Digital Media

Update 4:15 p.m.: To include comments from YouTube and Viacom.

A federal district court says Veoh, a Web video site that has come under legal fire from entertainment companies the past several years, is not liable for the copyright violations committed by its users, a decision that could help YouTube defend itself against Viacom's $1 billion copyright suit.

Universal Music Group, the largest of the four top record companies, accused Veoh of copyright violations in a lawsuit filed two years ago. But on Friday, U.S. District Judge A. Howard Matz granted Veoh's motion for summary judgment, and ruled that the company is protected against such claims by the Digital Millennium Copyright Act.

The decision would have meant more for Veoh if the video site was still relevant. The company has fallen on hard times since YouTube and Hulu took control of most of the online-video sector. Veoh's legacy, however, could be that it helped to establish that Internet service providers aren't liable for crimes committed by users.

"This decision reaffirms the judicial consensus and what we've known all along: the DMCA protects services like YouTube," Zahavah Levine, YouTube's chief counsel said. "With the DMCA, Congress intended to foster online platforms like YouTube, which empower users, offer new distribution channels for content owners, and respect copyright."

To be sure, Universal Music will file an appeal to Matz's decision and the case likely still has a long way to go.

"The ruling today is wrong because it runs counter to established precedent and legislative intent and to the express language of the DMCA," Universal Music said in a statement. "Because of this and our commitment to protecting the rights of our artists and songwriters who deserve to be compensated for the use of their music, we will appeal this ruling immediately."

Martz's decision is not binding on other courts and it must be noted that the case was heard in the Ninth District while YouTube's court fight is in the Second District.

"Our case is in a different forum, not bound by the Veoh case," said Michael Fricklas, Viacom's general counsel, in a statement. "We remain confident that we will prevail on the law and the facts. Today's decision contradicts the consensus that sites and copyright owners share the responsibility to use readily available tools to minimize copyright infringements."

How YouTube may benefit
YouTube and Google could be the big winner in all of this, said Fred von Lohmann, senior attorney for the Electronic Frontier Foundation. Viacom accused YouTube of infringing its copyright in a lawsuit filed in March 2007.

"Veoh's policies are very similar to YouTube's," von Lohmann said. "The judge gave Veoh a clean bill of health. I think the court in New York (where the Viacom-YouTube case is being heard) is going to take this ruling very seriously. The facts are very, very close."

In Martz's decision, he noted that this was not the first time a court has ruled that Veoh is covered by the DMCA's Safe Harbor provision.

"On August 27, 2008, Magistrate Judge Howard R. Lloyd, sitting in the Northern District of California, wrote that the court does not find that the DMCA was intended to have Veoh shoulder the entire burden of policing third-party copyrights on its Web site (at the cost of losing its business if it cannot)," Martz wrote in his decision.

"Rather, the issue is whether Veoh takes appropriate steps to deal with copyright infringement that takes place. The record presented demonstrates that, far from encouraging copyright infringement, Veoh has a strong DMCA policy, takes active steps to limit incidents of infringement on its Web site, and works diligently to keep unauthorized works off its Web site. In sum, Veoh has met its burden in establishing its entitlement to safe harbor for the alleged infringements here."

While the judge ruled against Universal Music group and delivered a blow to copyright owners, he also confirmed that such sites must take reasonable steps to stop infringement once they've been made aware of its existence on their sites.

The legal fight between Viacom and YouTube will likely go to trial sometime next year. Many observers thought that case would be the one to establish whether managers at YouTube and similar services would be required to police their sites. But YouTube vs. Viacom could be anticlimatic, according to von Lohmann.

"The ironic thing is that so much attention has been paid to the YouTube litigation," von Lohmann said. "But the law is actually being made in other cases because the YouTube case is turning into an eternal trench war. In the meantime, smaller companies like Veoh and Perfect 10 are defining the law. The courts have consistently given an interpretation (of the law) that has been in line with what Web 2.0 companies have been arguing."

Chris Stephenson, general manager of marketing for Microsoft's Zune music player, is leaving to join Universal Music Group.

Chris Stephenson

(Credit: Microsoft)

Stephenson was one of the people Microsoft tasked in 2006 with trying to cut into Apple's massive lead in music. Despite some early favorable reviews, Zune has so far failed to mount much of a challenge.

