Digital Media

Ever since ad-supported music service SpiralFrog shut its doors in March, former users have complained about receiving a glut of spam.

"SpiralFrog seems to have sold their members' e-mail (addresses) to spammers," a CNET reader commented in response to a May story about some of the company's struggles. "I signed up for the service with a unique e-mail address. As soon as the service shut down, I started getting massive amounts of spam sent to that address. Anyone else have this problem? Pretty slimy."

It's still unclear how many spammers obtained a list of e-mail addresses belonging to about 2.5 million registered users of the now-defunct service, as well as how they all obtained the addresses. But it is clear that at least one company obtained the e-mails by paying a former SpiralFrog salesman $8,500, CNET News has learned.

SpiralFrog CEO Joe Mohen authorized former employee Tim Bieber to sell customer e-mails with no privacy restrictions. Bieber's address has been redacted from this document.

(Credit: Greg Sandoval/CNET)

A review of SpiralFrog's documents provided by a start-up that purchased the e-mail list shows that SpiralFrog's founder and CEO, Joe Mohen, authorized the sale days before creditors took control of the company's assets on March 13, 2009. Leading up to the sale, Mohen gave the list to Tim Bieber, a former SpiralFrog salesman, as compensation for back wages the company owed him, records show. Mohen did this despite SpiralFrog's promise to protect users' privacy.

"SpiralFrog will not share, sell, or trade personally identifiable information collected at the site with third parties, except as described in this privacy policy," the company said in its privacy agreement. "On a confidential basis only, SpiralFrog may share personally identifiable information collected at the site with corporate affiliates, consultants, or third parties performing a specific service or function on our behalf."

Documents show the sale of the addresses had nothing to do with a company working on SpiralFrog's behalf. Indeed, the sale took place weeks after the music service shut down. Mohen acknowledged to CNET News that there wasn't anything in his agreement with Bieber to prevent the former salesman from selling the list as many times as he wanted, to whomever he wanted. Bieber did not respond to numerous interview requests.

"The users who signed up with SpiralFrog were given the clear impression that their e-mail addresses would not end up in the hands of spammers," according to a former SpiralFrog employee with knowledge of the sale, who spoke on condition of anonymity. "Companies routinely promise to protect privacy and very rarely break it. SpiralFrog kept its promise until the day before shutting down."

In 2000, Arizona Sen. John McCain called for legislation that would prevent bankrupt Web stores from selling their customers' personal information without their knowledge.

(Credit: Greg Sandoval/CNET Networks)

In two interviews with CNET, Mohen acknowledged that in March, he "licensed" the user data. Mohen told CNET in June that to the "best of my recollection," the licensing deals complied with SpiralFrog's privacy agreement. Last week, however, Mohen said the agreement he had with Bieber, based in Vancouver, British Columbia, did not go far enough to protect customer privacy.

"In retrospect, I should have added tighter language to that agreement," Mohen said a week ago. "In the later days of the company, Tim Bieber was owed money by the company, and I struck an agreement with Tim to avoid litigation. To satisfy the liability, I licensed to Tim the user database."

Plenty of consumers suspect retailers of secretly sharing their information, but because of the shadowy way in which spammers conduct their business, tracking down the responsible party is nearly impossible. And once an e-mail list falls into the hands of spammers, it can be sold and resold.

Internet users often go to great lengths to protect their e-mail addresses from spammers. The history of the Web, however, shows that for dying start-ups, the temptation is to look upon the data as just another asset to be liquidated. The situation at SpiralFrog is similar to one that occurred when the dot-com bubble burst in 2000.

Nine years ago, CNET News reported that three dot-com failures, including Disney-backed Web store Toysmart.com, tried to auction off customer data the companies once promised never to share, such as credit card data and phone numbers. Members of Congress, including Arizona Sen. John McCain, argued that bankruptcy didn't give companies the right to break promises to consumers.

The Federal Trade Commission sued Toysmart and eventually blocked the sale. As part of a settlement, Disney agreed to purchase Toysmart's customer information for $50,000 and then destroy it.

Authorizing the sale
The sale of SpiralFrog's user data began sometime around March 27, when Bieber approached executives at the start-up that purchased the list, according to that company's attorney.

The start-up's lawyer, who has asked to remain anonymous, said that after wiring $8,500 to Bieber on March 31 to obtain the user e-mail list, the company has not shared or sold SpiralFrog's user information with anyone, and it has obeyed all laws in acquiring the list. To prove his point, the attorney said that when Bieber first approached the start-up about selling SpiralFrog's user addresses, executives there wanted proof that he was authorized to sell the list.

That wasn't a problem. Bieber had asked Mohen for written authorization two weeks earlier, documents show.

"Joe, I'll be needing something simple in writing from you authorizing me to (be) selling this database as part of remuneration," Bieber wrote in an e-mail dated March 12, the day before creditors took control of SpiralFrog. "So far, the list is useless without some paper authorizing its resale--even loose paper explaining the nature of how I came across the list...You dig. Let me know ASAP."

Click the image above to read our story on how a fractured management hurt SpiralFrog

Mohen then gave him rights to use the list "for commercial purposes on a nonexclusive basis" for six months. Bieber forwarded the document to the start-up that purchased the list. In addition, the start-up's executives met in New York with Mohen, who confirmed that Bieber had the right to sell the list, the start-up's attorney said.

It is unclear whether Bieber distributed the list to anyone else.

Mohen said SpiralFrog had stopped paying employees sometime in November 2008 and that Bieber had worked for an extended period without receiving compensation. On February 26, 2009, Bieber wrote Mohen that he was prepared to take legal action, if he wasn't paid.

"Joe, hope (you) got good news from your conference call last night. I file a lawsuit next week naming (SpiralFrog) and 3V (the hedge fund that loaned SpiralFrog money for nearly two years), unless you provide me with funds and a payment schedule by end of week...I'm hanging by (the) ends of my fingernails."

Editors' note: Go here to read some copies of SpiralFrog's correspondence.

In July 2008, two months before start-up SpiralFrog's aspirations were shredded by the souring economy and a series of management gaffes, the long knives were already drawn in the music service's executive suite.

In a private meeting, CEO Mel Schrieberg was stripped of most of his power after SpiralFrog's board grew tired of his heavy spending on salaries and ineffective marketing strategies. Even worse for Schrieberg, the man intent on driving him out was an old friend and one of his main allies at the company, founder Joe Mohen.

"The board wants him removed now," Mohen wrote in a July 21, 2008, e-mail exchange with Amir Khan, an executive at 3V Capital Management, SpiralFrog's biggest financial backer. "He adds no value at this time. The management will be very demoralized, if he remains."

The start-up's short, troubled history saw other clashes among managers. At the center of most of them was Mohen. He butted heads with his handpicked CEO, as well as SpiralFrog's board of directors and financial backers.

To Mohen, SpiralFrog "was all about him controlling the company, no matter who was in charge," Schrieberg, who maintained his CEO title from January 2007 to October 2008, told CNET News in a phone interview. But Mohen, who had founded the pioneering voting site Election.com, hardly deserves all the blame for what went wrong.

Schrieberg, a former IBM executive, had no operational experience in advertising or in music. In e-mails sent to several SpiralFrog employees, Mohen called some of Schrieberg's decisions "insane."

