FULL STREAM AHEAD

By Marc Gunther

From Fortune, 10.09.2000, Fall Special Issue

Web entertainment sites are attracting fans, Hollywood talent, and investors willing to embrace risk. Now all they need is a business model that works.

Pop.com sounded like a can't-miss idea. The Internet entertainment venture was created last fall by some of the most powerful and talented executives in Hollywood, including Steven Spielberg, Jeffrey Katzenberg, and Ron Howard. Microsoft co-founder Paul Allen invested $50 million, so money wasn't a problem. A top Disney executive signed on to run the operation, and stars like Steve Martin and Drew Barrymore agreed to make short films for the Website. Declared Katzenberg: "Just as MTV introduced a new entertainment forum for music videos, we think this new enterprise will offer a new form of entertainment for Internet users."

It hasn't worked out that way. Pop's a flop--its Website hasn't launched and probably never will. Its owners laid off all but a dozen or so people in early September. Now Katzenberg describes the experience of trying to build an Internet entertainment site as "humbling." And an executive at another big studio asks, "If those guys can't do it, who can?"

Who, indeed? Entertainment on the Internet, a notion that has attracted hordes of would-be Spielbergs and such well-heeled investors as Allen and Netscape founder Jim Clark, for now remains mostly an unfulfilled promise. Most of the pioneers who have tried to deliver short films, animation, TV shows, or movies online have attracted tiny audiences and piled up red ink. One wildly overhyped site, called the Digital Entertainment Network, burned through $67 million in venture capital before going bankrupt last spring; investors Chase Capital, Intel, Microsoft, Dell, and NBC were among the losers.

But the category shouldn't be prematurely buried because of a couple of high-profile failures. Internet entertainment is still looking for its own William S. Paley or "I Love Lucy"--a brilliant entrepreneur or creative breakthrough to help define the new medium. A solid business model would help too. "There isn't a rational economic model for the creation of Internet entertainment content--yet," says Yair Landau, president of Sony Pictures Digital Entertainment. That's why big players like Sony, Disney, and America Online have been reluctant to pour money into what's been called Netcasting.

"We're a little bit ahead of ourselves in bringing this content online," says Justin Post, Internet media analyst at Deutsche Banc Alex. Brown in San Francisco, who's bullish on Internet entertainment in the long run. But right now, he says, "it costs more to deliver content on the Internet than you can monetize." He's counting only the costs of encoding, storing, and delivering multimedia content, not production or marketing costs.

No matter--dozens of companies, mostly small, are out there aggregating and producing Web shows, and many more want into the game. "Everyone in Los Angeles--well, maybe not everyone, but lots of people who are in the entertainment business--wants to be in the Internet business," says Randall Kaplan, an L.A. venture capitalist whose fund, Jump Investors, gets about ten entertainment-oriented business plans a week. "They want to create the next "South Park" online. They think they've got the next $1 billion franchise."

What makes the business so alluring is that a sizable audience already turns to the Internet for fun. Roughly ten million people visit AOL's chat rooms each month, six million download music from Napster, and others turn to eBay and ESPN.com and online game sites. The trouble is, not many of them log on to watch the literally thousands of short movies and TV-like "shows" now online. More new shows will debut this fall on the Internet than on television, but fewer people will tune in to all of them, taken together, than saw a single episode of CBS's "Survivor." And even by Internet standards, the entertainment outlets are small fry: Of the 100 most popular Websites for home users tracked by PC Data Online of Reston, Va., just one, Shockwave.com, is built around entertainment--and it is retrenching. For the typical dial-up user, watching animation or short films online is frustrating: Either you can peer at streaming, herky-jerky images on a matchbook-sized screen or you can wait for content to download, which is no one's idea of fun.

What's needed to clear up the picture? Mostly patience, the enthusiasts say. Internet entertainment sites will flourish once broadband and wireless connections to the Web proliferate and the online advertising business matures, going beyond banners to so-called rich media ads that look like TV commercials. That, plus personalization, should add up to a business: Entertainment sites can store programs on the Web, aggregate eyeballs over time, and learn who their viewers are and what they like; that will be valuable information for both programmers and advertisers, who will pay a premium to target their messages at specific audiences.