Whatever flaws or limitations the Zune did or didn't have, when comparing the music player to the iPod, Microsoft just didn't present enough compelling reasons for owners to switch.

In January, Microsoft reported that Zune sales plunged 54 percent from $185 million in the last quarter of 2007 to $85 million during the same quarter a year later.

Stephenson, whose departure was first reported by the Wall Street Journal, is leaving as the Zune team tries to regroup. The company is in the middle of shifting from a device centered business to one that focuses on the portable player as just one of many places where consumers will be able to access the Zune service. Over time, Microsoft said it will be available on a range of devices, including Windows Mobile phones.

Microsoft is getting behind the launch of the latest version of the device, the touch-screen Zune HD, on September 15.

"I think the latest device and software, which we'll be launching soon, are our best to date," Stephenson told CNET News. "Looking at all the blogs and pre-sales, we've got a great year ahead.

"I think we've established a clear entertainment brand for Microsoft," Stephenson continued. "That's a big win. I'm really proud of our achievements. We've never had a consumer brand in music and video, so coupled with Xbox, we've got a compelling entertainment story and an established internal infrastructure to drive it forward."

Stephenson will become chief marketing officer at Interscope Geffen A&M Records, one of Universal's top labels. His last day at Microsoft is September 4 and he begins working for Interscope three days later.

A screen capture of BigChampagne's new BC Dash, which enables users to monitor music consumption across the Web.

(Credit: BigChampagne)

Count BigChampagne among the companies trying to cut into Nielsen's media-measuring empire.

Universal Music Group, the largest of the four major recording companies, has agreed to a multi-year deal that calls for BigChampagne to help track the popularity of the label's music online. Traditionally, Universal has relied on Nielsen's SoundScan for such chores.

BigChampagne tracks online music and video consumption. Headquartered in Beverly Hills, Calif., BigChampagne is perhaps best known for being the first of the business-intelligence companies to measure activity at file-sharing networks, such as the original Napster.

"With the addition of BigChampagne, we provide a comprehensive view of the marketplace," Jim Urie, president and CEO of Universal Music Group Distribution, said in a statement. Urie said that the ability to measure radio, the Web, and brick-and-mortar retail stores "results in more opportunities for our artists and labels."

Universal's embrace of a Web intelligence product is symbolic of how important the Internet has become to the traditional music business, and the latest example of how Nielsen's competitors in a number of entertainment sectors are moving in on its core business.

On Saturday, Kenneth Li of The Financial Times reported that NBC Universal, Time Warner, CBS (parent company of CNET News), and Walt Disney are part of a consortium that intends to challenge Nielsen's decades-long control over the measuring of U.S. television viewership.

Nielsen representatives did not respond to an interview request but were quoted in Tvbythenumbers.com. They said the company "is committed to measuring across all screens--known in the industry as 'three screens': television, computer and mobile--as part of our long-term strategy. Over the last three years, we've invested more than a billion dollars in research and development as part of this effort."

Without accurate tracking numbers, advertisers say they risk wasting some of the $70 billion they spend on the U.S. TV industry annually. The perception by some in a multiple media areas is that Nielsen isn't equipped to provide all the answers--especially when it comes to the Web.

"The most deficient thing is there's no single source measurement (for TV and digital video)," Sam Armando, senior vice-president of audience analysis at Starcom Mediavest, told the Times.

Some in the music industry say a similar void exists in that sector. BigChampagne, which reached profitability not long after launching in 2000, hopes to fill it.

BigChampagne CEO Eric Garland

(Credit: BigChampagne)

Last week, the company rolled out BC Dash, a new browser-based tracking system that allows a user to monitor in real-time song sales or streams at a host of Web sites, offline locations and peer-to-peer networks. Some of the sources include iTunes, YouTube, MySpace, retail brick-and-mortar record stores, and Limewire.

The data can help the music director at a regional radio station learn what tunes are hot and that information can help him or her decide what songs to play.