Adding to the management dysfunction was Scott Stagg, who managed 3V (now called Stagg Capital), the company that loaned SpiralFrog $34 million. For nearly two years, Stagg paid all of SpiralFrog's bills. Only sumo wrestlers are more likely to throw their weight around than Stagg, former employees have indicated, and even Mohen says management couldn't do much without first checking with Stagg.

On March 13, 2009, the music service was forced to turn over assets to creditors and shut down. To find out how a company that some called a potential iTunes killer so quickly turned into yet another dot-com flameout, CNET reviewed numerous documents and interviewed 13 people formerly associated with the company, including former board members, executives, and employees.

Certainly, SpiralFrog, which was trying to succeed with an unproven business model, wasn't exactly in an ideal position from the start. But former insiders, most of whom requested anonymity, say inexperienced managers who allowed petty squabbles to cloud their judgment didn't do themselves or their company any favors.

Could have been a contender
In December 2008, cash-strapped SpiralFrog appeared doomed. Entertainment conglomerate Viacom had expressed interest in acquiring a minority stake in the start-up three months beforehand, but the deal fell through. Yahoo would also eventually kick the tires on SpiralFrog but it also passed. Stagg, in a December 11, 2008, e-mail to SpiralFrog's board, from which he had recently resigned, sized up SpiralFrog's bleak financial situation.

"At this time, the company is out of money, all employees have been terminated, (and) over $8 million of payables remain outstanding," Stagg wrote. "There are multiple lawsuits with pending judgments, and the major music publishers, including Sony/ATV, Warner Chappell, and Harry Fox are expecting $550,000 of long overdue payments. Sony ATV is demanding a payment of $100,000 by Monday, December 15, which, if the company fails to meet, might force SpiralFrog to remove all of Sony ATV's content from the site."

Stagg may have overstated the situation a bit. Money would eventually trickle back in--virtually all of it from him--to help the company limp along while the board searched for an acquirer. There's no doubt, however, that at that time, SpiralFrog was nearing collapse.

Mohen, 53, acknowledges that mistakes were made. But, he added, what else could you expect? SpiralFrog was breaking new ground as it attempted to become the first service to offer music downloads free of charge to the public. In his version of the company story, everyone did their best and came close to turning SpiralFrog into a hit service, which attracted more than 2.5 million register users before closing.

What really killed SpiralFrog, according to Mohen and Schrieberg, 66, was the collapse of the investment-banking industry in September and the nation's subsequent financial meltdown. "There is not much you can do when funding and advertising sales go down precipitously due to economic conditions," Schrieberg said.

Until the economic meltdown, Mohen said SpiralFrog was on track. "It was all going to happen for us in October," he said. "We came a lot closer than people will ever know."

Although Mohen declined to specify how SpiralFrog's prospects might have changed in October, records show that company executives believed that a Viacom investment, which to them seemed imminent, would save the start-up.

The terms of drawn-up contracts, copies of which were obtained by CNET, called for Viacom to give SpiralFrog $100,000 in cash and $6.5 million worth of advertising on its MTV Networks unit. In exchange, Viacom would receive 4.3 million shares of preferred stock. The deal, if closed, would have valued SpiralFrog at about $120 million.

In September, at about the time the economy was becoming unglued, Viacom backed out of investment talks, and SpiralFrog's chances to survive the recession soured. One executive who did business with SpiralFrog and had seen the company's books said it's hard for him to conceive that anyone would have bought it. The source said the company's debt was just too big and complicated.

Who is in charge?
Headquartered in New York, SpiralFrog was a different kind of start-up from the get-go. It funded operations through loans. The company issued secured notes, essentially a contract whereby a company promises to repay at a certain interest rate.

After receiving $9 million in traditional equity funding in 2006, Stagg's investment firm began loaning SpiralFrog money in May 2007. Eventually, Stagg would lend the music service $34 million in convertible notes, which gave him the option of converting the loans into stock. Stagg said he never recouped the money.

So why go that riskier route, borrowing money? Most companies that can attract venture capital do. Taking out loans is less attractive because loans typically have to be repaid with interest, regardless of how the company fares.

Another way SpiralFrog differed from most start-ups was that it spent lavishly on salaries. Start-up CEOs typically ask for more equity in their companies rather than a big paycheck. It's common to see Silicon Valley managers earn less than $150,000 a year.

Not at SpiralFrog, which paid Mohen $360,000 a year in annual "consulting fees," documents show. Before he departed, former CEO Robin Kent was paid a $340,000 salary. Schrieberg's salary was $279,000.

A power struggle between Kent and Mohen paved the way for Schrieberg's appointment as CEO. In December 2006, Kent nearly drove Mohen out of SpiralFrog in a failed takeover bid. Mohen barely had enough board votes to keep control, and Kent, who had become CEO only seven months earlier, was sent packing. Just days after that, Mohen handed SpiralFrog's CEO position to Schrieberg, whom he had known for 11 years, Schrieberg said.

It was a questionable call. According to several former employees, to entice users of illegal peer-to-peer sites to SpiralFrog's legal and free music service, the company needed a CEO with a strong background in advertising and music. Schrieberg, who spent most of his career as a sales manager at companies like Xerox and IBM, had neither.

Power struggle
In early 2008, Schrieberg spearheaded a massive search engine- and affiliate-marketing campaign that would eventually cost the company $11 million, records show. The strategy was successful at drawing visitors but failed to generate lasting interest. Most people stayed a few minutes, viewed a few Web pages, and moved on. The practice of paying for traffic was supported by the board of directors and Mohen, but eventually, they lost faith in the strategy and in Schrieberg.

Perhaps not surprisingly, by the summer of 2008, it was becoming apparent that Mohen, Schrieberg, and Stagg were competing for control of the privately held SpiralFrog, former employees say. SpiralFrog was dependent on Stagg's money, which gave him considerable influence. Schrieberg had the board behind him at least until July. Mohen's personal financial troubles and feuding with fellow board members, meanwhile, sapped much of his power.

Despite his significant consulting fees and the private sale of some of his SpiralFrog shares, Mohen took out a personal loan of $115,000 in 2007 from a financial-services firm that was doing business with SpiralFrog, records show. He acknowledged to CNET News that he has not yet repaid the loan.

Schrieberg said Mohen asked him to be the guarantor of an American Express card that Mohen would use for business expenses. And since it was Stagg covering those expenses, he could deny any charge. That made Mohen beholden to Stagg as well as well as Schrieberg, who said he was never reimbursed for more than $40,000 that Mohen rung up on the credit card.

As for how he got into financial trouble, Mohen suggested that it was because of SpiralFrog's collapse. "I risked everything on the company," he said, adding that he invested $400,000 of his personal wealth, an amount he says he never recovered.

But why would Schrieberg share his card with Mohen? Schrieberg said he was just trying to help him out. Several former employees said, however, that Schrieberg went to great lengths to ingratiate himself with board members, including Mohen.

During the two years Schrieberg was CEO, the company hired the sons of board members Steve Norcia, Tom Mackell, and Bob Gordon. Schrieberg confirmed this but said the board member's sons were well-qualified.

Hiring relatives of board members can be problematic, according to corporate-governance experts. Employees can file discrimination suits, if they believe that a board member's relative was given a promotion that rightfully should have gone to them. Schrieberg said all the hires were cleared by the company's legal counsel. He also denied that such decisions made him unpopular with SpiralFrog employees. On the contrary, he said, "I was revered."