"Most people I talk to believe that Internet-based entertainment is going to be a big business," says Frank Biondi, the former Universal, Viacom, and HBO executive who now runs an Internet-oriented venture fund. "The convergence of targeted marketing and programming on demand is what really excites me. Just think about the ability to insert customized ads into programming; you can't do that on television."

Even in their infancy, Internet entertainment sites have shown they can do things that you can't do on television--and we're not talking about live porn, fart jokes, or shows like "Tit Talk," which airs on romp.com, a site for guys. No, what's intriguing is the way entertainment sites are already having an impact on how Hollywood operates.

Consider a three-minute film called 405: The Movie, which has been seen more than 1.8 million times since it was posted in June on ifilm.com, a portal for film buffs. The movie, which uses digital special effects to show a jumbo jet landing on an L.A. freeway, is so arresting that the two young filmmakers, Bruce Branit and Jeremy Hunt, were signed up by the Creative Artists Agency after 405 went online.

Or look at how former Disney studio chief Joe Roth used the Internet to cast two small roles in the film Tomcats, being produced by his new company, Revolution Studios. MediaTrip.com, an entertainment Website controlled by Revolution, invited would-be actresses to post pictures and resumes online, and hundreds did; more than five million votes were then cast by visitors to the site. That generated traffic for MediaTrip and awareness for Tomcats at virtually no cost.

Or consider the novel programming being dreamed up by actors Matt Damon and Ben Affleck and their partners in LivePlanet, a startup that's trying to move beyond movies and TV to create a whole new kind of entertainment.

To get a sense of where the business is headed--or whether it's going anywhere at all--FORTUNE recently visited startups, a studio, investors, financial analysts, and agents who are immersed in the world of online entertainment. It felt a bit like what television must have been in the early 1950s: experimental, unpredictable, and fun.

Flash Makes a Splash

To Lawrence Levy, the newly hired 41-year-old CEO of Shockwave.com, there's no mystery about what's driving the company that calls itself the leading entertainment destination site on the Web. "Great media companies have always leveraged new technologies to create great media properties," Levy tells me. He points to a book of Warner Bros. cartoon art on his coffee table and offers a little history lesson.

Motion-picture technology helped create the studios, he says. Disney was built by animation. Cable distribution set the stage for ESPN and MTV. And in Levy's previous job as executive vice president and CFO of Pixar Animation Studios, which produced Toy Story, he helped build a company that married storytelling and cutting-edge animation. Now he's running a startup powered not just by the Internet but by a remarkably popular suite of software called Flash. "It's the same deal as Pixar," he says. "This is about building a fantastic, long-term asset."

Flash has become the standard tool for creating and viewing animation online; especially over dial-up connections, animation looks better than live action. Macromedia, a San Francisco-based software company that owns Flash, originally built the Shockwave.com Website to showcase its product. Web surfers loved it; at peak, more than 1.5 million copies of the free Flash Player were downloaded from shockwave.com every day. Suddenly, Macromedia had an unexpected asset--Internet traffic.

To capitalize, the company spun off Shockwave.com last winter as an independent media firm with its own financing. Sequoia Capital, Jim Clark, and former Warner Bros. chief Bob Daly invested $45 million. With his wallet bulging, Rob Burgess, the CEO of Macromedia and chairman of Shockwave.com, signed up some big Hollywood names to make shows in Flash: Matt Stone and Trey Parker, the creators of "South Park"; Batman director Tim Burton; and James L. Brooks, producer of "The Simpsons," among others.

Some say Burgess overpaid. The "South Park" guys, for example, reportedly will get $2 million--a full quarter of revenue for Shockwave.com--to create 39 short "Webisodes" of a new show. Burgess won't comment on the money, but he says writers and producers are drawn to Shockwave.com because he offers them creative freedom and the biggest entertainment audience on the Web. "We've got this worldwide network of theaters, and we've got people in seats waiting for entertainment," Burgess says. Shockwave had 8.2 million unique users in July, far more than any other entertainment site, according to PC Data Online.

