(FORTUNE Magazine) – In the past few months, the music industry has come face to face with the Internet--and it's scared. New formats for storing music, especially the one called MP3, make it a snap to share over the Net recordings that can be played, in full stereo, on PCs with speakers, in regular CD players, and on Walkman-like devices designed for MP3. Last year listeners downloaded literally billions of songs from Websites and paid for next to none of them.

Welcome to yet another chapter of The Internet Changes Everything. This particular one is a profile of two men on opposite ends of the music business spectrum: Val Azzoli, co-chairman and co-CEO of $700-million-plus-a-year Atlantic Group, which sells the work of artists like Hootie & the Blowfish, Jewel, and Sugar Ray; and Michael Robertson, CEO of a privately held Website called MP3.com, which gives away digitized songs by artists you've mostly never heard of and yet is perhaps the key company in this digital revolution. The men have never met; they are two of the many people, at companies ranging from Real Networks in Seattle and Microsoft in Redmond, Wash., to IBM in Armonk, N.Y., and Bertelsmann in Germany, who are either defending against or promoting this new technology.

The problem the $38-billion-a-year recording industry faces is that the ability to ship music directly may shift the balance of economic power. If artists can deliver to fans via the Net, who needs labels and distributors? The threat is nascent--Americans spent almost nothing on downloaded music last year and just $134 million on CDs ordered via the Web vs. nearly $14 billion on tunes bought in stores. But there is evidence of change: The Recording Industry Association of America says MP3 piracy may have helped drive a slight decline in music sold to the 15-24 age group in the past two years. "The barbarians are at the gate," says Robert Goodale, CEO of Ultrastar, a New York firm that helps artists connect with fans and promote music on their own Websites. "They're in the moats, and they're climbing up the sides of the castle."

MEET THE NEW BOSS

The Attila the Hun of this latest digital revolution is a blond, baby-faced 31-year-old named Michael Robertson, CEO of MP3.com. "We're working for a higher purpose," he says, earnest as a preacher. "We're providing artists with an option besides the traditional industry route--an avenue in which they have control of their destiny and keep ownership of their work."

Robertson's business consists of a site, www.mp3.com, where you can click on any of several thousand recordings and download it onto your computer's hard drive. At that point the song is, for all intents and purposes, yours to listen to on your computer's speakers or your stereo system, to transfer to an MP3 player like the Diamond Rio (a machine the RIAA would like to ban, but that's sold in places like CompUSA for $200), or to post to a pirate Website where thousands of your best friends can share them. The songs on MP3.com are not pirated, unlike many of the music files available on the Net--artists place their music here as a way of introducing listeners to their work.

Robertson runs MP3.com out of offices in a 1960s-era aerospace park on the north side of San Diego. "It's our only Internet company where they ask for your security clearance," says Mark Stevens, a general partner at Sequoia Capital and a director of MP3.com. Sequoia, the Silicon Valley firm that financed Apple, Oracle, and Yahoo, recently put $10 million into MP3.com. An IPO is planned for later this year, and Sequoia is betting that its investment will get paid back ten times over or more. At this point MP3.com has good buzz. If the company is rewarded by investors as other similarly hot Net firms have been, it will have the kind of highly valued stock that can fuel expansion, acquisitions, and the start of a full-fledged assault on traditional business.

For now, the company's still a tiny startup. As I sit down in a cheap chair in Robertson's utilitarian office, he offers to get me a drink. He comes back with a styrofoam cup of water.

Robertson is an old hand at this startup game, with a record that's mixed at best. Since graduating in 1990 from the University of California at San Diego, where he studied cognitive science, he's run a company that made software for digital cameras--it tanked--and an outfit called Z Company, which runs an odd assortment of Websites (including Filez, which offers downloadable freeware, Calendarz, and Websitez) with the sole goal of winning traffic that would in turn attract lots of advertisers. That--not high-minded visions of freeing musicians from the shackles of their corporate masters--is what led him to MP3.com. About 18 months ago he and his business partner, Greg Flores, noticed that the term "MP3" was being searched for more and more often on sites like Yahoo and Infoseek by people looking for digital music. (These days it's neck and neck with "sex" as the most-searched-for term on the Net.) So Robertson found the man who owned the rights to www.MP3.com. All Martin Paul had wanted was a Website with his initials, and since MP.com was taken, he had registered MP3.com. Having no idea that MP3 was a hot property, Paul sold Robertson the rights to the address for $1,000.