Click on the image above to see a full AOL invoice that led SpiralFrog's board to strip CEO Mel Schrieberg of most of his authority.

Nonetheless, Schrieberg lost the board's backing on July 21, when a $974,000 invoice from AOL, for affiliate-marketing services, reached the desks of Mohen and other board members. The bill was a shock; Schrieberg had told the board that the costs add up to about $600,000, according to 3V's Khan. In an e-mail exchange between Mohen and Khan, who was also a board member, Mohen lobbied for 3V to oust Schrieberg.

"(Schrieberg) needs to be kept out of the office," Mohen wrote. "When I saw the invoice today, I realized how serious this is...At this point, the majority of the board and senior-(management) team find him incompetent...Make him vice chair, and pay him for his cooperation."

Khan replied that Schrieberg was "CEO only in name. His duties are all gone to me." But Khan stopped short of agreeing to remove Schrieberg. "We can't have another CEO leave," he wrote.

Schrieberg said he resigned of his own volition in October. But he acknowledged that Mohen came to him sometime around July 21 and told him that Khan would be taking over most of the CEO duties. He said he agreed to go along with the plan because Stagg and 3V were already calling most of the shots. But Schrieberg strongly maintains that he performed well at SpiralFrog and that the board and senior management were aware of "every penny" he spent as CEO.

Starting over
In an interview, Khan and Stagg said Schrieberg was kept around because of the ongoing Viacom negotiations. Stagg said he and the rest of the board believed that removing Schrieberg would have rattled the entertainment conglomerate, which had expressed interest in obtaining a minority stake in SpiralFrog. With Stagg's blessing, Khan and some of his lieutenants at the hedge fund tried operating the start-up for several months without any official titles. In an interview, Mohen called this effort a disaster.

Click the image above to read our story on how SpiralFrog's founder, Joe Mohen, enabled a former employee to sell customers' e-mails.

"The management team to a person was alienated by Stagg's people," Mohen said. "That was because they tried to operate a business, and they didn't have the skills to do it."

In mid-September, the wheels came off. Viacom declined to invest in SpiralFrog. Stagg continued to provide some funding, but only a small percentage of what he once did. In November, Mohen gathered employees still left and told them that the company would not make payroll.

The situation was tough, but there was a brief upside for Mohen: without Stagg's money, SpiralFrog's management no longer had to placate him, former employees said. Mohen was named interim CEO and began looking for new investors. He tried convincing 3V to continue funding the company by threatening to steer SpiralFrog into bankruptcy and start all over with a new company.

Still, everyone knew that such an endeavor would be impossible, according to Stagg, because the licensing deals that SpiralFrog had with Universal Music and EMI were nontransferable. If SpiralFrog went bankrupt, Mohen would have to renegotiate for new music licenses.

Stagg made several unsuccessful attempts to take control of the board but always failed. "The truth is, we never had control (of the company) because we never had control of the board," Stagg said.

Click the image above to see copies of some of SpiralFrog's correspondence.

Proof that Stagg and 3V did control SpiralFrog could potentially cost the investor more than he's already lost over it. Antaeus Capital, a financial-services firm that began working with SpiralFrog in 2006, has asserted in a lawsuit that the start-up breached several agreements. The complaint, filed last November, alleges that SpiralFrog was really Stagg's property and that he should make good on the money the company owed. The case is still moving through the courts.

In the end, the current suit is a fight over the bones of a dead company. SpiralFrog's domain name was sold in May to MyMojo, a mobile-content site, for $20,000, sources say. After three years' worth of turf wars, more than $40 million worth of loans and investments, and a long list of unfulfilled promises, that's pretty much all that was left.

Below are several e-mail exchanges that were obtained by CNET News during a review of SpiralFrog's rapid rise and fall. For the complete series about SpiralFrog's collapse, please go here and here.

The first chain focuses on Amir Khan, one of SpiralFrog's financial backers, and his skepticism about SpiralFrog's marketing strategy in the summer of 2008. The second thread is a debate between Vesa Suomalainen, SpiralFrog's former chief technology officer, and Joe Mohen, the company's founder and chairman that occurred last fall.

It should be noted that the e-mail exchanges were originally forwarded to multiple people, and copies were subsequently forwarded to CNET from multiple sources. E-mail addresses, phone numbers, and other personal information were removed. Grammar was not corrected. The e-mails were placed in chronological order to make them easier to read.

Editors' note: In the first exchange, the recipients were members of SpiralFrog's board. Orville Hagler, a SpiralFrog employee, was CC'd.

From: Mel Schrieberg
Date: Sun, 13 Jul 2008 09:53:05 -0700
To: Hughes, Al; Amir Khan; Gordon, Bob; Preston, Frances; Gold, Jerry; Joe Mohen; Levin, Jordan; Hutchens, Mark; Strama, Mark; Stagg, Scott; Norcia, Steve; Mackell, Thomas Mackell.
CC: Orville Hagler
Subject: Traffic Analysis

The board committee on traffic analysis that includes Scott Stagg, Amir Kahn, Jerry Gold, Steve Norcia and me, met on the afternoon of Wednesday, July 9th. It was a very productive meeting given the complexity of the topic. As a result of our discussion, the consensus was that we serve two constituencies, that being strategic alliances and the advertising community, and our hypothesis is that these two entities have different criteria on how they view the company. To gain further insight with respect to strategic alliances, we developed a series of questions that I will pose to Jimmy Barge to better clarify Viacom's position. At this point, we believe that we need to grow our monthly uniques while migrating to quality visits.

From a tactical perspective, last Thursday, July 10th, the company achieved its highest daily uniques at 295,228, and we are pacing at 7,615,277. Our current spend is the same as last month, thus we are proportionately gaining traffic virally. I plan to decrease our spend towards the latter part of the month, which will result in approximately 7.1 million monthly uniques. Concurrent to this, I will start migrating to our Phase II quality traffic programs.

Thank you,
Mel

----- Original Message -----

From: Amir Khan
Sent: Sunday, July 13, 2008 4:20 PM
To: Mel Schrieberg
Cc: Orville Hagler
Subject: Re: Traffic Analysis

I am having 2nd thoughts. My friend came to visit the company on friday and he asked very pointed questions to which we had no answers about refresh rate and pages per visit compared to facebook etc., which we keep comparing ourselves to. If u look deeper our traffic numbers are a house of cards. I know him for 20+ years and there is no way he will invest in the company with such metrics. We need to discuss this again.

Amir Khan
Portfolio Manager
3V Capital Management

----- Original Message -----

From: Mel Schrieberg
Date: Sun, 13 Jul 2008 20:15:52 -0700
To: Amir Khan; Hughes, Al; Gordon, Bob; Preston, Frances; Gold, Jerry; Joe Mohen; Levin, Jordan; Hutchens, Mark; Strama, Mark; Stagg, Scott; Norcia, Steve; Mackell, Thomas J.
CC: Orville Hagler
Subject: Traffic Analysis

Amir

To your point we do know what our page views and refresh rates are but you are right we do not know how they compare to Facebook etc, - we are not comparing ourselves to social network sites in that they are not the model we are following - our site does not have any objectable content and therefore we are able to attract the Tier I advertisers where your social network sites can only obtain a CPM of $1;50 and we have averaged $14-16 and recently have an ad campaign with AT&T - their "blue room promotion" where we obtained a $26.00 CPM.