That number may be a bit misleading. Rivals say that Shockwave.com's audience comes not to watch shows but to download Flash and explore other features on the site, including games, music, and online greetings. Recently the site's No. 1 show was "Torpedo Joe," a creation of an Internet animation star known as Joe Cartoon; viewers shoot torpedoes at jumping fish. Like most entertainment Websites, Shockwave.com targets young viewers, particularly men.

Levy argues that Shockwave.com is poised to become a major player. It has traffic, a robust Website, first-rate content creators, Macromedia's technology, and at least the start of a brand. "To me, those are just the ante to be able to play the game," Levy says. "No other company out there has those core assets."

Even so, revenue was just $8.2 million for the year ended March 31; the company had an operating loss of about $18 million. One problem is that most people watch from offices, where connections are faster; it's tough building an entertainment business around lunch and coffee breaks. Another worry is the unsettled state of Internet advertising; right now the site relies on banners.

In September, Shockwave.com abruptly laid off about 20 of its 170 employees. "A year ago it was okay for companies to spend for market share," Levy says. "Those days are over."

Burgess and Levy would like to dress up Shockwave.com for an initial public offering as soon as they can. (Levy was hired, in part, because he oversaw Pixar's 1995 IPO.) The first Internet entertainment site to go public will be able to use stock to acquire competitors; everyone expects consolidation in the space. But even with its head start, Shockwave.com has a lot to prove. "We really are at an experimental stage," Burgess says. "I don't think anybody in the first year of cable understood how that business was going to evolve."

A Not.com in Seattle

It's practically the first thing Mika Salmi, the founder and CEO of AtomFilms, tells me when I arrive at Atom's office by the Seattle waterfront. "I don't consider us an Internet company," he says. I figure he's repositioning his business now that investors have turned sour on risky dot-com schemes. He may be, but it turns out that Salmi came up with the idea for AtomFilms before he'd even heard of the Net, while watching a French TV channel. Even today the company generates 60% of its revenues from licensing short films to customers like HBO, Blockbuster Video, and Continental Airlines; it sells videos and DVDs too. "We view our Website as just one of our product lines," Salmi says.

The son of a Finnish hockey star who played in the National Hockey League, Salmi, 34, has always been a go-getter. He started his first business as a teenager, teaching windsurfing on Lake Michigan; later he sold commercial real estate, worked as a deejay, promoted raves, coached a ski team, managed a rock band, earned an MBA in France, and, as an executive at TVT Records, discovered the rock band Nine Inch Nails. Living in Paris in the early 1990s, Salmi watched a TV channel that featured short films, music videos, and animation, and thought he'd like to start a similar channel in the U.S.

By the time he launched Atom in 1998 after a stint at Real Networks, Salmi had decided to build his channel on the Internet rather than on cable. He built Atom as a consumer brand and a business-to-business play, with a Website designed both to attract a broad audience and to market films to other outlets, including Websites, TV networks, and airlines.

"My feeling was, Internet entertainment was going to be big down the road," Salmi says. "I didn't know if it was going to be one year, three years, five years. The question was, How do we get to that point?"

Salmi has raised about $28 million, from such investors as Chase Capital, Arts Alliance, Allen & Co., Frank Biondi's WaterView Partners, and Warner Bros. Online (which, like FORTUNE, is a unit of Time Warner). Last spring he turned to Morgan Stanley to help raise more capital from a strategic partner, probably a big media or telecom company. Right now, Atom's losing money as it invests in marketing and infrastructure, but Salmi says that "being profitable isn't that far away."

What Atom has done well is build a brand. It has promoted itself aggressively, bought commercials on cable channels like MTV and Comedy Central, and come up with clever ways to get users to spread the word about the company. For instance, Atom has recruited a network of 250 "Atom Mavericks," fans of short films who get free baseball caps and videotapes of popular films and, in return, host screenings on college campuses and in their homes. Users also can become "Mogul Makers" by reading scripts submitted by new filmmakers and voting on which ones will get financed by Atom.