That simple transaction transformed Robertson's life. Robertson had nothing to do with the invention of MP3; he was not a music industry veteran; he was not a famous programmer; considering his middling record, he wasn't even all that skilled a marketer. But now he had a hot property. The day Robertson launched MP3.com the site got 10,000 visitors.

He started learning about the music business and says he was shocked by what he found: that musicians often get less than 10% of the price of a CD; that despite giving up so little of the sale, labels lose money on about 85% of their artists, depending for profits on hits like Hootie & the Blowfish's Cracked Rear View, which has sold 16 million CDs for Atlantic. Robertson also couldn't believe artists lock themselves into long-term contracts, like actors wed to 1930s Hollywood studios, and give up ownership of their recordings. All this has been true for years, of course, as anyone knows who is familiar with the business. But Robertson was amazed: "The system is broken," he says, "and we can fix it."

So Robertson came up with a new plan, one that seems at first glance to make MP3.com a marketing vehicle and record label that's more artist-friendly. When they sign up with MP3.com, artists agree to give away one song, which visitors can download free. If a visitor decides to order a full CD of that artist's music, Robertson presses the CD and ships it to the buyer. The artist sets the price of the CD, gets 50% of the price on every sale, and keeps full control of the master recording. Thanks to the free songs, Robertson has built one of the most popular sites on the Web, with 250,000 visitors a day. So far they have downloaded 18 million songs--and haven't paid a penny for one.

SAME AS THE OLD BOSS

The view from Val Azzoli's corner office is stunning. Outside, freezing rain pelts the pedestrians scurrying around Rockefeller Center. But here on the 26th floor of Atlantic Records' Manhattan headquarters, it's warm. The smell of fresh roses is soothing, and when I ask for a drink, tea is ushered in on a silver tray.

As I'm stirring in my sugar and milk, Azzoli rushes in and sits down on a large couch. The co-chairman and co-CEO of the Atlantic Group (positions he shares with the legendary Ahmet Ertegun) is dressed in all black. For a while we chat about the problems he's had putting in a tennis court at his home in New Jersey. But soon we're talking about the Internet. "I can't avoid it," he says. "I wish it would go away, because it's a pain in the ass. I don't want to retool my operation, but it's not going to go away."

Still shaggy haired at 44, Azzoli looks as if he could be a member of Rush, a band he managed for most of the '80s. He's an old-time rock & roll guy who got started when he gave up his job selling processed meat to manage a friend's band, Charity Brown (which had a hit in the '70s with "Take Me in Your Arms"). He has worked in music publishing, managed a slew of bands, and since 1990 held a string of positions at Atlantic. In 1996, Ertegun promoted him to the top jobs. Critics, perhaps fooled by his self-effacing style, said he'd fail. "I don't profess to be the smartest guy in the world," Azzoli says. Yet Ertegun credits him with a turnaround that made Atlantic the No. 1 label in 1997, with more than $750 million in sales. Last year Atlantic dropped to No. 2. (Who could compete with Sony Music in the year of Titanic?)

What Azzoli--and Atlantic--knows how to do is find bands, develop them into artists, finance their recordings and concert tours, and then market the hell out of their CDs. The whole business, of course, is predicated on selling that final product, the CD. But the digital delivery of music threatens to make the product irrelevant--people won't need a store-bought, record-company-packaged CD if they can just download the songs they want. Not only that, but if musicians choose to bypass the studios for Websites like MP3.com, the industry's control and ownership of the music are threatened. Atlantic is a member of SDMI, an industry group that wants to devise a standard for the technology that will protect copyright better than MP3, which allows for unlimited distribution. SDMI (short for Secure Digital Music Initiative) is led by the five major record companies: Warner Music (Atlantic's parent), BMG, Sony, Universal, and EMI.