The reason we have compared ourselves to Facebook is strictly one of gross traffic and I strongly believe if we were to make ourselves more of a social network site our traffic would be larger but it would defeat our economic model

I do not think our traffic is a house of cards - our phase one approach was to build traffic as quickly as we could, so that we could attract strategic partners and tier one advertisers and then migrate this traffic which we have stated to do, to enhanced quality programs. There are many sites Rhapsody being one that spends considerably more money on traffic enhanced programs and don't come close to our results. To expand upon this I have spent a considerable amount of time with AOL and Advertising .com executives, (recently a two day meeting in Baltimore with 14 of their executives in attendance) many of which have spent ten years on growing website traffic and they have not seen a site grow so fast. - the key to this is we have been able to converge the discovery and acquisition of music on our site - our pre -qualitative market research determined that this would be critical to our success. Yes, I would like to see greater stickiness to the site but please remember that up until now we have had only one music major. We have conducted three post launch focus groups and the main reason they have not come back to our site was not having a greater selection of music - this is now changing with the ingestion of EMI.

Amir, I would be happy to met with your friends again and clear up any miscommunications, I found them to be very bright and articulate and we might have not made ourselves clear on our business model; Your point is well taken on better site metrics, we are working on improving this area but as I stated at out committee meeting we can only determine the number of clicks for each of our programs (receive these from the vendors - Google, Yahoo, MSN, Advertising ,com etc.) but we cannot measure these as accurately as would like to with respect to the method Nielsen measure uniques - would take additional funding to outsource this capability

Thank you

Mel

----- Original Message -----

From: Scott Stagg
Sent: Sunday, July 13, 2008 11:54 PM
To: Mel Schrieberg; Amir Khan; Hughes, Al; Gordon, Bob; Preston, Frances; Gold, Jerry; Joe Mohen; Levin, Jordan; Hutchens, Mark; Strama, Mark; Scott Stagg; Norcia, Steve; Mackell, Thomas J.
Cc: Orville Hagler
Subject: Re: Traffic Analysis

I agree with mel and disagree with amir. We all are in agreement that our first objective was to grow uniques which we have done and there is clearly some disagreement about what our next step is, whether to continue growing uniques which the advitisers seem to want, or slow the unique growth and increase quality. To me, it is all about impressions and if the choice is to get there with more uniques and less pages turned vs less uniques and more pages turned, with both equaling the same amount of impressions, then I would choose the higher uniques.

Mel, could you please try to find out how many pages visitors average on facebook to potentially answer amirs friends concerns.

And amir, could you tell us exactly what you and your friends concerns are and what info you need from mel. Many people have put in an extraordinary effort to get where we are and this is far from a house of cards. Sent via BlackBerry by AT&T

----- Original Message -----

From: Amir Khan
Sent: Monday, July 14, 2008 2:19 AM
To: Scott Stagg; Mel Schrieberg; Hughes, Al; Gordon, Bob; Preston, Frances; Gold, Jerry; Joe Mohen; Levin, Jordan; Hutchens, Mark; Strama, Mark; Norcia, Steve; Mackell, Thomas J.
Cc: Orville Hagler
Subject: RE: Traffic Analysis

Mel & Scott,

My concerns stem from the following:

1. We are embarking on a massive capital raise. The investors we are and will be encountering for this round will be more sophisticated and we are having a hard time convincing people of the valuation of the company even after signing 2 majors and all the independents. If we are discussing raising money using the same instrument as our round last may, then clearly something is wrong.

2. Our entire financial model is based on a steady state mid teens pages turned per visit out in the future. While we are managing our uniques per month number pretty well, we are currently running at 2.6-2.9 pages per visit (public info as per alexa) instead of our presentation predicting 6-7 in July to Dec phase, with correspondingly low time spent on site. Therefore our available impressions are running at 40-50% of the model we are showing to investors. Just as we seem to be targeting uniques, we need to manage the pages per visit as well otherwise it will call into question the entire financial model. If we keep growing uniques per month but pages per visit lags, guess what - impressions served will be well below model projections. To put it bluntly, while we are 15x our Oct 07 uniques, we are just 2.5x Oct 07 impressions served. If I were looking at the company afresh, I would not buy the improvement in uniques quality assumption in our model without assuming a fall in uniques. Its just not possible!

3. The people we seem to be attracting to our site from the affiliate marketing programs are NOT interested in music. 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. I remember Jerry on the conf call could not digest that either. When my friend, Jassi, who recently sold his company at a nice price, and understands this space stayed focused on the quality of the uniques and we did not answer his question directly, I got more concerned. If we are going to compare ourselves to facebook, youtube in terms of total traffic, we must expect questions regarding the quality of traffic as well. Anecdotally, Saurabh, our intern last year who was a big facebook user turned probably 25-30 if not more pages per visit. I doubt if facebook, myspace, youtube or any of the beacons of the new internet age have ever relied on affiliate marketing. Their VC sponsors would not have allowed it. Finally I believe its entirely possible that youtube/myspace went to acquirers and told them we don't have a salesforce but you do and you can make this much money from us. By having a salesforce with 4-5 senior guys plus a bunch of juniors and not having a decent pipeline, are we telling the world that perhaps the model is faulty? Even if we assume we get a 15 CPM and myspace gets a 1.50 CPM, and if we have 2.6 pages per unique vs 25 per unique for them, we end up with the same gross revenue with the same uniques but we would have a bloated marketing cost, where they would have none. Add to that the fact that their inventory costs them zip, and we have large upfront acquisition costs and we end up keeping just 33% of our revenue (if we are lucky to use up the recoupable advance) hence on a net revenue basis we would be 1/3rd their net revenue with a bloated marketing expense. So before we start dreaming of youtube valuations, we have to get our perspective straightened out.

4. The investor presentation calls for a 2008 marketing spend of 7.9mm. If last month our total spending was 1.1 or 1.2mm, and we add to that what we spent in the other months so far, we will probably have just 3-4mm left for the rest of the year or 500k-670k per month (and we must include all sorts of marketing in this calc). If we require 1.1-1.2mm to get us from 5mm to 6mm, how come we will require lesser to keep increasing uniques?

5. If we keep buying traffic and we do ramp uniques to 10mm, we will have an even harder time bring up pages per visit from under 3 to plan, as compared to doing it now. We must improve the quality now, and stabilize traffic rather than aim for 7mm+. We can not become uniques addicts at the expense of quality. We got it above 5mm, let's just manage it within a range, all the while replacing affiliate programs for better programs.

6. If spiralfrogclub generated just 10,000 emails, and the Alicia Keys program (from which we expected 4mm new uniques) generated just 3,000 new uniques, we should make sure we don't commit the same mistake again. These viral programs accomplished just 1 thing - they made me sick. I am unwilling to see a single program we have in the works fail. And there have to be accountability and repercussions for any marketing failures going forward. I don't know whether we pulled resources from other projects to work on these as well so besides money; opportunity cost, manpower redeployment etc also need to be accounted for. Did these happen at the expense of release 3.0 or other enhancements which would make new visitors stick to us? And with the affiliate programs, are we doing the same?

