpiralFrog's main financial backer, e-mailed several fellow board members at the pioneering ad-supported music service.

Khan was frustrated by SpiralFrog's marketing efforts. In one case, the start-up spent $300,000 to host a video from pop singer Alicia Keys that managers claimed would draw 1 million new users. But without any of her hit songs in the clip, only 5,000 visitors showed up. Khan then zeroed in on SpiralFrog's spending.

The costs associated with search engine and affiliate marketing, which he termed as "buying traffic," were too high. In addition, Khan warned that investors and advertisers were sure to figure out that visitors to the site did little there but land and leave.

"The people we seem to be attracting to our site from the affiliate-marketing programs are NOT interested in music," Khan wrote. "Hence the low registration rate, pages per visit, time on our site, high bounce rate. I refuse to believe that people in the advertising world and the potential acquirers will not see this as buying traffic."

As for the Keys debacle, Khan aimed a thinly veiled attack at then-CEO Mel Schrieberg and his staff. These "marketing programs accomplished just one thing: they made me sick."

A January income statement shows that SpiralFrog lost $26 million in 2008 on revenue of $1.2 million.

(Credit: Screenshot by Greg Sandoval/CNET)

While efforts were later made to improve user loyalty, Khan's warning went largely unheeded. Costs continued to balloon, and a business model that required the start-up to spend 10 cents to earn a penny was never fully re-evaluated. The company, which some had predicted could snatch away the digital-download throne from the reining power, Apple's iTunes, lost a staggering amount of money and flamed out.

On March 19, 2009, the day the service folded, SpiralFrog owed more than $40 million. In 2008, records show, the company burned through $26.3 million while generating sales of just $1.2 million.

Plenty of pundits blamed the company's demise on the big music labels and the large licensing fees they charge, as well as the economic crisis that gripped the country last fall. Certainly, both played a part. But former insiders paint a much broader picture of SpiralFrog's spinout.

CNET News has examined the company's rapid tumble and reviewed dozens of communications, legal records, invoices, and expenditures--documents that were provided by former board directors, executives, and employees. Many of those individuals agreed to be interviewed, though most requested anonymity.

SpiralFrog's story will sound familiar to anyone who was paying attention to technology during the Internet bubble era. It had all the traits of many late-1990s dot-coms: an inexperienced and divided leadership, wild spending, and what former executives there now conclude was a flawed business model.

In a two-day report, CNET News offers a rare look inside a sinking start-up whose tale could explain much about ad-supported music services' continuing challenges. SpiralFrog, like its ad-supported music peers, was supposed to provide an attractive and legal alternative to music piracy, but these sites have yet to prove that free music can translate into profits.

Ruckus, an ad-supported service catering to college students, for example, closed this year, just ahead of SpiralFrog. Another popular but profitless streaming site, Imeem, ran into serious financial trouble earlier this year, before negotiating better terms from the music labels. Imeem is now rejiggering its business model and is "headed toward profitability," a company representative said.

Look out, iTunes
Founded in 2004, SpiralFrog would wait three years before finally launching its Web site. The company's goal was to give away music and support itself by selling advertising, just as traditional radio had done for decades. Instead of broadcasting music, SpiralFrog would offer digital downloads, a la iTunes.

One of SpiralFrog's main weaknesses, however, was that its downloads were incompatible with Apple's iPod, the world's best-selling digital-music player. Another was that it secured licensing deals with only two of the four major music labels.

Nonetheless, SpiralFrog executives claimed that fans of illegal peer-to-peer sites would flock to a legal source of free music, and advertisers would follow. SpiralFrog's management also believed that the record companies would rush to do business with anyone who competed directly with illegal peer-to-peer sites.

By licensing its vast music library to SpiralFrog in May 2006, Vivendi-owned Universal Music Group, the largest of the top four recording companies, handed SpiralFrog almost instant credibility. SpiralFrog became the first company to convince a major music label to offer downloads on an ad-supported basis.

But even then, there were leadership troubles. A nasty fight for control of the company between Joe Mohen, SpiralFrog's founder and chairman, and then-CEO Robin Kent resulted in Kent's departure on December 26, 2006.

With Kent out, some of SpiralFrog's original financial backers stopped funding the company. The New York-based company ran into its first financial troubles before debuting the site on September 17, 2007.