Despite his concerns about MP3, Azzoli is no Luddite. Once he joined Atlantic, he noticed quickly that technology was changing the landscape. First he fell in love with e-mail. "Having e-mail was the most amazing thing in the world," he remembers. A band's road manager could send him e-mail from the previous night's gig, with the head count and the amount of money they'd made. "I could get everything the next day without talking to him at 2 a.m."

Then the Net took off, and Azzoli noticed smart bands putting up Websites to market themselves and solidify their following with fans. In hotels, he noted the shift when movies on the hotel's entertainment network moved from being offered at specific times to being available on demand. "A light went on," he says. "I knew then it was just a matter of time, that if they can do this with movies, eventually we'll get to a music delivery system."

Atlantic may someday use the Net to deliver music to millions of consumers, but that's a ways off. For now, Azzoli is concentrating on the Net as a form of promotion. Atlantic put up its first Website in 1995 and began offering online chats, promos, videos, and even concert broadcasts. Its most successful promotion involved Tori Amos, the acerbic pianist who sings about rape and bitter love--not the stuff of mass appeal. The month before the release of her latest album, From the Choirgirl Hotel, Atlantic let fans download a song called "Merman" from a special Website. "Merman" wasn't in MP3 format--instead, it was digitized with a secure technology created by a2b music, a New York company owned by AT&T. While MP3 songs can be played by anyone, a2b songs come with a software "key" that prevents sharing. Even so, the Amos a2b promotion was controversial for Atlantic, because parent Time Warner (also the parent of FORTUNE's publisher) is opposed to offering free downloads of music. But Azzoli stood firm and pushed the promotion through.

It was a wild success. Since "Merman" had not been on any CD and would not be released on Choirgirl Hotel, the download was a must-have for Tori Amos fans. The catch was they could only get it if they pre-ordered the CD. Tens of thousands of copies of the song were downloaded. In the first week of the CD's release, 153,000 copies sold, rocketing it to No. 5 on the Billboard charts.

THE NEOPHYTE AND THE DINOSAURS

For all his revolutionary thinking, Michael Robertson hasn't sold 153,000 copies of anything. In fact, as of now, MP3.com just isn't lucrative at all.

The pied piper of downloads doesn't actually sell downloaded songs. Visitors to MP3.com can sample thousands of tunes, but when they actually order music they buy a physical CD that, you'll recall, is pressed only when an order is placed. Robertson owns a bunch of computer servers, which hold the digitized versions of tens of thousands of tunes from more than 10,000 artists who have signed up with MP3.com. The servers are connected to CD burners, each of which creates a disk in about 20 minutes. Robertson says MP3.com gets orders for more than 200 CDs each day. The average CD on MP3.com sells for $7, so even if he sells 250 a day, he's on a pace to deliver $639,000 of music this year. That's before he pays to press and ship the CDs, before he pays his 50 employees, his rent, and his marketing expenses--and before he pays 50% to the artists. (By contrast, the Tori Amos CD pulled in about $1.5 million in sales for Atlantic in one week.) Robertson claims that most of his revenues come from advertisers pitching to his many visitors.

Robertson is not about to start selling chart toppers anytime soon. He has dismissed major labels as dinosaurs, but they have a few things going for them, starting with marketing. Robertson, for instance, doesn't have anyone who pitches tunes by MP3.com bands to the hitmakers who select radio playlists. As for advertising, the only place an MP3.com musician gets plugged is, well, on MP3.com.

Yet even that can be enough for little-known bands with little to lose. Take Lotusland, which was called Ugly Beauty when it was signed to Atlantic. Lead singer Christy Schnabel says Atlantic did little to promote Ugly Beauty's CD, which sold just a couple of thousand copies in 1997. The band was dropped last Christmas.

This February it signed on with MP3.com. In its first couple of weeks on the site, the band got a few dozen downloads a day. Then it was featured in the site's "artist spotlight," and downloads shot up to 1,300 a day. "Our mouths hit the floor," said Schnabel. She says the ability to get its music out there despite the big labels has reinvigorated the band, even if sales are minimal.