The fundamental notion behind Atom is to connect filmmakers directly with the audience. Let others hire high-priced talent to generate buzz; Atom will pursue ways to get its viewers involved in developing and marketing shows. "We're not anti-Hollywood, but we're un-Hollywood," says senior VP Heather Redman. "When you're talking about making entertainment for cell phones, that may take very different skills from making a blockbuster movie."

Atom's vox-populi approach to filmmaking has yielded such hits as Bikini Bandits. Yes, it's just what it sounds like, a show about bikini-clad women on a crime spree, made by Peter and Steve Grasse, brothers who run a Philadelphia ad agency. I don't get Bikini Bandits, although I'm told it's an homage to the campy films of Russ Meyer. Bikini, a parody of "Survivor" called Survival Exposed, and a cartoon called Angry Kid have each generated well over one million viewings on Atom.

While Atom licenses most of its films at low cost--often as little as $500 or $1,000 per short--the company is making about 15 series of its own that cost about $2,000 per three-minute episode. (Most half-hour TV sitcoms cost more than $500,000 apiece.) Atom invests in these TV-like series only after testing the concept or pilot episode online. "We never go into production unless we know there's a demand," Salmi says. That's not a guarantee of success, but it should prevent expensive flops, something Hollywood's never been able to do.

The Writers' Studio

Having covered TV for years, I feel right at home at Icebox, a company founded by three TV guys that has offices in an industrial section of Los Angeles not far from the Sony and Fox lots. But the psychological distance between Icebox and the TV establishment is vast; this is basically a TV animation network on the Internet created by writers who are tired of dealing with TV networks.

They're all successful writers, mind you. Howard Gordon used to be executive producer of "The X-Files," while John Collier and Rob LaZebnik hold top posts at "King of the Hill" and "The Simpsons," respectively. But their company grew out of a failure: Gordon, 39, spent 18 months and $20 million creating and producing a show called "Strange World" that was canceled after just three episodes aired on ABC. It was a waste of his time and everyone's money, he thought. "To me, it hammered home the terrible inefficiency of the system," he says.

Surfing the Web later, Gordon found animation that looked great but was "barely passable" in terms of story. He recalls thinking, "This would be a great medium if my friends wrote for it." So he called his friends Collier and LaZebnik, and they formed the company and hired a new-media agent named Steve Stanford as CEO. They raised about $15 million, with eCompanies, the incubator run by Sky Dayton and former Disney executive Jake Weinbaum, leading the way. Other backers include Jump Investors, Bessemer Venture Partners, Credit Suisse First Boston, and Hollywood veterans Norman Lear and Ron Meyer.

In less than six months they launched Icebox.com. ("The name doesn't mean anything, but it sounds iconoclastic," a PR woman explains. "You know what it is, but you don't." Cool.) They now have production deals with about 75 accomplished writers and producers, including top people from "Seinfeld," "Party of Five," and "Frasier." Writers are invited to do the show they've always wanted to but couldn't get on a regular network. Says Gordon: "The premise of this company is a cultural one and a creative one, which is that no great show has ever become a hit because of the filtering process." It's another effort to strip away middlemen and connect producers with audiences. The other premise, albeit unspoken, is that most of the really funny people in America have already found their way to Hollywood, so there's not much point looking for them elsewhere.

All the writers get standard production deals, mostly Icebox stock. "It was so outside the norm, where everything is about status," says Gordon. "It reflects our culture, where the idea is roll up your sleeves, no bullshit, leave Hollywood behind, just bring your talent."

The business model is straightforward. Produce funny shows, generate traffic, sell ads, and, ideally, take the most popular online properties and turn them into TV series or movies so that they can really pay off. Icebox will share offline revenues with the writers; one monster hit like "The Simpsons" or "South Park" would pay for the whole company. Recently Icebox sold a sci-fi spoof called "Starship Regulars," created by co-founder LaZebnik, to the pay-cable network Showtime.

