Updated from 3:57 p.m. EDT

Microsoft ( MSFT) and RealNetworks ( RNWK) announced a $761 million deal Tuesday to settle their antitrust case and create a new partnership to distribute Real's music and digital-game services through the MSN network.

Real's shares soared 35% before the market opened, on reports that the companies were near a settlement of Real's 2003 antitrust suit. Shares of Real were recently trading up $1.91 at $7.65, while shares of Microsoft shed 9 cents to $24.37.

The new partnership gives Real a broader audience for its Rhapsody subscription music service and fills out Microsoft's music offerings. It teams the two former rivals against Apple ( APPL), the leader in the online music space with its popular iTunes music service and iPod music player.

But at the same time, Microsoft and Real will continue to offer competing online music players.

"Two players like this banding together -- that definitely represents a challenge" against Apple, says Michael McGuire, research director in Gartner's media group. "It's interesting to see the stated level of integration they're going to work toward."

But even together, Microsoft and Real still face the challenge of convincing consumers to pay a monthly fee for access to music instead of downloading and keeping it forever, the preferred method of getting digital music today.

"Maybe two teams working on this can come up with some compelling scenarios that they can present to consumers to make the subscription model more exciting to more people," McGuire says.

Under the agreement, Microsoft will pay Real a $460 million up-front cash payment to resolve all damages claims and give Real expanded access and long-term licenses to a wide range of Windows Media and securities technologies.

Under separate music and games agreements, Microsoft is scheduled to pay Real an additional $301 million in cash and provide services for 18 months in support of Real's product development, distribution and promotional activities.

Microsoft will promote Real's Rhapsody service on MSN Web sites and offer RealNetworks' digital games through MSN Games and Xbox Live Arcade for Xbox 360.

Microsoft will earn credits toward the $301 million for subscribers that MSN delivers to Real.

Support System

Real and Microsoft also will collaborate on casual games, with Real creating a new subscription service to be offered on MSN Games and developing a series of new casual games for Xbox Live.

In addition, Real will take steps to support MSN Search, Microsoft's Internet search product that competes against Google ( GOOG) and Yahoo! ( YHOO), and Real and Microsoft will jointly promote the use of Windows Media technologies with Rhapsody to Go.

In a demo during a press conference Tuesday morning, Real CEO Rob Glaser and Microsoft Chairman and Chief Software Architect Bill Gates offered a sample of the way the two companies would integrate their products.

They did a search on MSN for the Rolling Stones and then clicked on the results to play a song through Rhapsody. They also said Rhapsody would have its own tab on Microsoft's Instant Messenger technology.

The companies expect to roll out some products very quickly; others will not be available until the first half of next year.

The deal will not affect Real's relationship with Google, in which Real offers downloads of Google's toolbar with downloads of its Real Player, said Glaser, a former Microsoft employee.

The agreement should vastly expand the potential customer base for Rhapsody, given that MSN attracts more than 420 million unique users per month. Real has more than 1.15 million premium music subscribers.

Napster ( NAPS), whose subscription service competes against Rhapsody, seemingly stands to lose the most as a result of the Microsoft/Real partnership.

Real sued Microsoft in December 2003, charging that the software titan violated antitrust laws in the media-player market. Seattle-based Real charged its Redmond rival with abusing its monopoly power by restricting how PC makers install competing media players while forcing the Microsoft media player on users of the Windows operating system.

Real's' suit piggybacked a similar antitrust in the European Union, which has required Microsoft to sell versions of its Windows OS without its media player. Microsoft is appealing the EU ruling, which could take years to resolve. Whether a settlement with Real will affect the EU case remains unclear.

"The people in governments will make up their own minds," says Microsoft's General Counsel Brad Smith.

Picking Its Battles

The pact with Real is the latest in a string of settlements that Microsoft has entered into to try and leave its legal battles behind. Earlier this year, Microsoft agreed to pay IBM ( IBM) $850 million in an antitrust settlement.

In April 2004, Microsoft and Sun Microsystems ( SUNW) settled an antitrust and patent dispute in a deal valued at nearly $2 billion.

Microsoft previously paid Time Warner's ( TWX) AOL $750 million in 2003 to resolve their legal differences.

"This was probably the largest outstanding adversary that they were still doing battle with," says Tony Ursillo, a software analyst with Loomis Sayles, which owns Microsoft shares but doesn't have a stake in Real in its $68.4 billion in assets under management.

"It's been important for Microsoft to get back to the business of creating software and discovering new markets. They got to the point where they realized that all of these lawsuits were becoming an obstacle to doing that. Other than that, it's just a case of finding the right price," Ursillo says.

The antitrust litigation also was proving to be a considerable drag on Real's financials. The company spent $4.7 million on antitrust litigation last quarter, taking a bite out of earnings of 3 cents a share. The settlement, on the other hand, will be a nice boost to Real's balance sheet. The company expects it to help roughly double its cash and short-term equivalents to more than $800 million by the end of the year.

Real offers unlimited access to more than 1 million songs, and CD-burning and transfer to 100 devices for a fixed monthly fee, but it also recently launched a free service that lets users listen to up to 25 songs per month.

The company also sells music downloads at a cost of 89 cents per song and $8.99 for most albums.

Apple's iTunes music store -- the only music store that works with the company's wildly successful iPod music players -- sells downloads for 99 cents a month. Apple has traded barbs with Real over whether consumers want to buy music downloads or a subscription to listen to songs.

Over time, Glaser and Gates maintain, consumers ultimately will prefer an open system vs. Apple's proprietary technology.

"These are early days in not just digital music but in the digital-entertainment space," Gates said.

Senior writer Jonathan Berr contributed to this report.

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