7. If google adwords leads to more registrations, these people will probably come back and hence we should look at cost per pages visited by unique per program not just cost per unique. If we did that chances are the 28 cent to 8 cent comparison will look a lot closer. Furthermore don't we think search engine optimization is a better tool to drive people who are actually looking for music than affiliate marketing? I also believe we must do away with the email requirement. We can let the user choose a user name/password and let him decide if he wants to give us his email/tel no for email/text updates etc. That will be a lot more acceptable in the age group we are trying to serve. I remember arguing about this back in Dec with Roger Munford and I still don't think people like to give out email addresses for fear of phishing etc. If we are competing with pirate sites, we must understand the behaviour of our target audience.

8. Whatever happened to alliances with mp3 player manufacturers, cellphone companies, and generally anybody who would benefit by pushing us? Should we not have banners on their sites or make Samsung mention "compatible with spiralfrog.com"?

9. Our first priority has to be content acquisition, at the expense of every single thing including sales, uniques, salaries etc. I also believe we should line up a buyer who would buy us provided we got Sony BMG and WMG. With capital markets being the way they are, we can not rely on the assumption that a 20mm round is definitely going to happen. In my mind, its very hard to justify new hires, more marketing spend as time goes by especially with the markets being the way they are.

Having said all that, its not too late to rectify our message to investors to reflect what we have been doing. Our model needs to be more believable and yet we need to show a better sales pipeline. A 2.4mm pipeline is just not acceptable after having hired so many people in sales lately. Its possible that a strategic out of the 20 possible strategics will value our uniques differently but we cant believe that. We must be able to convince more people - I hv heard too many comments about potential investors peeling back the layers and not being impressed with uniques quality.

AK

Editors' note: The e-mail exchange below occurred last fall between Vesa Suomalainen, SpiralFrog's chief technology officer, Joe Mohen, the company's founder, and Matthew Stern, vice president of marketing. Others who received the e-mail were a combination of managers from SpiralFrog and 3V Capital Management, the start-up's main financial backer.

From: Vesa Suomalainen
Sent: Thursday, September 25, 2008 1:38 AM
To: Jesse Paynter; Matthew Stern
Cc: Joe Mohen; Amir Khan; Michael Puccini; James Campbell
Subject: business case for paid search?

I have not seen this written down anywhere, so I thought I'd take the initiative so we can allagree on the numbers before making a decision whether it makes sense to continue spending money on paid search on Google, Yahoo and MSN adwords. Please feel free to correct if I got any of this wrong.

We've been spending up to $600K on paid search per month over the last several months. For the most recent month that I have detailed numbers (June), we paid roughly $530,000 for 2.65 million.adword clicks, resulting in just over 140,000 user registrations. Each click cost us approximately 20 cents, and the regitration rate from paid search was roughly 5.4%.

This means it is costing usabout $3.70 per registered user obtained through paid search. At an average 6.5 pageviews per visit (latest month stats from Google Analytics), we're earning roughly 3.25 cents per user visit in ad revenue (assumptions: 2 ads per page, average $5 CPM, 50% of ad inventory sold each month). It would take 114 visits per user to earn back the money spent on paid search to break even. And that's assuming we'd keep 100% of the revenue - not figuring the 66% royalty due to the music content owners.

It is therefore difficult to arguevia a business case to continue funding paid search. The per-click rate is simply too high for an ad-supported business. Paid search ads are primarily designed for businesses that sell goods for relatively high prices - using paid search as a method to drive traffic for an ad-supported site would be difficult to support even if the conversion rate (from click to registration) would be 100%.

The obvious concern is what would happen to our traffic and ad sales if we stop paying for adwords? For one, our unique visitor numbers would drop by the corresponding number. However, since nearly 95% of paid search clicks end up in just one or two pageviews, our average pageview count would go up dramatically - and the # of total pageviews would drop but not by the same ratio as unique visitors. There's clearly a cost to this, but it's very difficult to argue that the downside is worth the guarantee of losing money on every dollar spent.

The other statistic that ought to dramatize the paid search cost number is this: 12 months after the launch of the site, where one would expect numbers to have stabilizedfrom the early peak in marketing spend and the initial delay in sales revenue, we're still spending upwards of 300% of our revenue in marketing costs (I don't have the latest sales figures so I could be off here a bit) - whereas e.g. Napster which was losing money every quarter due to their high marketing spending was using about 25% of their revenue to drive traffic.

There seems to have been universal agreement that our affiliate marketing program (Platform A) was not appropriate for our site given the high cost and the low conversion ratio - but I'd suggest the paid search is not much different. It will be difficult to defend this amount of sustained marketing spending to a new incoming investor who's going to scrutinize our business model and numbers carefully before making an informed investment decision. There are other, more inexpensive methods to drive traffic that we should pursue - e.g. traffic sharing programs with other sites or lower-cost pad clicks with music discovery sites. Paid search has an obvious cost incompatibility with our pennies-per-visit banner-ad-based business model.

----- Original Message -----

From: Matthew Stern
To: Vesa Suomalainen; Jesse Paynter
Cc: Joe Mohen; Amir Khan; Michael Puccini; James Campbell
Sent: Thursday, September 25, 2008 2:31 PM
Subject: RE: business case for paid search?

I agree with the sentiment (decrease dependence on paid methods while searching for alliances - barter or otherwise), however the metrics have been getting better since June. I will do a full reconciliation at the end of the month, but judging on pacing so far, this is what we see:

September will see the highest ever monthly membership total (30% higher than June) yet September versus June member acquisition costs are 63% less expensive September will see the highest ever impressions served (16% higher than June) yet September versus June cost per impression are 58% less expensive Page/visit September versus June are 70% higher (7.45 vs. 4.39) Time on site September versus June are 140% higher (8 minutes vs. 3:20)

NOTE: The improvements are from finding alternative and less expensive banner programs that also deliver better metrics versus Platform A's incentivized traffic. Also, I do not include the NFL costs in September - the $200,000 spend netted 8,175 clicks and 407 registrations.

Finally, to bring this full circle, there have been fruitful discussions with like-music sites to swap traffic and share revenue...stay tuned.

----- Original Message -----

From: Vesa Suomalainen
To: Matthew Stern
Cc: Amir Khan; Peter Desloge; Michael Puccini; James Campbell;
Joe Mohen; Jesse Paynter
Sent: Thu Sep 25 18:21:50 2008
Subject: Re: business case for paid search?

I'm afraid you're missing my main point. We must adjust our user aquisition costs and methods to fit our own revenue model for it to make sense. We've now proven that any amount spent on paid search or other cost-per-click advertising is guaranteed to lose us money. The oher point is that the amount spent on marketing in a given month should be a sensible proportion of our own ad revenue - not a multiple of it.

According to a spreadsheet by our SEM vendor Bluemark, we've paid for 15.6M adword clicks across Google, Yahoo and MSN since February 2008 at an average price per click of just under 20 cents. This amounts to a total of $3.12M. This number is astounding - and does not include the other marketing programs (Platform A, Alicia Keys, NFL etc. etc.).

The NFL promo seems to have a set a new record for our user acquisition costs - $491 per registered user. Paid search looks rather attractive in that light....

