Everyone knows the story of Napster, the peer-to-peer file-sharing service that was shut down by the major labels a decade ago. The destruction of Napster pushed peer-to-peer file sharing underground, leading to the rise of Grokster, the Pirate Bay, Megaupload, and dozens of other services that facilitate illicit file sharing. It may also have created a larger market for licensed services such as iTunes.

But a new Google-funded study argues that the destruction of Napster and the litigation campaign that followed it had deeper and more far-reaching implications than is commonly appreciated. The author, Rutgers-Camden law professor Michael Carrier, conducted interviews with dozens of senior executives who were working at music labels, venture capital firms, and music-related startups during the Napster era.

Many of them argued that the labels' aggressive litigation campaign against Napster and other early music startups created a venture capital "wasteland," with music-related startups unable to raise money. The result, Carrier concludes, has been a stunted pace of innovation that continues to this day.

The Recording Industry Association of American disputed Carrier's findings. "The fundamental mistake that this study, and other pieces like it, make is to assume that the only type innovation is technological," the organization said. The firms the labels sued a decade ago were "not innocent 'innovators,'" the group wrote. "Most unlicensed p2p services were very well aware that what they were doing was probably illegal, and they were deliberately architecting their software to be able to avoid knowledge."

A scorched-earth campaign

The emergence of Napster was a shock for the major labels, which had grown fat on two decades of rapid growth in CD sales. Many of them "saw the Internet as a fad." So it was a rude awakening to discover that millions of their former customers suddenly had the ability to share label music with one another at negligible cost.

The labels responded harshly, suing Napster and eventually driving the firm into bankruptcy. And Napster wasn't the only target. Around the same time, the labels also sued cloud music pioneer MP3.com. It would sue numerous music startups during the aughts.

Defending against copyright litigation can be tremendously expensive. Two people told Carrier that defending a lawsuit by a major label cost $150,000 to $200,000 per month. That's enough money that many startups would go bankrupt even if they ultimately prevailed in court.

And the intimidation tactics reportedly went beyond suing startups. The labels also threatened to file personal lawsuits against the officers and major investors of music startups.

"They suck companies dry"

The executives Carrier talked to said the labels made life miserable even for startups that tried to follow the rules.

One executive tells of a startup with millions of users that was sued by the labels. The firm told the labels "You guys made your point; we will charge anything you want to charge, and you can take any percentage you want to take." But the labels reportedly responded, "No, we want you to turn it off."

Indeed, some respondents charged that the labels treated lawsuits against music startups as a short-term revenue source. The labels "sat in meetings with digital startups and tried to take as much money as they could. They knew their business model was not going to work, that this was not recurrent revenue." But bleeding music startups dry helped the labels hit their quarterly revenue targets.

A venture capitalist reported that the labels insisted on signing short-term deals, one or two years at a time, that could be renegotiated if the startup was more profitable than expected. "As soon as the companies are profitable, they suck companies dry," the VC said.

CD protectionism

This seems short-sighted. Online piracy wasn't going away, and the failure to provide consumers with access to the music they wanted in convenient online formats surely drove some customers over to the dark side. So why did the labels pursue such an aggressive strategy?

One factor was the adamant opposition of brick-and-mortar retailers to online distribution. At the time that Napster burst onto the scene, retailers like Walmart and Tower Records were the labels' primary revenue source. Indeed, some interviewees argued that the labels treated these retailers, not individual fans, as their primary customers. Major retailers had substantial leverage over record labels because they decided whose products would be prominently featured in stores. And they insisted that music not be made available online at prices that would undercut the market for CDs.

The labels were also reluctant to undercut the market for physical CDs because they had billions of dollars invested in infrastructure for creating and distributing CDs. One label reportedly "spent a billion dollars on trucks to distribute their CDs." That investment would be wasted if the industry shifted toward low-cost digital downloads.

The labels' obsession with preserving the market for CDs led to unrealistic expectations for digital services. For example, before iTunes established the 99-cent price point for music singles, one label was "adamant" that "the single should be priced at $3.25." That was high enough that a customer who bought "two or three" singles would replace the revenue from selling a full album.

Carrier also charges that the labels were excessively focused on short-term profits. Executives' bonuses were based on quarterly profits. Nobody got a bonus for making a long-term investment that wouldn't pay off for a few years. Hence, they were more inclined to view the startups they were negotiating with as short-term sources of cash rather than long-term business partners.

The RIAA responds

The RIAA is not impressed with Carrier's study, and the organization shared with Ars a draft of a forthcoming response. It characterizes it as "wild speculation based on various assumptions, anonymous musings, and no real metrics," and as a vehicle to communicate the author's "biased views of the industry and clear preference for venture capital investment over protecting the arts."

The industry group argued that lawsuits were essential to allowing labels and artists to claim a share of the revenues from online music consumption. "Finding for Napster would have instantly granted every online service the right to copy and distribute (or at least facilitate such action) without any permission or license, and there would have been absolutely no incentive for Napster to negotiate for them," the RIAA said.

The RIAA also disputed the premise that litigation has diminished venture capital investment, though here it focused more on the 2005 Grokster decision than on the Napster case. "The legal digital music market grew from less than $200 million in 2004 to more than $3 billion in 2011," the association said. "After a unanimous Supreme Court ruling against Grokster, venture capital investment grew for Media and Entertainment to 7.1 percent of total VC dollars from just 4.6 percent before Grokster."

Finally, the industry group argued that some of the stories told in the study are "bogus." For example, Carrier pointed to a PC World article claiming that the major labels had sought $75 trillion in damages against LimeWire, "a figure higher than the Gross Domestic Product of the world." But as Mike Masnick of Techdirt, no friend of the RIAA, pointed out, there doesn't seem to be any credible evidence for the $75 trillion figure. The case was eventually settled for $105 million.

The RIAA has a point in at least one respect: given Carrier's methodology, it's worth taking the study with a large grain of salt. It's not a surprise that entrepreneurs and venture capitalists who locked horns with the recording industry in court a decade ago would be willing to badmouth the industry today. Virtually all the quotes are anonymous, and it's not clear if their claims were independently fact-checked.

Still, the study does point to some serious problems with the recording industry's litigation strategy. The fact that litigation costs have forced startups into bankruptcy after winning in court is a cause for concern. And the uncertainty of the law, along with the threat of statutory damages as high as $150,000 per work, makes it more difficult than it should be for businesses to stand up to industry bullying. The industry's litigation campaign really does seem to have hindered innovation, even if the situation is not as dire as depicted by the RIAA's worst critics.

Update: After this story went live, Carrier sent Ars the following statement: