On the morning of June 27, Sam Yagan huddled with his partner, Jed McCaleb, before one of the five computer screens in their dingy, one-room office in Hoboken, N.J. Yagan, chief executive of startup MetaMachine Inc., watched as McCaleb clicked the refresh button on his Web browser again and again. They were waiting for the U.S. Supreme Court to hand down its ruling in the case Metro-Goldwyn-Mayer Studios Inc. v. Grokster Ltd. -- the record and movie industries' lawsuit against a file-sharing service that let people swap pirated copies of music and films.
Yagan and McCaleb weren't defendants. But they marketed their own file-sharing software, called eDonkey, which had roared past Grokster to become the most popular service in the world. In fact, while few people over 30 have heard of eDonkey, file-sharing on its network accounts for more than one-third of the volume of data sent over the Web, estimates researcher CacheLogic. On average, 3 million people are using its software at any one time to share music and movies. If Grokster lost, they were in deep trouble.
Late that morning they got their answer: The Supreme Court ruled unanimously against Grokster, with Justice David H. Souter writing the company's intent to facilitate illegal activity was "unmistakable." The two at eDonkey were stunned. McCaleb, the company's 33-year-old founder, tapped a few keys, rested his index finger on the enter button of his computer, then looked Yagan in the eyes. "If I hit this button," he said, "we shut the site down. What do you want to do?" The 28-year-old Yagan graduated from Harvard University and earned an MBA from Stanford, but no class could have prepared him for that moment. "What do you do when the Supreme Court smashes your business? What do you do when your business partner asks: 'Should I just end it all right now?"'
Yagan and McCaleb didn't end it all right then. Instead, they started negotiations with the record industry and pored over their options. On Sept. 28, Yagan told a U.S. Senate committee he had "thrown in his towel" on the disputed service. Now he is trying to reinvent eDonkey and use its popularity as a foundation for a legitimate business.
Although eDonkey is the biggest, it's representative of what's happening with other file-sharing services. After the Grokster decision, the Recording Industry Assn. of America (RIAA) sent cease-and-desist letters in September to seven major services, sending them scrambling to figure out a new business approach. What they come up with will determine whether file-sharing becomes a respectable, legal way to market and swap music -- or whether it persists primarily as an underworld of illegal, pirated tunes. "The [file-sharing] landscape in America is going to be dramatically different just 30 days from now," says Mike Weiss, CEO of StreamCast Networks Inc., which owns the Morpheus file-sharing service.
The record industry has an interest in eDonkey and its peers pulling off their revamps. Music executives saw that shutting down Napster, the first major file-sharing service, in 2000 largely backfired. A host of new services sprang up to fill the void for swapping songs. Now, record labels are working with Yagan and others in the hope that legit services will become attractive enough to draw music fans away from systems for piracy. "We think [file-sharing] has great potential and we'd like to see it succeed," says Mitch Bainwol, chief executive of the RIAA. "The key is providing consumers with legitimate alternatives."
No doubt, demand for digital music is taking off. Music downloads, from sites such as Apple Computer Inc.'s (AAPL ) iTunes, are expected to generate $875 million in 2008, up from $180 million last year, according to JupiterResearch. Music subscriptions, from Yahoo! Inc. (YHOO ) and others, are on track to hit $850 million, compared with $150 million last year.
But can Yagan and eDonkey find a place in the new world of music? They need to muscle their way in between successful legit services like (AAPL ) iTunes and Yahoo Music (YHOO! ) and still-free services like FrostWire that are developed underground by amateurs. An even bigger barrier may be eDonkey's existing software. While the company can avoid being hauled into court by putting out software that complies with the Grokster decision, its millions of users may decide to hang on to their old eDonkey software and continue swapping files illegally. "They are going to have to prove that their value is something other than free music," says David Card, senior analyst at JupiterResearch. "I'm highly skeptical they can do that."
Yagan -- animated, confident, and exceedingly polite -- is an unlikely candidate to be running the company responsible for more illegal music and movie transfers than any other. Besides his academic credentials, Yagan is a serial entrepreneur who was given the reins at MetaMachine in 2002 in part due to his success in starting TheSpark.com out of his Harvard dorm room. By paying Harvard undergrads to write CliffsNotes-like summaries and analyses of classic works, he stocked his Web site with SparkNotes, a series of free online study guides. The company made money from advertising on the site. Yagan sold the business to Barnes & Noble Inc. (BKS ) for $3.75 million in 2001.
EDonkey, which has continued to offer its controversial service since June, generates revenues in two ways. It sells advertising on one version of its software, which is available to users free of charge. Another, ad-free version is sold to users for $19.95. Virtually everyone opts for the free version, though that means ads flash as they search and download files. Advertising accounts for two-thirds of its roughly $2 million in revenues.
In future versions of its software, eDonkey will have to include technology to detect, and charge for, copyrighted songs. So how can Yagan persuade people to use his software if they can't get the broad selection of free music they're used to? One approach he thinks is promising is akin to broadcast television, where the content is paid for by advertising. He's investigating technology from a startup called INTENT MediaWorks LLC that lets people download a song for free if they watch or listen to an ad first. Combining that approach with eDonkey's many users, he thinks, could create a powerful network.
Another approach takes a page from Mary Kay Cosmetics Ltd.'s marketing. People refer songs to their friends and get paid a small fee if their friends buy the tunes. Yagan isn't sure the idea will fly, but others are banking on it. Peer Impact pays users 5% of the price of a download in store credit if a friend buys a recommended song. While the fees are only a few cents, Greg Kerber, CEO of WurldMedia Inc., which makes Peer Impact, says they foster loyalty. "I invested in a Dave Matthews song a few weeks ago," he says. "I've already paid for the song and made 32 cents."
Yagan is also in serious discussions to merge his company with an existing file-sharing service called iMesh. The service has already worked out agreements with all of the major record labels to market their music, and it's developing social networking technology that lets people set up their own profiles online and communicate with friends. Its music subscription service, which debuts in a few weeks, is expected to cost less than $10 a month. If the two companies merge, iMesh would have access to the eDonkey network and will look to convert the user base to its new software. Yagan confirms the talks are ongoing but warns that he is still considering several other options.
Yagan is sanguine that eDonkey will evolve into something very different from what it has been. He recently moved eDonkey's office into Manhattan, since his Hoboken landlord wanted to lease the space to another company. Stopping into a nearby restaurant on moving day, he sips a Corona and scarfs down tuna tartare. He looks tired but upbeat. "My colleagues at the other companies are in a much different position in their careers," he says. "I'm 28 years old. I went to Harvard. I went to Stanford. This is just a business to me. It isn't like I've spent my whole life getting to this moment." Just then, his cell phone rings. One of the new office's computers is on the fritz. He leaves the Corona half-full on the bar and heads back to the office.
By Burt Helm in Hoboken, N.J.