BigChampagne CEO Eric Garland is the first to admit that the company has benefited from the massive shift in listener's habits the past several years. Ten years ago, Garland said, his company was surrounded by doubters, people who didn't think there would ever be anyone willing to spend to acquire intelligence about Internet-music listeners. Nine years ago when BigChampagne was founded, the market was insignificant. Not anymore.

"The Internet has inherited the music business," Garland said. "When you look at MySpace plays, Rhapsody, iTunes, Last.fm, all of that dwarfs traditional music purchasing. Instead of CDs, we paid attention to this sleepy little Internet thing, but it happened when no one was watching. Well, we were watching."

To be sure, SoundScan offers customers its own Internet tools and the company has been the nearly unchallenged leader in counting music purchases in the United States since 1992. Anytime a song or album moved up the Billboard charts, it was SoundScan that said it was so. Before SoundScan arrived on the scene, music companies gathered sales information calling stores and asking clerks which records were moving. Not surprisingly, the system was easy to manipulate.

SoundScan changed all that when it brought in bar codes and computers to objective sales tracking.

In a 1992 story in The New York Times, a source told the newspaper that the major record labels likely paid SoundScan $750,000 a year for the company's data.

Things have changed in the 17 years since. Music industry sources say that SoundScan charges the top recording companies "on a market-share basis." That means the larger the share of overall music sales a label possesses, the more it must pay SoundScan for its data. Exact figures weren't available but Universal was paying between $7 million and $8 million a year in the middle part of this decade, the sources said. The third largest label, Warner Music Group, was paying about $4 million.

SoundScan will likely be forced to lower prices as the importance of tracking CD sales decreases--the bread and butter of its business--and Internet sales go up. The company's prices will also be under pressure from smaller but less expensive competitors, such as BigChampagne.

"Given the current economic conditions, every business is trying to do more with less," Garland said. "We have to help them find efficiences because the industry is constricting."

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."

Universal Music Group and YouTube have answered the question of whether any of the major labels will be interested in joining the new all music video Web site, Vevo.

Sony Music Entertainment has joined the venture, the companies said Thursday in a statement. Vevo will launch sometime later this year featuring video content from at least the two largest recording companies. (Universal is the largest.)

Some of the acts represented by the two labels include Amy Winehouse, U2, Bruce Springsteen, Duffy, Alicia Keys, Beyonce, Eminem, AC/DC, Kelly Clarkson, Lady Gaga, Carrie Underwood, Mariah Carey, Akon, The Killers, Mary J Blige, Black Eyed Peas, and Justin Timberlake.

Warner Music and EMI have yet to sign up, but music industry sources say that talks between the companies continue. Vevo is the brainchild of Universal Music CEO Doug Morris, who has long dreamed of a standalone video site where his artists' music videos would be the marquee product.

MTV turned music videos, which were once considered little more than a promotional tool for the labels, into a gold mine 30 years ago. Since then, music videos are far and away the most popular content on YouTube.

Vevo will not only feature traditional music videos, but possibly also present reality shows, video blogs, and other content built around artists. Universal said in the statement that it is also looking for outside investors.

While the labels will supply the content for Vevo, YouTube will look after all the back-end chores. Vevo will likely name former Universal Music exec Rio Caraeffas president.

Universal Music CEO Doug Morris partnered with Google's Eric Schmidt on Vevo. Now Sony Music Entertainment is joining the venture.

(Credit: Universal Music Group and Stephen Shankland)

Rio Caraeff

(Credit: Anne Gim)

Rio Caraeff, executive vice president of Universal Music Group's eLabs, is expected to be named president of Vevo, the music video site formed by Universal Music and YouTube, sources close to Vevo said.

Universal and YouTube officially unveiled Vevo in April, saying it would be a showcase for the major labels' music videos and other video content. The site is expected to launch later this year, and Universal and YouTube executives continue to negotiate with the other three major recording companies--EMI, Sony Music, and Warner Music Group--to bring their content into the fold.

Vevo is the brainchild of Universal Music Group CEO Doug Morris, who has long sought a way to distribute his company's music videos in a high-quality format. Universal's YouTube channel is by far the most watched on the entire video site.

Caraeff formerly led E-Labs, a digital business unit of Universal Music, the largest of the labels. Prior to that, he led Universal's mobile unit and he's also worked at Sony Pictures Digital. He is expected to be formally named president when Vevo launches.