The other obvious consideration is our present funding situation. When we're having trouble paying emlployee salaries and basic expenses, it is the wrong priority to spend money on marketing programs that can at best be called loss-leaders. In my view, we should hunker down for a while and get our content catalog and site features enhanced, build no-cost traffic sharing partnerships, establish a strategic alliance or two, get more funding and then relaunch.

----- Original Message -----

From: Joe Mohen
To: Vesa Suomalainen; Matthew Stern
Cc: Amir Khan; Peter Desloge; Michael Puccini; James Campbell; Jesse Paynter
Sent: Thursday, September 25, 2008 6:32 PM
Subject: Re: business case for paid search?

The only caveat I would throw in here is that paid search would make sense if the acquired users were to return to the site more often. Put another way, if our 2.4MM registered users came back twice a week, then we might view this differently.

While u r correct with the NFL digitally there were also approx 6 TV spots that went with it, and that mitigates this, although we can't say how much

----- Original Message -----

From: Vesa Suomalainen
Sent: Friday, September 26, 2008 11:48 AM
To: Joe Mohen; Matthew Stern
Cc: Amir Khan; Peter Desloge; Michael Puccini; James Campbell; Jesse Paynter
Subject: Re: business case for paid search?

I believe we have established that we end up losing money even if the users acquired through paid search keep returning to the site.

To be fair, let's adjust my calculation below to grant that registered users end up spending more amount of time on the site than the average - which is skewed downward by those paid search users that end up quickly leaving the site. From Google Analytics stats for October 2007 (when we had no paid search programs ongoing), the average pageviews per visit was 14 and # of visits per user per month was 2. These numbers are very close to our original business plan assumptions.

Let's even use an average of 15 cents per paid search click. And a generous conversion rate of 10% to become registered users. And blindly assume all registered users end up becoming permanent members. Each such user would cost us hence $1.50. At 14 pages/visit we'd earn 7 cents per visit in ad revenue (2 ads per page, $5 CPM average, 50% of ad inventory sold). Next, we'll need to adjust this to subtract 66% royalties due to music owners - leaving us 2.38 cents per visit. It would therefore take 63 visits from each such user for us to break even. At an average 2 visits per month, we'd need each user to become an active SpiralFrog member for over 5 years to make this work financially. Our present stats show that a registered user stays active an average of less than 2 months.

We can therefore conclude that paid search and cost-per-click advertising is permanenty incompattible with our business model. Even with the generous assumptions made above, there's no way to make the numbers work in our favor.

It would be helpful if someone could send a note indicating our ad sales per month and % of ad inventory sold each month. For too long, we've lived in an environment where some of this data was kept secret, disallowing us to make rational decisions elsewhere. I've heard that one of the main arguments in favor of continuing with paid search is our ability to earn ad impressions already sold - but if you believe in this logic, it's akin to spening more money so we could keep losing even more.

----- Original Message -----

From: Joe Mohen
To: Vesa Suomalainen; Matthew Stern
Cc: Amir Khan; Peter Desloge; Michael Puccini; James Campbell; Jesse Paynter
Sent: Friday, September 26, 2008 8:54 AM
Subject: RE: business case for paid search?

I think it is more complex. While I more or less agree with your points, there are more variables.

First, is our ad sales are in their infancy. It is too soon to judge marketing costs relative to them.

Secondly, it is true that you need a certain amount of "uniques" to get the attention of customers and key industry players. If our uniques fall below a certain level, potential customers will not take our meetings, and partners will not take us seriously; even Viacom might walk away. You will not get into meetings. While most of what Mel did was insane, there is some truth to this point.

Thirdly, the key business variables are how often users come back to our site. We need more data points on this. I think it might make sense for you to go through all the FEEDBACK emails (starting with right after EMI was added), to see what people are telling us about our site, what they like about it, what they do not. You did a good job of this late last year, and it would be interesting to see what they are saying now.

It might also be useful to read the SpiralFrog blogposts, to see what real users are writing.

----- Original Message -----

From: Vesa Suomalainen
To: Joe Mohen; Matthew Stern
Cc: Amir Khan; Peter Desloge; Michael Puccini; James Campbell; Jesse Paynter
Sent: Friday, September 26, 2008 10:02 AM
Subject: Re: business case for paid search?

For a while, I guess we all were sold off on the "mometum theory". The belief was that if we demonstrated solid user growth and increased # of uniques, 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 outrigth cheating, at least self-deception. 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 uniques # to continue growing. Anyone who'd ask us direct questions about average # of time spent on site or average # of pageviews, or retention of registered users would immediately find out our little secret. And these figures stay permanently in our books for incoming investors to look at and ask us after-the-fact. How do we explain spending $1.5M in marketing in the month of June when our resulting revenue was $69,711? An ooops?

This is our opportunity to start fresh and blame the months passed as a failed experiment. I'd argue that our main problems are lack of music content and lack of site features - fixing these two is key to our future success. If there's one aspect I'd like to emphasize above all is that the unbalanced and incorrect focus on paid marketing is sapping our resources for money, development resources and management attention - besides being counter-productive to our overall goals.

Next week, we hope to add the IODA catalog to our live site - this is 1,081,028 additional tracks, bringing us close to the 3M track marker. And this aggregator catalog is multiple times more relevant than the similar-sized Orchard label which is mostly unknown European music. Do we have a marketing program ready to go when this catalog goes live?

And our main problem in getting these 1M tracks online quicker? Finding a soul in this company who's able and willing to pay for the $2,000 that it cost us to buy the hard drives required to ship the content from Seattle to our production data center in Ashburn. I find it somewhat ironic to be discussing spending priorities of several millions and a few thousands in the same email, but here you go.

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.

Three years ago this month, the Financial Times and The New York Times chronicled the emergence of an untried but promising new digital-music service: SpiralFrog.

Some of the hurdles that contributed to SpiralFrog's spiral out of the sector are the same confronting former rivals.

The start-up would offer music free of charge to consumers and attempt to hand the bill to advertisers. Since then, we've seen a dozen companies make names for themselves by offering their own twist on the ad-supported music model, including MySpace Music, Imeem, and Pandora. But regardless of how anyone has tweaked it, not a single service in the still-nascent sector has proven that it knows how to offer consumers a compelling free-music service while providing advertisers an effective way to deliver their messages.

Music fans generally refuse to pay to listen online and resent on-site advertising. The hard truth is that to this point, ad-supported music as a standalone business has failed.

Ruckus and SpiralFrog have closed their doors. Imeem faced a financial crisis earlier this year, until receiving new funding from investors and price concessions from the music labels. A year after Qtrax obtained licenses from all four of the top recording companies, the company appears to be struggling to pay its bills and has yet to launch.

In May, CNET News reported that MySpace Music's performance has underperformed. Several music sites have overhauled their business models (Lala) or are trying to do so (iLike).

Pandora's popular iPhone app, meanwhile, has helped spur user growth, but the company has also opted out of ad-supported music for the site's heaviest users. The company said last month that those tuning in for more than 40 hours a month must pay 99 cents to continue listening.

And if you're waiting for the Swedes, in the form of white-hot music service Spotify, to come charging over the hill to show us how to make the model work, you needn't bother. Three industry sources told CNET News last week that the service--expected to debut in the United States next year--is struggling to convert users into paying customers. Just like others on this side of the Atlantic, Spotify hasn't figured out how to make money.