"Given that we're creating shows with the same people who created the big, successful brands for the networks--as well as the people they identify as the next generation of creators--we see no reason why we can't be the place where those kinds of hits come from," Stanford says. Stanford, who is 35 and a former Oracle executive who left Silicon Valley for Hollywood, is counting on great shows to generate traffic. "Quality entertainment is something people will seek out and tell their friends about," he says. Icebox reached a mere 102,000 home users in July, according to PC Data Online, but the site is only a few months old and has spent less than $500,000 on marketing.

If content is truly king, Icebox should rule. By sticking with established talent, Icebox has produced the most consistently entertaining shows on the Web. "Mr. Wong," its No. 1 show, is a politically incorrect, hilarious little sitcom about an acerbic Asian butler and his snobby female boss. "Zombie College" is an offbeat black comedy, and "The Elvis and Jack Nicklaus Mysteries" are worth checking out just for the theme song.

While the Icebox crew may be frustrated by the network system, their site is the most TV-like on the Web. It's built around regular series, not games or short films. A new episode goes up every day. And, yes, the guys in charge read every script. But do they give those "notes" that writers dread getting from network suits? "Very rarely," says LaZebnik, smiling. "And we like to call them 'suggestions.' "

Sony's Game Plan

If Web startups want to use the Internet to bypass the Hollywood establishment, how does the establishment respond? To find out, I went to see Mel Harris, the affable, 57-year-old chief operating officer of Sony Pictures Entertainment, who, as second-in-command of the giant TV and movie studio, also oversees Sony Internet content in the U.S. He offered perspective, something that's often missing when the debate over Internet entertainment narrows in on one company's layoffs or another's big hit.

Harris' booming voice hints at where he got his professional start--as a morning disk jockey in his home state of Kansas nearly 40 years ago. He's worked in local radio, local TV, syndication, TV and movie production, cable, and the video business. In fact, he's devoted much of his career to helping so-called traditional businesses adapt to new media. He's also a keen student of the industry, with a Ph.D. in mass communications; his thesis analyzed TV viewing patterns.

Here's one thing he's learned: Americans have an enormous appetite for entertainment, notwithstanding the skepticism that has greeted most new technologies. "In 1978," Harris recalls, "the idea that people could actually have a copy of a movie in their home--unless they were a mogul with a screening room--was about as alien as the thought of the Internet was a few years ago." He also remembers broadcasters saying people wouldn't pay for cable because they were used to getting TV for free.

Despite that, Harris sees little point in shoveling traditional content like movies, TV shows, and animation onto the Internet--at least for now. "We don't look at this as another great place for us to make a syndication sale of 'Married ... With Children,'" he says. That's why Sony may appear to be an online laggard, even when compared with the other media giants. It hasn't spent hundreds of millions of dollars building a portal like Disney's go.com, nor has it developed online shows like Time Warner's entertaindom.com has.

But Sony already owns one profitable Internet entertainment business, and it is quietly building two more. The moneymaker is a role-playing game called Everquest, with 280,000 subscribers who buy the game on CD-ROM for about $50 and pay about $10 a month to play; it will generate about $100 million in revenues--more, most likely, than all the entertainment sites combined. Sony likes this business so much that it has bought the rights to develop similar games using George Lucas' Star Wars characters.

The other businesses that Sony is preparing to launch aim to be broader. By next year, Harris says, the company hopes to begin offering its movies online. While a wide rollout will await the spread of broadband, Harris says, "we've put a lot of time and investment and thinking into the business model and the technology." He won't get specific, but most likely movies could be downloaded into PCs, digital video recorders like TiVo and Replay, cable set-top boxes, TV sets with built-in hard drives, and perhaps videogame consoles like the Sony PlayStation. Don't forget that, as a manufacturer of consumer electronics, Sony helps shape all those devices.