Caraeff is known for his willingness to embrace technology and its role in the entertainment industry. In January, Caraeff praised YouTube for its shift in focus toward monetization of online video, saying "They have finally turned the spotlight on 'How do we turn this into a business' and that's benefiting the entire ecosystem of content owners as well."

Universal Music CEO Doug Morris is partnering with Google's Eric Schmidt on Vevo.

(Credit: Universal Music Group and Stephen Shankland)

Universal Music Group and Google are now partners in the music-video business.

The largest of the four top recording companies and YouTube's parent company announced on Thursday that they are working together on Vevo, a new music and video entertainment service set to launch later this year. YouTube will handle the technology while Universal Music supplies the content. The two companies will share ad revenue.

The companies said and at this point it appears that Universal's content and artists will be the only label represented on the site. However, Doug Morris, Universal Music's chief executive, said in a conference call with the media that he is in negotiations with other top record labels and is confident they will join.

Google CEO Eric Schmidt said on the same conference call that YouTube and Universal Music have renewed their existing licensing agreement. YouTube will continue to be licensed to allow visitors to use songs from Universal Music. Professionally made videos from the label will only appear on Vevo, the companies said.

This is the first time that YouTube has launched a satellite Web site, Schmidt said but he added that he hopes there will be more.

For Universal Music, the move means that Morris has obtained the standalone music-video service that he has long wished for. Ever since MTV became a cultural force and huge financial success by offering music videos on TV, the record industry realized that it goofed in thinking of music videos as a promotional tool. Morris has said that in this era of declining revenue in the sector, he doesn't see anything as "promotional" and argues that music videos are worth cash.

In September, CNET reported that Morris was looking for a way to build his own video site. It appears now that Morris already had the partner he needed in Google. Sources close to Universal Music said last year that Morris wanted his artists' videos to be given a higher profile and presented to viewers with higher-quality video than what YouTube offered. But where could he go to find an audience as gigantic as YouTube's? Vevo undoubtedly will have what Morris wanted.

For Google, which acquired YouTube in 2006, the agreement continues the company's streak of signing partnerships with top entertainment companies. For the past year, YouTube has been steadily shedding its rogue reputation among music, film, and TV companies.

On Monday, CNET reported that Sony Pictures is in talks about licensing some full-length films to YouTube.

When it comes to challenges, the new joint venture faces plenty. While Universal Music's YouTube is by far the largest on the site, with nearly 4 billion views, nobody knows for sure whether a standalone music-video site can attract a big audience or ad revenue.

The question is whether Universal Music's content is attracting viewers to YouTube or whether visitors stumble on to the videos while they are already on YouTube. Either way, the companies say they are confident that the site won't have any trouble drawing fans.

"We believe that at launch, Vevo will already have more traffic than any other music video site in the United States and in the world," Morris said in a statement, presumably referring to the traffic Universal sees at its YouTube channel." And this traffic represents the most sought after demographic for advertisers, especially as advertising dollars continue their shift from old media to new."

(Credit: INgrooves)

INgrooves, a digital distribution company, is fast becoming a favorite of music acts embarking on comebacks.

Last year, San Francisco-based INgrooves oversaw digital distribution and marketing for the release of Dolly Parton's album "Backwoods Barbie." The record debuted as the No. 1 country album on iTunes. This spring, when the spoof metal group Spinal Tap releases its first album since 1992, the boys in the band are trusting INgrooves to distribute the material to iTunes, Amazon, and other online retailers.

But just don't call the privately held INgrooves a music label. "I don't like the label... label," quipped Robb McDaniels, the company's CEO.

McDaniels says INgrooves is a service company that acts much like an indie record company, such as IODA or The Orchard, but has no wish to compete against record labels. And in fact, one of the 7-year-old company's most important clients is Universal Music Group, the largest of the top four recording companies. Universal last year invested in INgrooves.

McDaniels recently spoke with CNET News to discuss where digital distribution was headed.

Q: Do you consider yourself a label?
McDaniels: I don't like the label...label. We provide some services that an artist would expect from a label. We provide some services that an independent label would expect from a major label. I think we are as good as anyone out there in terms of digital distribution and marketing.

