Napster Meister

By FRANK GIBNEY JR.

Thomas Middelhoff liked the Post House because the clubby Manhattan restaurant seemed just the place in which to persuade Shawn Fanning that the two men had a lot more in common than a lawsuit. It was early September. Middelhoff, 47, chairman of Bertelsmann, the world's third largest media conglomerate, had never met Fanning, 20, whose ingenious file-sharing program, Napster, had created the world's biggest online free-music community--one that was costing Middelhoff and the rest of the music industry many millions of dollars in lost sales. But by the time they tucked into their steaks, the code-writing whiz was digesting the media mogul's sermon on the Internet being the world's first viable commercial democracy.

"I had to explain the Bertelsmann culture and the Internet, the speed at which everything is changing and the importance of our similar thinking about the value of membership communities," recalls Middelhoff, stopping just short of delivering the sermon again. By the time they finished the $219 Phelps Insignia Cabernet, Fanning was entranced by the precision and the passion, and he walked back to his hotel convinced that the gregarious German with the rimless glasses and earnest gaze was a man he could trust.

It was that discussion that led to last week's audacious partnership between Napster, the 18-month-old music swap shop that has spawned a following of 38 million file-sharing enthusiasts, and Bertelsmann, the German behemoth that began 150 years ago as a religious-hymnal publisher. No matter how it benefits (or maybe damages) both sides, the deal vaults the global entertainment industry into a new arena, where the game will be played by the freewheeling rules of the Internet, not the dictates of a handful of media barons. "Peer-to-peer file sharing is the future of media distribution," says Eric Scheirer, media and entertainment analyst for Forrester Research. "This is an incredibly significant development."

Under the agreement, Napster will develop a business model that should allow record companies and performers to be paid for their music. To help the tiny, 53-employee company overcome the enormous technological hurdles involved, Bertelsmann has opened a $50 million line of credit that could easily double. (Now hiring: any geek who thinks he or she can come up with a way to keep music files simultaneously accessible and copyright protected.) The Germans agreed that once the new model is in place, Bertelsmann's subsidiary BMG Entertainment will make its music catalog available and drop out of the copyright-infringement lawsuit that Napster has been fighting for nine months. Even before the deal was announced, Middelhoff began working the phones to persuade his counterparts at Time Warner, Sony, Universal and EMI to do the same.

And if all that happens, Bertelsmann becomes a majority stakeholder in the world's largest community of online music enthusiasts, with 38 million potential new customers not just for its music offerings but ultimately for books and movies and videos as well--the stuff that Internet types call content. "This could be really amazing," gushes Middelhoff, who is rarely able to contain his enthusiasm over a good opportunity. "This is like AOL in the beginning, a new community that we can build around the world. AOL is the example."

Everything about the Napster partnership is classic Middelhoff. It is counterintuitive, iconoclastic and so bold as to be regarded with derision, if not anger, by some of his competitors. Bertelsmann may lack the cartoon rabbits or mice that make its competitors household brands, but under Middelhoff, it has become more global and more diverse than most of them. Last year the privately held company had sales of $13.7 billion and profits of $480 million. Its empire stretches from John Grisham's novels (Random House) to Whitney Houston's hit tunes (BMG), and from Family Circle magazine to Germany's most prominent publications, like the provocative newsweekly Stern (both owned by Gruner + Jahr). Through a joint venture with British media giant Pearson PLC in the RTL Group, the company owns syndication rights to a vast universe of television programs, including Baywatch and The Price Is Right. And Bertelsmann also does a multibillion-dollar global business in printing and publishing services; the magazine in your hand may have come off a press at one of its 18 global plants.

Even before Napster, Bertelsmann's e-empire spanned global Web brands, including partnerships with giant search engine TerraLycos, music sites CDNow and GetMusic and a 40% interest in Barnes&Noble.com Middelhoff claims that as of July, Bertelsmann was ahead of every competitor except the Walt Disney Co. in visitors to its online sites. "Speed, speed, speed" is the Middelhoff mantra. "The world is changing fast," he said over dinner in Germany last June. "Companies must continually reinvent themselves and not be tied to one structure."

As for the man who brought Bertelsmann into the Internet age, the lanky Middelhoff was dreaming in digital streams before most of his counterparts knew what they were. He wrote his doctoral economics thesis in the mid-'80s on the failure of one of Germany's first online businesses. And once he arrived at Bertelsmann headquarters, he didn't wait long before pushing the stodgy company to break out of the cow pastures that envelop its local borough of Gutersloh (population 78,414). In 1995, shortly after he was named head of corporate strategy, Middelhoff persuaded the tightfisted Bertelsmann board to gamble $50 million on a 5% stake in a nascent Internet company called America Online. It was a masterstroke. The $50 million AOL investment turned into $1.8 billion and propelled him into the president's suite in 1998.