CNET News has recently completed a two-month examination of SpiralFrog, the now-defunct download service that was among the pioneers of the ad-supported model. The review provides an unprecedented view of the many challenges facing companies in this sector. SpiralFrog's tale sheds light on the kind of rates advertisers are willing to pay and the licensing fees the top music labels charge. None of it is very promising.

There's no doubt now that the much-hyped SpiralFrog was never among the front-runners. The service offered music from only two of the four top recording companies. Users couldn't download SpiralFrog's tunes to their iPods. And documents show that the start-up spent millions of dollars on marketing but never attracted a loyal following of significant size.

There may be a temptation to dismiss SpiralFrog's problems as unique to the company. That would be a mistake. There's no question that some of the same factors that stymied SpiralFrog are bearing down on many of the company's former rivals. "This version of ad-supported model is certainly on life support," said Mike McGuire, an analyst at research firm Gartner. "I think we can say this round didn't quite work."

Migration to downloads
One sign that some players in digital music are losing faith in the ad-supported model is the rise in companies looking to sell downloads, according to one music industry executive. "That's become the fallback position," the source said.

A copy of a $1.8 million bounced check written by Qtrax to Oracle, which filed a breach of contract and copyright lawsuit last month against the yet-to-be-launched music service.

(Credit: Screenshot by Greg Sandoval/CNET)

All four of the major music labels declined to comment for this story.

Imeem, which has mostly focused on streaming ad-supported music to users' PCs, has recently begun testing a download store. Music industry sources told CNET News last month that iLike, which powers Facebook's most popular music service, was in talks with the major record companies over licensing downloads.

For two years, Imeem has posted links to Apple's iTunes and Amazon.com's MP3 service on its site to enable visitors a means to buy songs. MySpace Music, YouTube, Pandora, and Spotify do the same. But Imeem is testing how effectively it can sell a limited number of tracks from Warner Music Group and several independent labels directly to consumers.

Selling downloads directly, rather than linking to another retailer, is more lucrative. A music site that sells downloads can make 30 cents from direct sales rather than the 5 cents that the so-called affiliate partners pay, according to an industry source. The trick for any upstart download store is to convince customers of Apple's iTunes and Amazon's MP3 service--by far the leading download stores--to try a new outlet.

Nonetheless, the behemoth record labels are willing to work to help ad-supported sites survive. Imeem is the poster child for how the labels have changed their approach to these services. Founded in 2004, Imeem came very close to running out of money until it found new funding and also negotiated better licensing deals with the labels earlier this year. Some of Imeem's rivals asked and received similar concessions, industry sources said.

That hasn't stopped the complaining, however. The people who run digital-music stores continue to quietly argue that licensing fees charged by big record companies are still too high for stores to eke out a profit. Music industry insiders say it's not their fault that the start-ups have failed to win over advertisers. What are they supposed to do--give their content away? That won't happen, executives say.

Overpaying for music
CNET News' review of SpiralFrog showed that in 2006, SpiralFrog agreed to pay $3.2 million to Universal Music Group, the largest of the top four recording companies, in up-front fees. Documents indicate that in 2008, SpiralFrog set aside $3.5 million to license music from EMI, the smallest of the major labels. That deal triggered a "most favored nation" clause in Universal's contract, and SpiralFrog ended up paying an additional $1 million to Universal.

From a SpiralFrog June 2008 expenditure list. Note: SpiralFrog had no licenses with Warner or Sony. Figures represent amounts the start-up expected labels to charge.

Although SpiralFrog managers never secured deals with Sony Music Entertainment or Warner Music Group, the music service budgeted $5 million and $3.3 million, respectively, to acquire licenses from those services, records show. Those figures were all minimums. Under the agreements reached with Universal and EMI, had SpiralFrog made revenue above those minimums, the company would have been required to split that revenue 50-50 with the labels.

By the time SpiralFrog compensated the labels and music publishers, the company's managers figured that 66 percent of their revenue went to the music industry, records show. SpiralFrog's deal with the major labels was different from those negotiated by most music-streaming Web services, which pay penny-per-play rates. Their agreements are to pay a cent, or some fraction of a cent, each time a song is played.

It appears that it made little difference whether the record companies got their money before or after a sale. The rates they charged forced ad-supported companies to generate big ad revenue in order to cover costs.

SpiralFrog, for its part, never came close to covering costs, documents show. The start-up lost more than $26 million in 2008.

Advertisers are simply unwilling to pay the music sites a premium rate. In order to charge advertisers $10 for 1,000 impressions, ad-supported sites must operate their own sales teams, which is expensive. In SpiralFrog's case, the company's salespeople were successful at signing a few marquee advertisers, including McDonald's and Microsoft, but much too often, the company found itself selling excess ad inventory through remnant ad networks, which typically pay 50 cents or less for 1,000 impressions.

Advertisers aren't willing to give the ad-supported sites top dollar because they know that people aren't necessarily staring at a computer while listening to songs online. Instead, they tend to check e-mail or Facebook, do homework, eat dinner, or browse the Web in other browser tabs. In contrast with radio, Web listeners have become accustomed to music without audible ads embedded into the streams--and they don't want those ads, according to Gartner's McGuire.

Another gripe that advertisers have is that many ad-supported sites don't reach big enough audiences. Mel Schrieberg, SpiralFrog's former CEO, said SpiralFrog couldn't get in the "tier 1" advertising door with fewer than 5 million users. To generate this kind of traffic, SpiralFrog spent $11 million in 2008 on search engine and affiliate marketing, which gobbled up the little revenue the company was able to generate.

But Susan Kevorkian, a digital-music and mobile-entertainment analyst at IDC, points out that a large audience doesn't mean instant success. Although MySpace Music has access to the social network's shrinking but still large audience, she said the service still "hasn't performed to industry expectations."

Is there any hope?
One bright spot is that some investors are sticking with the sector.

In addition to Imeem, Spotify and Pandora found new funding. Investors including British venture capital firm Wellington Partners were part of a $50 million round of financing for Spotify, according to the Financial Times. And Pandora last month announced that it had raised $35 million of additional funding.

Ali Partovi, iLike's CEO, argues that the ad-supported model works for music, but not when you're giving songs away.

"We've built a self-sustaining ad-supported business--positive cash flow over the past eight-month period," Partovi said. "That's with only one full-time ad salesperson. What's our secret? It's simple: we're not trying to help consumers get unlimited music without paying for it. Instead, we're focused on music discovery. We deliver all the other things that music consumers love without risking a lawsuit or paying high royalties."

That may be true, but iLike is among the companies discussing downloads with the music labels.

Click the image above to read the lead story of our series on SpiralFrog. Stories on SpiralFrog's internal strife and customers' private information will appear Tuesday.

Matt Graves, Imeem's spokesman, said his company is trying to be innovative and not solely rely on traditional online advertising, such as on banners and display ads. The company is trying to mix things up with in-stream audio ads and custom-tailored campaigns. The music service recently promoted a download giveaway from Wal-Mart Stores and offered users a chance to remix songs from artists such as rapper Flo Rida.

"If it's all about displays, then users will get ad-blind," Graves said. "We're enabling advertisers to do a deep integration."

IDC's Kevorkian agrees that until now, ad-supported music has failed, but she sees some possibilities.