Robertson believes his company will be a key outlet for such artists. When Universal and Polygram merged early this year, the company dropped hundreds of bands. Claims Robertson: "You can take an artist that never made any money for themselves or the record label, and that same artist can move to the Net and sell one-tenth and make a lot more money." The 150 bands that sign up each day get Robertson's logic--keeping 50% of a sale does sound a lot better than keeping 10%. But here's a reality check: let's say Lotusland sells 10,000 CDs, more than anyone has ever sold via MP3.com. With its CD priced at $5, Lotusland would make $25,000--not exactly a living for a group with four members.

And as more bands sign on to MP3.com, how will Lotusland stand out from the thousands of others? "Today, everybody is suggesting that MP3.com is where the little guy can get music heard," says Marc Schiller, CEO of Electric Artists, a Web music marketer in New York. "A year from now it'll be interesting to see what MP3.com looks like. How will people rise above the noise?"

It's hard to say. While MP3.com, like Amazon, has lists of top picks and highlights featuring certain artists, it doesn't have established companies marketing its products--Amazon does, of course, as book publishers advertise their wares in print, in stores, and even online. That's why for all Robertson's talk of the "dinosaur" record companies, the future of MP3.com may well depend on cooperation between the neophyte and the dinosaurs. Already, some companies have promoted new CDs by giving away an MP3 song. (DreamWorks Records used MP3 to help push the band Buckcherry.) In March, MP3.com posted a Tom Petty song from his new Warner Music album, Echo. In three days, 156,000 people downloaded the song. Now the album's out and is selling well. Is that because of the MP3 release? Will MP3.com visitors click on a link and buy the CD at Amazon? Robertson doesn't know. "You have to look at the whole digital music thing as a baby," he says. "It is a baby that can't walk and talk yet, but it's just starting to learn."

"BLAH-BLAH-BLAH DOT COM"

Hanging on Azzoli's wall is a signed photo of Pete Townshend, the former guitarist of the Who. When I tell him that Robertson has a poster of Townshend in his office, Azzoli gets going. "Blah-blah-blah Net, blah-blah-blah dot com," he says. "It's all about the artist. The rest means jack shit. Unless you have a great artist and great music, it's all bull."

Ironically, Azzoli and Robertson see eye to eye on what the Net might be best for--finding and developing artists. "Maybe this is where MP3.com comes in," Azzoli says. Rather than plunk down $1 million to break a new band, why not test its popularity on the Web first? This, he adds, is "where Atlantic is going." He sketches a possible future: He'd sign a band and put it on the Internet. Let people vote if they like it. If they do, Atlantic puts the band on the road. If that goes well, Atlantic will help it make an album. Then the company will use the Net to see in what areas of the country the band is most popular so that it can target its shipments of CDs.

For now, however, Azzoli views the Net as a marketing tool. He loves Atlantic's Webcasts--live broadcasts of performances via the Internet. These free-flowing affairs often combine performance and interviews. In January, Atlantic's boy band du jour, Sugar Ray, went online to promote their new album, 14:59. They had performed on Jay Leno the night before, and now they strummed through their single "Every Morning" as fans across the Web tuned in. In the course of two hours, 13,000 questions were posted. "Mark, are you a virgin?" a fan wants to know of lead singer Mark McGrath. "Did we mention we're touring?" someone in the band cracks.

14:59 has gone double platinum, but there's no way to tell how many sales were inspired by Web promos. Not knowing doesn't seem to bother Azzoli. Indeed, for all his talk of embracing the Internet, he seems remarkably unconcerned with the details. He sheepishly admits that he has never downloaded an MP3 song.

What interests Azzoli is what this new medium means for the future of music. Ultimately, he believes, Atlantic will sell subscriptions and pipe tunes into customers' homes via the Net for a flat rate of, say, $10 a month. If that sounds a lot like cable TV, it's because Azzoli believes new media adapt to existing media. "People thought TV would kill movies. It didn't. People thought videos would kill movies. They didn't; it's a bigger business now," he says. "We now have TV, videos, and movies living in harmony, and movie studios are making more money. The same thing is happening in music."

Despite his confidence, Azzoli isn't entirely sure how this Net thing will play out. He does know there's a lot at stake: "I'm either going to be a star, or I'm going to be selling FORTUNE magazine at the corner newsstand, saying that I used to be a star."