Digital Media

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.

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."

SpiralFrog met its end just days ago, and already, operators of other ad-supported music services are rushing to put distance between their business models and that of the doomed site.

"The concept was good, but the management, board (not all), and execution were poor," wrote Robin Kent, the former CEO of SpiralFrog who went to work as an adviser to Qtrax, one of SpiralFrog's competitors. "It was obvious to anyone...it wouldn't survive."

What might encourage supporters to jump to the defense of ad-supported music services, which don't charge users to listen to music but support themselves through ad sales, is the undeniable whiff of failure floating around the sector. In the first three months of the year, SpiralFrog has followed Ruckus, the music service that catered to college students, onto the scrapheap.

Ad-supported music sites have been around for two years, and some have burned through lots of cash, but none has reported a profit. According to a letter sent to investors by SpiralFrog's attorneys last week, the company owed $34 million when it ceased operations on March 13.

Then there's the crumbling ad market. Even before ad money began drying up, questions lingered about whether ad-supported sites could generate high-enough ad rates to pay their costs, which include the hefty fees they pay to license music. Now, against this bleak landscape, comes a new threat.

Some label executives are questioning the value of offering the public music free of charge. For decades, a large number of people have believed that giving away music, such as playing songs on broadcast radio or handing out CDs at concerts, promoted music and helped boost sales. But now some in the music industry suspect that instead of promoting sales, ad-supported services are replacing them.

The problem appears to come down to a question of control. Broadcast radio for years served to introduce the public to new music. Radio was and still is a powerful music discovery tool, says Mike McGuire, a digital-music analyst for research firm Gartner. Only word-of-mouth recommendations drive more music sales, says McGuire, who is working on a forthcoming report on the topic.

But many ad-supported music sites are very different than broadcast radio. Traditional over-the-air radio enabled listeners to hear songs for free but gave them no control over when, or how many times, the song played. At Imeem, a social network that focuses on video and music, and YouTube, the Web's top video site, visitors can listen to songs in their entirety as many times as they want.

"There's nothing left to promote...this way," said a high-level music industry executive who wished to remain anonymous. "At what point do they stop promoting and start competing?"

(Credit: Greg Sandoval/CNET)

According to information supplied to CNET News by the music executive, who requested anonymity, a recent study showed that music purchases made by people who listen to three free-music sources fell 44 percent from the first quarter of 2005 to the third quarter of 2008. Over the same period, the purchases made by people who listened to four sources declined 49 percent.

The sources of free music included both traditional and new-media sources, such as broadcast and online radio, cable and satellite music channels, as well as TV and Web music video outlets.

There are plenty of questions that the data doesn't answer. For example, what were the buying habits for people that listened to two sources or one? Did they boost sales? That information wasn't provided. But what's important to music executives is that the data indicated that the more free music sources a person had, the fewer the number of purchases he or she made. That's not what the record companies want to see.

The source also said the labels are not giving up on sites like Imeem, Pandora, or YouTube. Nonetheless, this is likely one of the reasons why some recording companies are asking for higher fees in negotiations with digital services.

The thinking among some of the labels is that if ad-supported services are cannibalizing music sales, the record companies want licensing fees to cover the losses, the source said. The music services say they can't pay any more.

Matt Graves, an Imeem spokesman, acknowledged that his company's executives asked for and received a break on their licensing terms from some of the labels. That was before the economic meltdown. The labels are less willing now to cut similar deals, the music industry insider said.

Graves said this kind of thinking is short-sighted. He said ad-supported music has been the best defense against piracy. He said the labels should remember that Imeem and the other sites pay licensing fees and often share ad revenue with the labels. Peer-to-peer sites, he says, don't pay or share a cent.

"I think there is a hope in the music industry to turn back the clock," Graves said. "This is not 1999 anymore. There just isn't as much money as there once was in music. Imeem is not only sharing ad revenue but generating significant download sales. I understand their hopes. If my income dropped by 50 percent in four years, I'd probably be feeling the same way, but we're trying to help them understand the new reality."

McGuire from Gartner argues that a big part of the problem is that ad-supported services haven't figured out how to make money. He says they have struggled to charge advertisers an effective CPM, which, in Web advertising, stands for cost per thousand (page) impressions.

Michael Robertson, a well-known Silicon Valley entrepreneur, founder of MP3tunes.com, and record industry adversary, has long been critical of ad-supported plays. He says the economics just don't work because the sites must pay penny-per-play royalty rates to the major labels, and they just can't deliver enough ads at a high-enough CPM to cover the royalty fees, much less than the other costs of running a business.

He says the sites can't generate a high CPM because advertisers know that people often listen to the free music that YouTube, Imeem, and Pandora offer without paying attention to the ads. "People's ears may be engaged, but it doesn't mean their eyes are."

"What's stunning to me is that anyone is surprised about SpiralFrog," Robertson wrote to CNET. "The economics are very obvious to all in the know, but people keep pretending that the charade of ad-supported music works. It does not."

