The Sound at Napster: Tick, Tick, Tick...

A boardroom battle may add to the company's financial stress

It just keeps getting worse for war-weary Napster Inc. The online-music pioneer, already paralyzed by assaults from the recording industry, now faces a nasty conflict within its ranks. On one side is an early backer of the company. On the other side is Napster and two board members. If they don't resolve their dispute, it could derail a buyout offer by Bertelsmann AG, leaving the onetime Internet highflier in dire financial straits.

According to a lawsuit filed on Mar. 25, board member John Fanning, who helped finance Napster in its early days and is the uncle of Napster co-founder Shawn Fanning, is suing fellow directors John Hummer and Hank Barry. His claim: The two venture capitalists are no longer directors because shareholders voted them out on Mar. 24. Fanning also claims that Napster's preferred stock, which Hummer and Barry hold, was converted into common stock on Mar. 11. If that's true--an assertion the company disputes--it would put Fanning on equal footing for a payout should Bertelsmann buy the company.

In the unusual lawsuit, Fanning asks the Delaware Court of Chancery to validate the new board so it can consider pressing issues facing Napster, including a buyout offer. BusinessWeek has learned that Bertelsmann has made a $15 million bid for the company, according to an insider and a record-industry exec. The media giant, which already has loaned Napster $85 million, wants to buy the company to gain full control before committing any more money, say the sources.

A new cash infusion is critical to Napster, since the startup is running low on cash, says an insider. That's one reason why Fanning is rushing into court. His complaint states: "Any delay in determining the validity [of the new board] threatens irreparable harm."

That time is of the essence is the sole thing the two sides agree on. Napster CEO Konrad Hilbers rejects Fanning's claims that the board's makeup has changed and the preferred stock was converted. "The allegations in the lawsuit are legally groundless," says Hilbers in a statement. Napster declines further comment. Bertelsmann refuses comment. Hummer, Barry, and John Fanning did not respond to calls or e-mails seeking comment.

One thing that's clear is the dispute could prompt Bertelsmann to abandon its buyout offer. Instead, the music giant may choose to call the $85 million note, which could prompt Napster to consider radical steps, including bankruptcy protection, say analysts. BMG has been hoping to avoid a public and costly bankruptcy proceeding. But it may prefer that outcome to becoming embroiled in an internal war at Napster. "With all the online services being launched right now, Bertelsmann is under immense pressure to make its Napster deal pay off," says one record-industry executive.

Exactly who capitalizes on a buyout is at the heart of the dispute. If Napster goes into bankruptcy, the company's investors and founders, including the Fannings, could end up with zilch. Typically, the last investors in a startup get their money back first because they pay a higher price for a smaller share of the company. By contrast, the earliest investors get paid back last because they receive a lot of stock on the cheap. At Napster, venture firms Hummer Winblad Venture Partners and Angel Investors LP put in about $15 million in May, 2000. Since that was the last financing, they may well be entitled to most of the $15 million Bertelsmann is offering. Fanning's class of stock is likely among the last in line.

And that's the rub. According to his lawsuit, all of Napster's preferred stock has been converted into common stock, which would put Fanning alongside other shareholders when they divvy up any proceeds from a buyout.

Ronald C. Conway, a founder of Angel Investors, says Fanning has contributed little to Napster, unlike other investors. "In my opinion, Fanning's lawsuit is motivated by the ugly trait of greed," says Conway, who put almost $2 million into Napster.

This latest conflict comes at a terrible time. Napster is making progress in settling its beefs with the record labels. And the company is testing a new online subscription music service that would be undermined if the fracas dragged on. Worse, now it looks like Napster's undoing could come down to a few million dollars instead of anything related to the company's business.

By Linda Himelstein in San Mateo, with Tom Lowry in New York

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