So, if I'm a label or artist, I hire you to do what?
McDaniels: We're agnostic to whether you're a label, artist, production company; really we work for anybody that controls the rights to media, images, video, and of course audio.

We provide sort of a menu of services that you can pick and choose from. It starts with distribution and it's really the entire supply chain process for content managers. What we've built is more of an asset management system rather than just a distribution infrastructure.

Tell me about what you're doing for Nokia.
McDaniels: This is an extension of our deal with Nokia for their online stores. Comes With Music is their new initiative based out of the United Kingdom but I understand it's about to launch in the U.S. and a few other territories. It's another retail outlet for us. It's another way to reach the consumer and a great outlet for our independent music. We sort of approach the retail model in much the same way we approach the client model. We're agnostic to the manner to in which music fans consume music.

Spotify is one of your distribution partners. That's the site everybody is talking about in Europe right?
McDaniels: We've just signed Spotify. There certainly has to be a music solution out there that's getting all the buzz. In the seven years we've been doing this I can't tell you the number of times that one of my employees has come into my office and told me this is going to change the way we consume music or this is going to spell the end of us. Snocap was one at one point. Spotify is certainly getting all the buzz now. It's a streaming-based model that allows music fans to effectively access millions of songs and share playlists and I think their music interface is catching on with fans.

I think what's really happening is consumer behavior patterns are changing. It used to be when we're moving from the CD to the digital download everybody was saying that music fans still want to hold something, hold the physical good in their hand and that's why CD sales would stay strong. Now consumer behavior is moving more towards digital downloads and everybody is saying everybody wants to own the download and they want to carry it with them wherever they go and streaming models aren't going to take off. Well now the consumer is saying I don't need to own the download. I'm happy with a cloud model where all my media is housed somewhere in an Internet locker for me and I can access it at any time. One of the reasons that consumer behavior is changing is because streaming is becoming more portable and interoperable.

I can access that music for more devices and more places and so it's becoming more convenient. I think that Spotify is hitting the market at the right time. I don't know it's that novel of an idea but I think it's got great timing and great user functionality.

Tell me what artists you work with and give me an example of what you do for them.
McDaniels: We provide services to Universal Music Group, K-Tell and VP Records as well as successful artists that are going out on their own: people like Dolly Parton and Too Short. We did Dolly Parton's last release worldwide digital. Dolly formed her own label called Dolly Records and was looking for a digital partner for distribution and digital marketing. We signed her to an agreement and she opted into our worldwide digital distribution and our strategic marketing services. Our marketing group did an analysis of which retail partners would be the best ones, would do exclusives on the Dolly album, "Backwoods Barbie." We then set about executing the marketing plan leading up to the release and then pushed it out to all of our online and mobile outlets on the day of the release. It was Dolly's highest Billboard debut ever. We did very well digitally for her. The album has gone on to sell over 130,000 copies.

Who else have you done that for?
McDaniels: Artists we've worked for directly are Too Short, Tila Tequila, Snoop Dogg's Doggystyle Records, Thievery Corporation, and the Crystal Method.

What are you doing for Universal?
McDaniels: About a year ago they made a strategic investment in us and we are providing them with digital distribution services. They looked at our software platform and they felt that it would be the right thing for the delivery of their content in North America. What our system does is handle the Universal Music Group Distribution labels and we deliver all their content under their contracts in all of North American retailers.

You're doing only UMGD. Why aren't you doing delivery for all of its labels, such as Geffen?
McDaniels: Universal is obviously a very big client for us. They have a large catalog. The digital logistics business is very complex. Nobody really other than the people involved understands the complexities involved. To take on that large of a catalog with all the intricacies of distributing out to dozens if not hundreds of different retailers is a large undertaking so we decided to stage the migration of their catalog to our system.

What is your relationship like with retailers and services such as YouTube?
McDaniels: We deliver content into YouTube, audio and video, for INgrooves clients. We sit in the middle. We're like a clearinghouse between content owners, typically labels or artists, and online and mobile retailers. We're like the Visa of media. We receive back from all of the retail channels all of the sale statements and process all of the paybacks to the content owners. We see all of the sales data, all of the content. We know who's buying what, where, when and how much.