How to save the record label (maybe)

With CD sales continuing to fall, record labels realize they must reinvent themselves or perish.

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NEW YORK (Fortune) -- Thom Yorke, Radiohead's elfin lead singer, has talked in interviews about the apocalyptic changes that await us in the not-so-distant future. So perhaps it wasn't surprising that he and his band mates recently dumped EMI, their longtime record company, and released their new album on their Web site.

This decision by one of the music industry's more revered acts begged the question: How long will it be before record labels disappear entirely?

Maybe not as soon as you'd think, says Josh Deutsch, CEO of Downtown Records, a New York City-based label whose influence far exceeds its diminutive size. Shortly after launching Downtown little more than two years ago, Deutsch enjoyed a tremendous success when his company released Gnarls Barkley's genre-confounding "St. Elsewhere", the breakthrough pop album of 2006. "St. Elsewhere" went on to sell 1.3 million copies, according to Nielsen SoundScan, and Deutsch became a music business star.

Since then, his track record has been mixed. The 46-year-old label head had high hopes for soul singer Kevin Michael's self-titled first album. But it only sold 10,000 copies when it was unveiled earlier this year despite a great deal of media buzz and a song on HBO's "Entourage". Even so, Deutsch has been able to add some intriguing new artists to the Downtown roster like the Baltimore rapper Spank Rock and the French techno duo Justice whose single "D.A.N.C.E." was almost inescapable last summer. Downtown has also signed Mos Def, the talented rapper who lately has more success in Hollywood then on the mike.

Why are these artists flocking to Downtown when labels are supposed to be irrelevant? Because Deutsch is pursuing new businesses at a time when his industry sorely needs them. One of the reasons Gnarls Barkely became such a rage was that Downtown released the duo's first single, "Crazy," on MySpace, generating millions of streams before it hit stores, back when the social networking site was at its peak of coolness.

Now Deutsch is exploring ways to offer his artists' songs for free and still ensure they are paid. "There's been a huge change in consumption patterns," says Deutsch, who spent his earlier years in the music business working for big labels like Virgin and Elektra (now part of the Warner Music Group (WMG)). "Labels obviously have less control over distribution. We're dealing with the most powerful distribution medium ever created and for better or worse, it wants to share."

Obviously, labels have been weakened. But Deutsch argues they still have an important role to play. What worked for Radiohead isn't practical for every artist. The band built a ravenous fan base working with EMI, its longtime music industry. That's why it could handle the digital distribution of "In Rainbows" itself. (It did need XL, an independent record company, to distribute the compact disc.) That's not necessarily true for less famous artists. Says Deutsch: "For new artists, it's a pretty expensive proposition to create compelling music and then create demand through video channels, online communities and radio, all which still drive real sales and increase the artist's other revenue streams that are actually growing - like touring and merchandising."

Deutsch is also trying to stay ahead of the curve online. It's not enough any more to preview songs on MySpace anymore. He recognizes that younger music fans are increasingly discovering music on MP3 blogs like Pitchfork and Stereogum where bands often offer post their songs for no charge. So he is using that template to create an entirely new business for Downtown. In November, Deutsch launched RCRD LBL, which he describes as "the first online music label offering free, sponsor-supported MP3s." His partner is Peter Rojas, co-founder of Engadget, a popular tech blog and an old hand at creating thriving digital communities.

RCRD LBL's selection is rich. The site started with songs by over 275 artists from 15 independent labels including not just Downtown, but respected competitors such as Modular and Turntable Lab. And unlike nearly after other MP3 blog (at least the many this writer has visited) artists are actually compensated even though fans have already downloaded hundreds of thousands of songs at no cost on the site. "The kids can steal our music and I can still get paid," says Spank Rock. "God bless RCRD LBL, and God bless the Internet."

Deutsch is also actively luring bigger acts to RCRD LBL. In February, Moby, an artist on EMI's Mute label, released a free "mega mix" from "Last Night," his forthcoming album, on the site. In return, RCRD LBL is sharing some of its revenues with the bespectacled rock star's revenues based on page views. Moby understandably finds all this intriguing. "I Iove the fact that as the old/traditional infrastructure of the music business is breaking down, it's being replaced by new and more compelling institutions like RCRD LBL," he recently wrote on his own Web site. "The vice-grip hegemony of the corporate labels and corporate radio stations is loosening every day, which can only be seen as a good thing for music and listeners."

Well, maybe. Of course, the reason RCRD LBL can afford to do this is that corporations like Puma and Virgin America are paying for advertising widgets on the site. Still, both companies say they, too, are impressed its bleeding edge quality. "It's no secret that online media investment is rapidly increasing, and that the environments that are most compelling are the ones delivering great content for free, says Barney Waters, marketing vice president for Puma North America. "RCRD LBL fits that bill."

Deutsch declines to disclose RCRD LBL's financial results. However, he insists, "We're months ahead of where we thought we would be."

Now you can see why Deutsch is more optimistic than, say, Thom Yorke about the future. If labels are to survive, they have to reinvent themselves. That's what Deutsch is busily doing at Downtown. It looks like he's going to be around for a while.