Six months later, SpiralFrog made the bold claim that its 850,000 registered users made it "the third-largest legal music download site in (the United States) and Canada." Only iTunes and Rhapsody, operated by RealNetworks and MTV, were larger--or so the company said.

At about the same time, SpiralFrog appeared to have come into big money. The staff swelled from 12 in early 2007 to more than 30 by springtime the next year. Several longtime music industry veterans joined the company, and in June 2008, SpiralFrog cut a licensing deal with EMI, its second major label. To some observers, the fledgling music service was on a roll.

"We built a very strong brand and image in the marketplace in a short period of time," said Schrieberg, SpiralFrog's CEO from January 2007 until October 2008. "(We) did not have the opportunity to fully realize our potential."

According to documents and insiders, however, most of SpiralFrog's accomplishments were a mirage.

Traffic jam
SpiralFrog executives always had a simple plan to grow their business: build an audience through aggressive marketing and then turn casual visitors into loyal users. Schrieberg and the board agreed that the main goal should be to attract what the former CEO calls "tier-1 advertisers," companies such as Nike, AT&T, and McDonald's.

SpiralFrog's traffic for two years. The dramatic July 2008 falloff coincides with the board's decision to cut spending on affiliate marketing. Traffic bottoms out in October, when money starts running out.

(Credit: Google Analytics)

"When I visited McDonald's and some other tier-1 accounts," Schrieberg said in an interview, "we found that in order for a tier-1 account to place ads on a site like SpiralFrog, (it) needed a minimum of 5 million monthly unique (visitors). Our thought was that we needed to build volume and then swing over to quality. If you didn't build the volume, you could never get ads on the site from tier-1 advertisers."

That was the plan. The execution was something different.

SpiralFrog managers began dabbling in search engine marketing early in 2008. That's the practice of paying search engines to map Web site links and small ads to the results pages for particular search terms. This helped the company top 2 million visitors in March 2008 and 3 million the next month.

The growth was good, but SpiralFrog's leaders wanted more. Schrieberg and the board then tried affiliate-marketing programs, mostly at AOL's Platform-A. AOL promised to spread the start-up's brand across its own sites, as well as hundreds of affiliated sites.

In June, the company exceeded its original traffic goal when it recorded 6 million visitors for the month. But instead of celebrating, a few at the company were chewing their fingernails. To attract those visitors, the company had paid dearly.

According to a list of projected expenditures from July 2008, SpiralFrog expected to spend $2.8 million with Google that year and $1.5 million with Yahoo. Charges at rival MSN are unclear. The tab for AOL's affiliate marketing in 2008 was more than $3 million, an AOL attorney confirmed. According to a copy of an income statement completed in January 2009, SpiralFrog's 2008 sales and marketing expenses came to $11 million--nearly twice the $5.6 million the company paid in music licensing that year.

Not all of that was search engine marketing. There were the promotional costs, which included the $300,000 sunk into the much-ignored Alicia Keys video, $200,000 tied to the National Football League, and $500,000 plunked down on "microsite" SpiralFrogClub.com.

While the Keys video cost the company about $60 for each of the 5,000 registered users it brought to the site, the NFL deal saw even worse results. SpiralFrog paid about $490 for each of the registered users it generated, records show. SpiralFrogClub, meanwhile, attracted a dismal 225 registrations in the first month and was scuttled by September 2008.

None of these missteps were lost on the man who paid most of SpiralFrog's bills: Scott Stagg, the managing director of 3V Capital Management (now called Stagg Capital), the Connecticut-based hedge fund that bankrolled the company for nearly two years. On May 18, 2008, in a response to an e-mail from Schrieberg about the importance of unique visitors, Stagg clarified what he thought the company should focus on.

He noted that SpiralFrog had initially projected 2008 revenue at $55 million, then reduced estimates in January that year to $25 million, then reduced them again three months later to $3 million. "Uniques are great, but hedge funds want to see revenue," he implored.

Stagg e-mailed Mohen and Schrieberg again on June 3, saying he wouldn't be able to "lend the company any more money" and he suggested that Schrieberg "might be prudent to conserve the cash you have by slowing down significantly the paid searches, especially since we are not generating advertising dollars."

Despite all the spending on marketing, SpiralFrog was generating little ad revenue and seeing hardly any increase in active users, according to Khan, the No. 2 man at 3V.