Before taking office, Middelhoff spent a year in the U.S., improving his English and trying to get to know every media bigwig in the States. He and AOL CEO Steve Case became good friends, and Case began to introduce Middelhoff around. Although he may have that steely look and the precision dress of a Frankfurt banker, his new media friends discovered Middelhoff to be a man of surprising charm and easy humor. That down-homeness may reflect his roots. He lives on a farm outside Gutersloh with his wife, five children, 45 cows and sheep, and a duck pond. "Thomas can defuse the tension in any room," says Aydin Caginalp, Bertelsmann's U.S. attorney for 18 years.

Among Middelhoff's new acquaintances was Samuel ("Si") Newhouse, chairman of Advance Publications, which publishes, among other magazines, Vanity Fair and the New Yorker. A week after attending Si's birthday party, Middelhoff bought Advance's Random House book business for $1.4 billion.

But in January, the Bertelsmann train was sidetracked. Middelhoff's good friend Steve Case announced that AOL was buying Time Warner (TIME's parent company), and other media megamergers left little room for the big deal that might seal a No. 1 content position for Bertelsmann. The private Bertelsmann's board has a deep-rooted aversion to debt. So Middelhoff redoubled his efforts to reorganize the company around digital content and in one stroke sold off its stake in a string of companies before the dotcom meltdown. That netted an estimated $15 billion in cash ($8 billion from AOL Europe alone) to shop with.

Which underscores another point about Middelhoff. "I've learned to be flexible and wait for the right opportunity," he says. "But I have also been very lucky." Lucky enough to have a war chest at a time when Internet assets are dirt cheap.

For Middelhoff, Napster was a natural solution to his long-standing pledge to make Bertelsmann king of the music-content world. "I realized that we had to pursue music from two sides," he said last summer. "There is content, but there is also online file sharing. We could not get ahead without file sharing." Bertelsmann's technology arm had been working on its own file-sharing system for months. "But we realized that all the technology gave us was an illegal way to distribute files," says Middelhoff. "We had to make it legitimate, and Napster already had a base to work from."

So in late August, Middelhoff decided to go after Napster himself. Ironically, he came to that conclusion after a meeting with Seagram chairman Edgar Bronfman Jr., a staunch Napster foe, in which they discussed ways to resolve the Napster question. "We walked out of Edgar's office, and Thomas and I looked at each other, and it just clicked," says Andreas Schmidt, president of the Bertelsmann E Commerce Group, who orchestrated the partnership. That day Schmidt got on the phone to Napster CEO Hank Barry and began eight weeks of intense transcontinental negotiations, from San Francisco to Miami, New York City to Gutersloh.

It is a long way from that base to a real solution, however. Though other music companies last week voiced cautious approval of the Bertelsmann move, there is considerable resentment. Indeed, it took intense negotiations last month and, ultimately, management fiat for Middelhoff to get the support of top executive Strauss Zelnick at his own BMG. So far, nobody has indicated any willingness to drop the legal action against Napster. "We're still not on Napster's side," says Zelnick, laughing. "We're suing Napster. But we are also on the side of creating an array of legitimate distribution alternatives."

The sticking point now is the new business model, which nobody at either Napster or Bertelsmann is certain of. The main reason is technology. So far, it just isn't clear how to track every digital file out there and put a user name and a price on it. And there are huge questions about what a reasonable price would be. Barry has suggested a monthly fee of $4.95. But websites all over cyberspace burned furiously last week as Napster fans threatened to ditch the service if it charged as much as a nickel for music-file access.

"We are convinced we can preserve the values of the community while having something that will be supported by the industry," says Barry, though he has no clue as to how Napster will be profitable. But that's what Bertelsmann's millions are all about--a vast new effort to overcome the technological and fiscal hurdles. Napster, which has been in a hiring freeze while it fought the court action, now is one of the few places in Silicon Valley with a HELP WANTED sign on its door. Fanning has big plans for a next-generation service with enhanced file-sharing and instant-messaging capability.

That is a long way off, particularly if the courts rule against Napster in the next several weeks. No matter, says Middelhoff. "I am always an optimist," he insisted to Fanning last Tuesday, as they walked briskly along Manhattan's Central Park South to announce their new partnership. "It's a beautiful, clear day, I think really a good day for a new beginning."