The story of Kaleidescape Inc., as told in court testimony in San Jose, Calif., recently, provides a cautionary tale about some of the thorniest snares in digital media design today.

For now, the tiny startup is enjoying a moment of victory. At least temporarily, it has dodged the threat of having its product, a novel home media server, banned from the market. But Kaleidescape will likely be entangled soon in an appeal, and it has not escaped the wider thicket of distrust that stretches from Silicon Valley to Hollywood. That environment still crimps and contorts innovation for people in both camps.

The tale begins on Feb. 8, 2001, when three entrepreneurs nurturing an ambitious concept formed a company they called Next New Gig. Ultimately, it led to a battle that pitted the startup against a consortium of the largest companies in the electronics and movie industries, which alleged copyright infringement.

"At the time of our incorporation, we decided to explore the business of delivering high-quality movies to homes over the Internet," said Michael Malcolm, a tall, sandy-haired professor-turned-entrepreneur who is Kaleidescape's chairman and CEO.

Malcolm had pulled off two successful startups before. In 1992 he founded Network Appliance, a company that defined the network-attached storage box and spawned a multibillion-dollar business. He followed that up in 1996 with the more modestly successful CacheFlow, which defined an appliance to accelerate Web traffic.

"We didn't know what product we wanted to build or what market we wanted to go after. We just wanted to work together," said COO Cheena Srinivasan, the second Kaleidescape co-founder. A slight and dapper Sloan business school grad, Srinivasan cut his teeth at Sun Microsystems Inc. before joining up with Malcolm at NetApp.

Srinivasan helped Malcolm recruit the third member of the founding trio. Daniel Collens, who is no longer with the company, was at the time an up-and-coming engineer at CacheFlow with a degree from the University of Waterloo, Ontario--the MIT of Canada--where Malcolm had once taught computer science.

Soon after the company was formed, Collens and Srinivasan attended a conference about pay-per-view video in New York that sparked some ideas. "We envisioned a personal video library--a PVL--that would get movies over the Net, but there were challenges getting licenses to the content," said Collens, a tall, dark, ponytailed engineer who sported a company polo shirt during his court appearances.

After several interviews with Hollywood studio execs in 2001 and 2002, "it became clear there would be a high hurdle to get movies for downloading," said Malcolm. Besides the tough financial terms of the studio's licensing contracts, Malcolm faced a classic chicken-and-egg problem. "To get the studios to license content we needed a lot of eyeballs, but to sell a product we needed to have content people wanted to watch," he said.

Somewhere along the way, two ideas came together. Plenty of content was readily available on DVD disks, and the trio had a wealth of experience building hard-disk-based appliances. Thus was born the concept for Kaleidescape: a consumer-friendly array of hard disks to neatly store and rapidly access a personal library of DVDs. If the idea caught on, the startup could gain a following that it could eventually transition into the era of video downloaded via broadband connection directly from the studios.

The company got its name from the way the system showed art from DVD covers on a big-screen TV. When you choose a movie, the rest of the art covers swirl around like colored beads in a kaleidoscope to reveal other titles closely related to it.

"We didn't want to be a DVD company. That was just something to bootstrap the company," said Collens. But the subsequent design and the troubles it entailed wound up leading down "a long, convoluted path," he said.

For several months, Collens, Malcolm and Srinivasan debated the details of the product that would store hundreds of DVDs and manage them in much the same way that the iPod does a CD collection. Two recurring questions emerged in some of the e-mails from those days: How would the company address the problem of users who might copy rented or borrowed disks into the system? And how would it handle compliance with the Content Scramble System (CSS) defined by the DVD Copy Control Association, a consortium of the top movie studios, consumer electronics suppliers and computer companies?

Should the system include a carousel to physically house the DVDs? Too bulky. Should it destroy the DVDs after copying them to disk? Not likely to go over well with users, who might want to use the disks in a car video player or in some other way.

In the course of discussions, the founders considered as many as 15 ways of destroying copied disks. They even debated whether the company should be in the business of archiving the disks themselves.

Malcolm immersed himself in copyright law and even briefly retained the services of copyright expert David Nimmer. With Collens busy starting software design and building out the R&D team, the company hired a consultant to sort out the issues of DVD licensing.

"We didn't know anything about the DVD CCA back then," said Collens.

There was plenty to know.