Meanwhile, a Sony unit called Sony Pictures Digital Entertainment has begun developing original, interactive content for the Internet. One model for what's to come is a Sony online show called Dawson's Desktop, an Internet brand extension of the popular teen drama "Dawson's Creek." Fans can go deeper into the story by reading the lead character's e-mail or diary and watching his home videos.

The trick, for Sony and everyone else, is to time this market; moving too fast means piling up big losses, while sitting on the sidelines for too long could give competitors a head start. For Sony and the other media giants, including America Online and Yahoo, the risk of waiting probably isn't all that great, since they have the resources to acquire startups once the business takes off. Harris is keeping a close eye on the field, saying, "Of all the things we're involved with right now, this is the one I find most exciting." That tells you something.

Change Agent

No one I've interviewed has been more bullish on Internet entertainment than Dan Adler, head of new media for Creative Artists Agency. His department has grown from two to 15 people in the past year, and he's done talent deals with about 50 sites. "New media has become a meaningful business, rather than a pipe dream," he told me when we first met in his L.A. office, his e-mail pinging in the background. Adler's addicted; he laments that his Blackberry had crashed during the MTV Video Music Awards, so that he "was not able to use my time inside Radio City Music Hall as productively as I had hoped." He's been plugged into new media for nearly a decade, ever since his first visit to the MIT Media Lab in 1991, when he worked as an assistant to CAA founder Michael Ovitz.

Now I'm sitting in a restaurant in New York's SoHo, waiting to see Adler again and wondering what he'll say about the layoffs at Pop.com, Shockwave.com, and Scour.net, a multimedia search engine in which Ovitz has a stake. It's been a dismal week for content plays.

Turns out he can't say much about Pop. "Steven and Ron are agency clients," he explains. Besides, he adds, no one ever said inventing a new entertainment industry would be easy. "These are high-profile examples that are not necessarily indicative of any broader, underlying issues or concerns."

Adler suggests that if there's a lesson to be drawn from the setbacks, it may be that a new medium demands new formats. "Some of those who have struggled have looked at the Internet as a means of distributing traditional content rather than as an opportunity to create something new." It's the "I Love Lucy" problem again; no one has really figured out yet what Internet entertainment can do that's truly exciting and unique.

To that end, Adler and CAA are working with a company called Cyan to create Web entertainment. The firm, started by brothers Rand and Robyn Miller and based in Mead, Wash., created Myst, an immersive game that remains the bestselling CD-ROM of all time. "The hope is that they will create the products that will help define the medium," Adler says.

What's more, amid the gloom of the moment, he's just made a deal for a new project called Jackass from the cutting-edge director Spike Jonze and a young actor named Johnny Knoxville. Designed for TV and the Internet, Jackass has been described as a "nonlinear guerrilla-style comedy" about a man with an uncanny ability to absorb punishment. In one segment, Knoxville shoots himself in the face with pepper spray and gets zapped with a stungun to test the effectiveness of self-defense equipment. In another, wearing a prison-issue orange jumpsuit, leg irons, and handcuffs, he enters a hardware store and tries to buy a hacksaw. MTV bought the TV rights, but in an unusual move CAA, Jonze, and Knoxville retained the Internet rights and held an auction to sell them. They sent e-mail to entertainment Websites that gave out passwords to a protected site offering a Jackass preview and waited for the bids to come in.

Jonze, 30, is a hot property. Born Adam Spiegel--he's an heir to the Spiegel catalog fortune--he renamed himself after a 1940s bandleader, worked as a photographer, co-founded a magazine, got seriously into skateboarding, made music videos, starred in the movie Three Kings, and directed the independent hit Being John Malkovich.

Adler hopes Jackass will become the breakthrough he's been waiting for. "When the Internet begins delivering content that you simply cannot get elsewhere--and I think that includes a show like the online version of Jackass--the potential size of the business will be limitless," he says. Who knows? A show created by one guy who's constantly reinventing himself and another who's willing to endure pain? That sure sounds like the future of Internet entertainment to me. onally, town by town.