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Weekly Column

Son of Napster: One Possible Future for a Music Business That Must Inevitably Change

Status: [CLOSED]
By Robert X. Cringely
bob@cringely.com

When I mentioned in last week's column that I would this week be writing about a legal way to do a successful music downloading business -- a business that would threaten the Recording Industry Association of America and its hegemony -- dozens of readers wrote to me trying to predict what I would write. Some readers came at the problem from a purely technical perspective, ignoring the fact that the real issues here aren't technical but legal. Some readers took a legal approach, but they tended to ignore the business model. Some were looking solely for the business model. Interestingly, nobody even came close to my idea, which makes me either a total loon or a diabolical genius. Truth be told, I'm probably more of a diabolical loon.

The reason I am even writing this column is two-fold. The biggest reason is simply because I would like people to consider lateral solutions to problems. I am pushing the concept of problem solving in a new way. There is no particular methodology here, just the underlying concept that if things aren't working the way you like, think of something different. Too often, people restrict their thinking or they somehow expect the world to change just for them, which it won't. But taking a lateral approach often yields interesting results. And once you've found an approach, maybe it can be applied to a different problem. What I am about to describe as a model for music distribution might be even better for something else. You tell me.

The second reason I am doing this is because I don't like the current situation in the recording industry where power is concentrated in the hands of executives who are doing all they can to stop the rotation of the Earth. Technology has already changed the economics of music creation and distribution, but the record companies are resisting with every weapon they have. I would too if I was in their position, which is fat, rich, and having everything to lose. But times do change, and I think the music business is ready to adopt new ways of moving forward. And once that happens, it will resume growing. But what is needed for that to happen is a catalyst, which I am attempting to provide right here.

If anyone actually does this business, don't forget where you first heard it. Of course, if you actually spend the $2 million as I suggest and lose it all, please forget my name.

The business I am about to describe has not been legally tested. I have run it past a few lawyer friends of mine, but a true legal test can only be done in the courts. Having said that, the universal response I have received from lawyers can best be described as giddiness. They get it. And the implications of this idea -- the sheer volume of trouble it could create -- gets their billing glands working.

Without having been truly tested, so far I have yet to find a lawyer who sees a serious flaw in my logic. What I am about to propose is apparently not illegal under current law, which of course means that the RIAA will throw their lobbying muscle into making it illegal, getting Congress to pass a new law specifically against my technique. The trick then is to establish the business before that can happen. Gentlemen, start your engines!

I call my idea Son of Napster, or Snapster for short.

Napster failed because it was determined by the courts to violate intellectual property rights and because it did not have a successful business model, or any business model for that matter. Any successor to Napster must be both legal (if barely) and profitable.

First the law. Snapster is built on the legal concept of Fair Use, which allows people who purchase records, tapes, and CDs to make copies for backup and for moving the content to other media. So a CD can be copied to an MP3 player, for example. But to remain legal, the MP3 player should be that of the CD owner and not that of another person. CDs can be lent, sold, or borrowed, but in order to make backup or media-shifting copies, the copier must own the original CD. If the original CD is no longer owned by the maker of the backup or media shifting copies because the CD has been sold or given away, any copies should be destroyed under U.S. copyright law.

Snapster is all about ownership. Snapster will be a company that buys at retail one copy of every CD on the market. Figure 100,000 CDs at $14 each requires $1.4 million. Snapster will also be a download service with central servers capable of millions of transactions per day. Figure $100,000 for the download system and bandwidth for one year. Throw in $100,000 for marketing and $400,000 for legal fees and the startup capital required for the business is $2 million.

Snapster has to be a public company. It would have its IPO as soon as possible after all those CDs have been delivered. It must be a public company right from the start of operations. Say Snapster goes public on NASDAQ at $20 per share. The IPO sells one million shares (10 percent of the company) netting $20 million minus underwriting fees. So almost from the beginning, Snapster has millions in the bank and a market capitalization of $200 million. What is critical here for the business success is not the price per share but the broadest possible ownership of shares. But the way those additional shares would be sold would be through stock splits, not supplemental offerings. This means that early investors would benefit greatly from being early investors and the Snapster founders would benefit most of all.

By limiting issued shares to 10 percent of total Snapster ownership, stock splits could be used to maintain the price of each Snapster share at $20. Since Napster at its peak had 60 million global users, I see that as a size to which Snapster could grow, meaning each original share would eventually be split into 60 shares. If the share price remained at $20 -- which it logically would because, as you will see below -- most investors would only need to own one share. That means investors at the IPO would see their $20 investment quickly grow to $1200 and the market capitalization of Snapster would become $6 billion.

Don't forget my founders' shares, right?