"This model has some flaws that need to be addressed before it works as a standalone model," Kevorkian said. "That said, there's a possibility that it could be deployed in conjunction with a hybrid paid model to help generate revenue so that the music provider isn't solely dependent on ads."

Copy of Qtrax's bounced $1.8 million check to Oracle that was included in court documents. Routing numbers were redacted.

(Credit: Greg Sandoval/CNET)

Oracle, the giant enterprise software company, has accused Qtrax, the legal peer-to-peer music service, of copyright infringement and breach of contract in a $2 million lawsuit filed last week in Northern California.

Qtrax is the music service that was ridiculed in January 2008 after the four major labels denied the company's claims that it had licensing agreements with them. Eventually, Qtrax did get the major label deals. Nonetheless, the start-up has apparently run into some trouble paying bills in the past several months, said a source close to the company.

Oracle said in the complaint, filed with U.S. District Court for the Northern District of California, the problem began when Qtrax's payment for database software Oracle provided bounced. In November 2008, Oracle received a $1.8 million check from Qtrax but the check was returned for insufficient funds, Oracle alleges in court documents.

Numerous attempts were made to collect the money from Qtrax, but the company never made good, Oracle claims. "Qtrax's failure to pay the outstanding invoices constitutes a material breach of the software license," Oracle's attorney wrote. Meanwhile, Oracle asserted in the court documents that Qtrax continued to use Oracle's software.

Oracle representatives did not respond to interview requests. Allan Klepfisz, Qtrax's CEO, acknowledged that the company has been "at times short of money" but has recently acquired new funding.

"We're not in trouble, thankfully," Klepfisz said. "I feel both Oracle and ourselves will get beyond this. You should also know we have not used any of the licenses under this contract (with Oracle)."

Qtrax's troubles come at a time when ad-supported music sites are struggling to generate revenue. Two of them, SpiralFrog and Ruckus, were forced to shut down earlier this year.

Weeks after writing off its Imeem investment, Warner Music Group has once again thrown in with the video- and music-focused social network, a source confirmed on Monday.

Only this time, Warner doesn't have to dip into its wallet to acquire an even larger interest in the start-up, according to a story by Peter Kafka at All Things Digital, who broke the news.

What the third largest recording company has agreed to give up for the stake is to rip up the old licensing contract and create a new one that asks for less money each quarter, according to Kafka. My source, who is familiar with the deal, confirmed this.

Warner didn't appear happy last month about having to write down $33 million, most of it from investments made in music site Lala and Imeem.

Warner Music's writedown--$16 million in Imeem and about $11 million in Lala--is a reflection of the company's valuations during the economic downturn, said Edgar Bronfman Jr., Warner Music's CEO at the time.

The top four music labels--Universal Music Group, Sony Music Entertainment, Warner, and EMI--have all been relaxing the financial terms they require from start-ups.

Too bad SpiralFrog and Ruckus couldn't have held out a few more months, perhaps the music services that went bust earlier this year might have negotiated better terms.

SpiralFrog's traffic over the past year.

(Credit: Siteanalytics.compete.com)

Update: To note that SpiralFrog users did not purchase music.

Controversy trailed SpiralFrog while it existed and continues to hound the company, even after closing down.

Some shareholders of SpiralFrog, the ad-supported music download store that shuttered its site on March 19, are unhappy with how the company's assets are being sold. Separately, several site users have complained that they weren't warned they could lose their music if the site closed down.

New York-based SpiralFrog offered free downloads to users who agreed to be served advertisements with their songs. They never purchased the music outright and conditions of use always included watching ads and returning to the site once every 60 days. In August 2006, the company announced that it had acquired the rights to offer Universal Music Group's vast library of songs. SpiralFrog managers proclaimed that ad-supported music would defeat illegal file sharing. The New York Times wrote SpiralFrog could be an iTunes killer.

After that, however, the company suffered through management shakeups and cash crunches, and failed to cut partnerships with two of the four largest music labels. When it finally closed down, SpiralFrog owed at least $34 million.

Some of the people who lost money when SpiralFrog went down have spoken to CNET News about whether some of the company's assets are worth more than they are being sold for. For example, MyMojo.com, a mobile content service, acquired SpiralFrog's domain name for $20,000, sources told CNET News.

John Ferber, who co-founded Advertising.com, also started MyMojo. Ferber declined to comment on the price he paid for SpiralFrog's name, but did confirm that the firm handling the sale, Gottbetter & Partners, didn't contact him. Once Ferber, who sold Advertising.com to AOL in 2004 for nearly $500 million, heard about SpiralFrog's collapse, he went to Gottbetter.

So, did Gottbetter advertise the sale of assets or contact SpiralFrog's biggest competitors?

Representatives from such music services as Imeem, RealNetworks' Rhapsody, and Qtrax say they were never contacted about any potential interest in SpiralFrog's assets. Scott Rapfogel, the Gottbetter attorney handling the sale has not replied to numerous interview requests.

One question is why wouldn't the agent in charge of selling SpiralFrog's assets try to drum up interest with a few phone calls to SpiralFrog's competitors or interested reporters?

Switching to the question of SpiralFrog's DRM; some of the site's users are bitter about losing the music they downloaded. When SpiralFrog went dark, CEO Joe Mohen said that SpiralFrog's music would be available for an additional 60 days. What Mohen meant was that if users visited the site on the last day the service operated and updated the DRM on their songs, they would have access for two months from that day.

SpiralFrog's songs required users to visit the site at least once within a 60-day period or the music would be locked down.

"I understand I'm whining and bitching about ostensibly free music," wrote a former SpiralFrog user in an e-mail to CNET News. "However, my point is it was never stated anywhere on their Web site that we would lose the rights to the music if the site went under. Nor was it ever clearly stated about what us listeners had to do to keep the 'rights' to the music."

The question about DRM-restricted music and what happens to it when a company stops doing business has come up often in the past year. Yahoo, Microsoft's MSN, and Walmart.com are three services that stopped issuing DRM keys for their music when they wanted to alter or shut down operations.

In contrast with SpiralFrog, customers of each of the companies would not lose their music totally. They still would be able to hear songs, but would be prevented from moving them to new devices.

Imeem, a social-networking site geared for music fans, has obtained new funding that in all likelihood saved the company from closing, according to music industry sources.

The money received so far by Imeem, which streams ad-supported music to users' PCs, is unlikely to last the company through the end of the year but the start-up's financing efforts continue, said the sources.

In March, TechCrunch reported that Imeem was in financial trouble after managers failed to sell the company or raise more money. At that time, the company denied that a shutdown was imminent. The company went back to some of its investors, which included some of the major music labels and asked for help, which it received. But last month Imeem went back to investors and told them even with the added assistance, Imeem needed new funding to survive, according to two industry sources.

An Imeem spokesman declined to comment.

Imeem made it clear that if it didn't raise money soon, the situation was "dire," one source said.

This first quarter of 2009 has been particularly bitter for ad-supported music sites. SpiralFrog, a site that offered ad-supported downloads closed its doors in March. In January, Ruckus, the music site tailored for college students, shuttered operations.

Some of Imeem's remaining competitors are facing their own struggles, including MySpace Music, the joint venture from News Corp. and the major labels. Music industry sources say the big recording companies are dissatisfied with the ability of the 8-month-old service to generate revenue. Read more about that here.