McGuire agrees that ad-supported sites must adjust their models but disagrees that they are without hope. He says that if word of mouth is still the best music-discovery tool, then social networks are places that "amplify word of mouth." He says his research shows that awareness that social networks offer music is still very low.

This means, said McGuire, that "there's a lot of room to make these things vibrant and relevant."

SpiralFrog users can continue to play songs obtained from the now defunct company for two more months before they become inaccessible, according to a source close to the company.

The ad-supported music service shuttered its Web site late Thursday evening and ceased operations, the source told CNET. Some customers of the service asked on Friday how long their music, which is wrapped in copy-protection software, will continue to play. A source familiar with SpiralFrog's operations said the service's digital rights management technology, designed to prevent unauthorized copying, will lock up the music indefinitely after 60 days. The songs could live again should SpiralFrog's assets be acquired and the new owner decide to relaunch the service, the source said.

DRM critics will certainly cite this as further proof that the technology is anti-consumer. The software remains hugely unpopular among many music fans for limiting their ability to play songs on devices of their choice. The critics argue that a person never really owns DRM-locked music because they need server keys provided by service operators to unlock the songs. But Christopher Levy, a vocal proponent of the technology and considered one of the leading experts in the field, questioned whether customers should be angered about losing music they never paid a cent for.

Christopher Levy

(Credit: BuyDRM)

"(Protecting songs with DRM) was the only way that SpiralFrog could offer the model," Levy said. "The record labels refused to go to market without it. This was a very good business proposition for consumers. They received free music as long as they agreed to be bombarded by advertisements...I think it's hard to criticize the company...I think 60 days is very impressive."

Levy, who owns the company BuyDRM, says consumers deal with DRM every day in ways they don't notice. The technology is improving and soon it will be even less obtrusive. The technology helps protects the rights of content creators, consumers, and technologists, he said.

"When DRM is right in the middle of all three, that is where happiness is," Levy said. "Consumers are getting more comfortable with DRM and it isn't going away. It may need to change, but it's not going away."

Antipiracy software is used by the film industry and by music subscription services, such as Napster and RealNetwork's Rhapsody. But in the past year, download sites like Apple's iTunes and Amazon have rejected copy-protection software with the blessing of the major record companies.

The Federal Trade Commission on Wednesday is hosting a conference on the use of DRM at the University of Washington School of Law, said Levy, who will speak at the gathering.

According to an FTC press release, DRM "is expected to become increasingly prevalent in the U.S. marketplace in the coming years" and address "the need to improve disclosures to consumers about DRM limitations."

(Credit: SpiralFrog)

Update, 10:38 p.m. PDT: To include more background on factors that led to shutdown.

SpiralFrog, the pioneering ad-supported music service, quietly closed down on Thursday. SpiralFrog's site went dark at about 4 p.m. PDT.

A source close to the company told CNET News that SpiralFrog has ceased operations and assets have been surrendered to creditors. To keep operations going last year, the company issued secured notes in order to borrow at least $9 million from several hedge funds and others.

SpiralFrog representatives weren't immediately available for comment.

New York-based SpiralFrog made a splash in August 2006 by attempting to offer music free of charge to the public while supporting the site through ad sales. Media outlets such as The New York Times, Reuters, and USA Today questioned whether the site might one day challenge Apple's iTunes.

Some argued that SpiralFrog's business model was the answer to illegal file sharing.

But the model has yet to be proven. SpiralFrog is the second ad-supported service to shut down in 2009. Ruckus, which catered to college students, also shuttered operations.

The deaths of these companies come at a time when executives at some of the top labels are questioning whether ad-supported sites boost music sales or cannibalize them.

In SpiralFrog's situation, the company couldn't overcome "a macro-economic perfect storm" says a source close to the company. The sagging global economy, combined with "the collapse of the capital markets" and rapid compression of the ad markets," led to the company's demise, said the source.

That only tells part of the story, however. In truth, the service never caught on with music fans. SpiralFrog's downloads were locked in Digital Rights Management at a time when most of the front-running music services, such as iTunes and Amazon, were freeing songs from copy-protection software, enabling them to play on numerous devices.

In addition, SpiralFrog's music library was always much more limited than iTunes, Imeem, or other competitors. After signing a licensing deal with Universal Music Group, the largest of the four major record companies, in the summer of 2006, nearly two more years would pass before the start-up signed a second top label: EMI.

This meant that SpiralFrog never was able to offer songs from Sony Entertainment Group or Warner Music Group, which account for a large chunk of overall music sales.

The company saw two CEOs come and go, conflicts between managers and founder, Joe Mohen, and perhaps most significantly, the company struggled with debt.

A year ago I wrote that SpiralFrog was borrowing money to fund operations and avoided a debt crisis by renegotiating the loan terms. At the time, SpiralFrog had borrowed more than $9 million, but in March 2008 was given an additional year to repay it.

According to a story published last month in Digital Music News, SpiralFrog's debt was coming due and the story suggested the company may not have the means to repay it.

Here's the obvious question raised by the demise of SpiralFrog and Ruckus; is the ad-supported music sector seeing a shakeout?