Each Snapster share carries ownership rights to those 100,000 CDs. You see, Snapster is a kind of mutual fund, so every investor is a beneficial owner of all 100,000 CDs. Each share also carries the right to download backup or media-shifting copies for $0.05 per song or $0.50 per CD, that download coming from a separate company we'll call Snapster Download that is 100 percent owned by Snapster. With one million co-owners each downloading one CD per month, gross revenue would be $6 million per year. If they download an average of 10 CDs per month revenue grows to $60 million per year. At these download volumes and with the very low cost of running the service, the $200 million market cap is justified even at the lower sales level. At the $60 million sales level, the share price ought to rise. Now grow the business to its logical size of 60 million users. At 10 CDs per user per year, Snapster download revenue would be $3.6 billion or about a quarter the size of the current recording industry, which it would effectively replace. With 90 percent profit margins, Snapster would be making $3.2 billion per year in profit. Based on a modest price-to-earnings ratio of 10-to-1 (I am choosing this low number because of the obvious legal issues involved in this business) Snapster's market capitalization is now up to $33 billion, which is more than any current record company. Investors who paid $20 at the IPO will now find each of those shares worth $33,000, which is comparable to Microsoft or Dell or Cisco in success except that Snapster would do this all in one year.

Interestingly, $33 billion represents approximately the total market capitalization of all the major record companies, which we'd have to expect would be driven down by the success of Snapster. So Snapster would be a transfer of wealth from current owners of record company shares to owners of new Snapster shares.

Now I REALLY want you to remember to send me those founders' shares!

What I have described is legal, it just leverages technology in a way that has never been done before. There are precedents for group ownership of recordings and certainly the law of mutual funds is very clear. Of course, the RIAA will have a response. They will file suit, probably claiming restraint of trade, but this simply will not stand and it is impossible to believe they could get any form of retraining order. Still, Snapster must have funds to support a vigorous defense -- a defense that has been planned well in advance. The RIAA will also try to have laws passed making Snapster illegal, so an anti-RIAA lobbying effort would also be a good idea.

You may see Snapster as a great idea or as the worst thing you have ever heard, but I see it as a method for accelerating change that was inevitable. Technology has changed the economics of the music business. Traditional record companies are dinosaurs. Thanks primarily to personal computers, musicians today can afford to make recordings in their homes that are comparable in quality to anything coming from a $500 per hour recording studio. Remember that most record contracts charge production expenses against the artist's profit share, so the performer ends up covering those expenses, not the record company. This is just one of many ways record companies set barriers to entry and take advantage of artists.

Thanks primarily to the Internet and to CD burners, artists don't really need record companies anymore for manufacturing or distribution. Under current recording contracts, the costs assigned to these functions are horribly inflated. It is cheaper to do it yourself.

That leaves marketing as the sole record company function that might retain value. So let the record companies become marketing service providers. Or let them go out of business.

But wait, that isn't fair!

Many things aren't fair in life, Virginia, but Snapster is fairer than most. Look at it from the perspective of the music consumer. Since Snapster would have only a quarter the revenue of the system it replaces, that means consumers would be getting more music for less money. And as Snapster owners, which they would have to be by definition, consumers would benefit from the many Snapster stock splits it would take to reach 60 million beneficial owners, and then the increase in stock price beyond that. This is more benefit than these same people ever got from the record companies. And since Snapster would quickly become the most broadly traded stock of all, this transfer of wealth would have a broad benefit.

But what about the poor record companies and their owners?

To paraphrase Marie Antoinette, if they have no sales, let them buy stock. There is nothing that would keep owners of record company shares from selling those shares and replacing them with Snapster shares. The earlier they do so the more they would benefit both because they'd be selling before the record company shares went completely in the tank, and they'd be buying before Snapster shares had fully appreciated. It is one thing to maintain the status quo and another to recognize the inevitability of change and benefit from it.

Investors in companies that manufactured horse drawn carriages could have tried to make automobiles illegal or they could have sold their carriage shares and bought car shares. Which makes more sense? There is more money to be made by embracing this future than by fighting it.

The questions that are left unanswered in this are what will Snapster do against competitors, and what will the company do after there are no more CDs to buy? With the barrier to entry at $2 million, Snapster will have competition, but there are advantages to being the first mover and plenty of room for price cutting, which is even better for consumers. In fact there is probably room for many Snapsters, though I'd expect the first Snapster to be the biggest Snapster.

What is more problematic is what Snapster, as essentially a repository of oldies, would do to further grow its business and maintain earnings growth. This is the same question as asking what Microsoft will do after the age of the PC is over. The company could diversify and go into other businesses. It could extend the concept of a mutual fund even further and strictly manage its excess profits as investments. Or it could find some way to plow the money back into the music business, which I think would be best, but I can't see exactly how it would be done. Still, it is a good idea.

What do you think?

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