AOL's Advertising.com delivered clicks, but SpiralFrog couldn't turn that traffic into registrations. SpiralFrogClub's lone purpose was to promote the music service. But what would promote the promotion site?

(Credit: Screenshot by Greg Sandoval/CNET)

"(Management) said, 'We are starting to get orders from advertisers at a pretty high CPM (cost per thousand ad impressions),'" investor Khan said in an interview. "They did get a few, and they said they would get a lot more. We had doubts. Stagg initially thought (Schrieberg) was right, but eventually, he swung around to the opinion that this was just a waste of time. Nothing was getting converted into real traffic. But by that time, we were in the middle of talks with Viacom."

In the summer of 2008, Viacom, the conglomerate behind MTV and Paramount Pictures, had expressed interest in investing in SpiralFrog. According to Khan, the start-up's leadership couldn't pull back on marketing for fear that a drop-off in traffic would spook Viacom out of the deal.

SpiralFrog had built an image as a digital-music up-and-comer by buying traffic. To preserve that image, the company needed to keep buying.

"Amir and I have been having many discussions concerning our site traffic," Schrieberg wrote to several board members in an August e-mail that asked for the authorization to spend $250,000 on search engine marketing. "We both agree that we need to achieve in the area of 5 million monthly uniques to preserve the Viacom strategic alliance."

Self-deception, a little secret
There's nothing illegal or unethical about paying for clicks. Thousands of companies do it every day to advertise their Web sites and services. Google's AdWords service, which supports pay-per-click advertising, is what fueled the company's meteoric rise. Google earned $21 billion from AdWords last year alone.

Like many other companies, SpiralFrog tried to market itself as a popular service to improve its chances of attracting advertisers, according to documents and former employees. The problem was that its traffic couldn't be sustained without costly search engine and affiliate marketing.

Sites with loyal followings usually don't have to do this, said Andrew Frank, an analyst at research firm Gartner. While some advertisers are happy with raw traffic, most typically want to partner with sites that attract lots of return visitors and maintain engaged audiences, he said.

"The smoking gun is if the traffic disappears when you stop buying," Frank said. "The idea is not to buy traffic. It's to generate loyalty...Most of the top sites don't talk clicks. They talk about active users, people who come back multiple times in a month."

In October 2008, SpiralFrog got a chance to see how the site fared without the marketing efforts. The month before, Viacom had informed SpiralFrog's leadership that it would not invest. Following that, Stagg cut off funding. When the marketing programs were halted, traffic numbers crashed. SpiralFrog saw just 775,547 unique visitors in October, a fraction of the site's monthly peak of 7 million. Records show that the number of monthly visitors hovered around the 800,000 mark until the site shut down its operations.

One person who was with SpiralFrog from start to finish was Vesa Suomalainen, its chief technology officer. According to Khan, Suomalainen's tech team was the only SpiralFrog unit that performed well. In multiple e-mails during 2008, Suomalainen revealed his skepticism of the company's spending.

On September 24, 2008, as SpiralFrog prepared to push on without Stagg's money, Suomalainen began an e-mail debate with Mohen, the company's founder and chairman. Suomalainen urged Mohen not to spend more resources on search engine or affiliate marketing.

Click the image above to read our story on what SpiralFrog tells us about ad-supported music. Stories on SpiralFrog's internal strife and customers' private information will appear Tuesday.

"For a while, I guess we all were sold...on the 'momentum theory,'" Suomalainen wrote. "The belief was that if we demonstrated solid user growth and increased the number of unique visitors, it would open more doors for us at advertisers and music labels, and amongst the press and music industry. The cost did not matter, since the exposure would be temporary, and we would switch from paid to organic growth in a matter of months, if not weeks.

"I started arguing in late spring that this is, if not outright cheating...at least self-deception," he continued. "We were claiming super-unique user growth while we knew we were just getting users to bounce off our site. Our approach was not far from hiring Internet users in India to click on our home page to get the unique-visitor number to continue growing.

"Anyone who'd ask (SpiralFrog) direct questions about average...time spent on (the) site, or average number of page views, or retention of registered users would immediately find out our little secret," he wrote. "These figures stay permanently in our books for incoming investors to look at and ask us after the fact. How do we explain spending $1.5 million in marketing in the month of June when our resulting revenue was $69,711--an oops?"

Editors' note: Another story about SpiralFrog's last days, called "How turf wars and miscues crippled SpiralFrog," will appear Tuesday.