Digital Media: Building a Foundation for the Future –

Digital media has gone mainstream. With increased computing power, cheaper processors, innovative new platforms like the iPod and extensive broadband penetration (both wired and wireless), digital media is no longer the sole province of hobbyists. If personal computing and the Internet represented the “megatrends” of the 80s and 90s, respectively, digital media should be regarded as this decade’s “megatrend.”

We segment digital media into three categories-infrastructure, services and content. Recently, myriad new content has sprung up. While Web logs (blogs), social networks and other forms of digital content have not generated significant advertising revenue, they have attracted loyal niche audiences. This “long tail” of digital media content may very well help to seed the next big thing.

Nevertheless, we have focused the majority of our efforts on infrastructure and services. In our view, it is still too hard for consumers and businesses to access popular forms of digital media.

One example is digital music. While iTunes and other paid music services have won many loyal users, peer-to-peer (P2P) distribution shows no signs of slowing down. Consumers like P2P networks because the content is “free,” but they also value the wider selection: P2P networks contain roughly 20 times more tracks than Apple’s iTunes. Still, the quality of music files on networks is uneven, with many incomplete songs and much spyware. With the help of Shawn Fanning, who founded Napster, we saw a day when some subset of consumers would be willing to pay for P2P music that they knew was authentic. We subsequently invested in SNOCAP, which is building a rights clearinghouse for the distribution of digital content over P2P networks. Founded by Fanning, SNOCAP has signed deals in place with Universal Music and Sony BMG Music Entertainment, among others. These labels have agreed to upload their content to SNOCAP’s servers so that SNOCAP can validate that the P2P music that consumers are downloading is legitimate. Although the company still has a long way to go, it is poised to provide much more reliable infrastructure for the P2P networks of tomorrow.

Savage Beast Technologies also makes it easier for consumers to find the digital music they want, but its approach is quite different.

Too Much Information

According to a study by the Recording Industry Association of America (RIAA), more than half of consumers who enter a music store or the music section of a retail store leave empty handed. To a large degree, they are overwhelmed by all of their choices. One of the main reasons why finding music is so difficult lies in the way in which it is categorized and presented to consumers. The same principle holds true in the digital realm. Music sites either assign fixed labels to music (e.g. “alternative country”) or try to convince consumers that they should be interested in a piece of content because their peers like it (collaborative filtering). Savage Beast has taken a different approach. Its dynamic matching engine isolates hundreds of individual music properties of music and provides results that are not based on static, pre-stored relationships. Savage Beast will soon release a player that enables users to isolate specific song qualities that appeal to them and program custom radio stations in real-time.

Like digital music, video over the Internet is bedeviled by some basic structural problems. These days, consumers and business customers expect to be able to see news videos, take video tours and more. Still, companies need help in distributing video to their customers and employees. Among other issues, streaming video within an organization requires so much bandwidth that it can take down an entire corporate network; and people who do not have access to broadband connections have trouble streaming or downloading video content. (Business travelers of the world, unite!) We have invested in two companies that are addressing these problems: VitalStream (OTC: VSTH), a content delivery network (CDN) that competes with Akamai Technologies (Nasdaq: AKAM) in transporting large video and audio files across the Internet; and Ignite Technologies, which allows corporations to distribute DVD-quality video to users regardless of the speed of their connection. Both companies are delivering on the promise of video over the Internet by providing a more reliable infrastructure for businesses and consumers.

Looking at digital media more broadly, we are particularly bullish about performance-based Internet advertising and direct marketing. Research shows that consumers spend 15% of their leisure time on the Web, while advertisers have only allocated 4% of their media budgets to Web advertising. In our view, this discrepancy-coupled with the increased interest of advertisers in performance-based media that they can track-will continue to fuel successful private companies for the foreseeable future.

As promising as this industry is, abusive advertising and spyware are cluttering inboxes and costing consumers and companies millions. BlueLithium, a performance-based online advertising network, is setting a higher standard. Founded in June 2004, it has eschewed common practices like pop-under and pop-over advertisements and formed strong relationships with Fortune 500 brands that do not want their ads displayed just anywhere. Our hope is that BlueLithium will lead the way in creating compelling advertising and direct opportunities that do not impede users from finding the content that they need.

The New Multitasking

A recent Yahoo study conducted by Forrester Research and Headlight Vision found that over half of broadband users use online and offline media simultaneously. These people don’t have ADD; they are “turning to the Internet to supplement other traditional media such as radio, newspapers and television,” to quote the study. As it becomes easier for businesses and consumers to rely on digital media for information and entertainment, we expect digital media to become even more ingrained in peoples’ lives. We are especially encouraged by the growth of subscription-based services like RealNetworks’ Rhapsody, which just logged its millionth customer. Rhapsody’s success testifies to consumers’ willingness to rely on digital networks for their entertainment content. As WiFi and WiMAX extend broadband coverage to mobile environments, we expect consumers to become even more interested in subscription media at the expense of physical media like CDs and DVDs. Dual-radio cell phones that can access both cellular and wireless broadband networks will speed this transition.

With a stronger backbone, digital media will undoubtedly spawn many new forms of content. The key lies in producing content that does not repurpose existing media. When America Online acquired Time Warner, for example, it trumpeted its plans to bring Time Warner’s magazine assets to the Web. Unfortunately, no one consulted with consumers, who to date have been unwilling to pay for recycled media. (The Wall Street Journal is one of only a few publications that have succeeded in charging customers for online access.)

Quite naturally, both businesses and consumers want content that is qualitatively different from what is already out there and takes advantage of the unique properties of the device that they are using. New content entrants like Podcasts do not pass this test. In our view, Podcasts are repurposed content that has been taken from blogs and transferred onto MP3s. Are Podcasts a valuable feature? Undoubtedly, several of our companies are contemplating distributing their own Podcasts. Nevertheless, we do not yet understand how Podcasts will become a standalone industry.

Still, we do not believe in predicting the future. As digital media completes its evolution from test pattern to high definition, the only thing that is certain is that there will be even more venture activity in digital media in the months and years to come. That’s not predicting the future; that’s reality.

Survival Tips for Digital Media Investors

1. Don’t repurpose old content. New technology demands new media.

2. Don’t bet on huge infrastructure shifts. The rollout of new technologies like WiMAX will take longer than you think.

3. Avoid digital media executives who just want to get paid. Hollywood and Silicon Valley cultures do not always mesh easily, particularly when it comes to salaries and assistants.

4. Don’t second-guess the consumer. VCs’ love for gadgets and new innovations does not always correspond with the needs of most consumers.

5. Beware of consumer electronics adoption cycles. It can take several years for manufacturers to design new products into their devices.

6. Marketing is not just about customer acquisition. Don’t forget to allocate marketing dollars to the conversion and retention of customers.

7. Some customers are not worth the trouble. Movie studios, cable companies and cellcos are difficult and penurious-avoid them.

8. Focus on being best, not first. Consumers will not be fooled into putting up with an inferior product just because it is first-to-market.

Source: Alex Gove, WaldenVC

Alex Gove is a Vice President at WaldenVC, a venture capital firm that focuses on investments in digital media companies. Additional focus areas include software as a service and information services. Additional information may be found at www.waldenvc.com. Alex mat be reached at alex@waldenvc.com.