The anti-iTunes arms dealer

Apple rules music retail for now: iTunes passed Wal-Mart (WMT) last year to become the top-grossing music store in the world. But that doesn’t mean things will stay that way.

The latest challenge to iTunes comes from Bill Nguyen, the serial entrepreneur who founded Lala.com.

Palo Alto-based Lala is an online jukebox with 8 million songs; you can buy the rights to stream a radio-quality version of any song for 10 cents or download a higher-quality version for 99 cents. He says he’s averaging about $67 per year from paying customers.

By itself, Lala poses no threat to the iTunes juggernaut. But now it’s teaming up with Google (GOOG) and Facebook, arguably the two hottest properties online. Late today Google is expected to announce a partnership with Lala that should drive massive amounts of new traffic to the service.

And just last week, Lala announced that it will team up with Facebook and its 300 million users to push a new form of music distribution: song gifting. Soon, Facebook’s legions of social networkers will be able to do more than chat, update and poke — they’ll be able to buy each other songs, right within Facebook’s payment system.

We caught up with Nguyen soon after the Facebook announcement to ask about his vision for digital music, and why he dares to take on iTunes and Apple (AAPL).

Fortune: What’s the elevator pitch on Lala. What business are you in?

Nguyen: We’re a music service. But I think what makes us different from some other music services is we focus so much on helping you discover new music by using social behavior. There used to be such great radio and MTV that would help us find music, and a lot of those sources don’t really exist in the same way anymore.

So how long did it take this deal with Facebook to come together?

We’ve been having conversations with a lot of different partners about how to make Lala a part of what they do. There’s a lot of music out there — there are 8 million tracks. A lot of companies say, “there are 8 million tracks, come to our site and knock yourself out.” The reality is none of us have the time or the patience or even the knowledge to find what we want to listen to.

So we’ve been working for the last couple of years to try to add context. We launched a service with CMJ, we launched something with Pitchfork, we launched something with the guys at Billboard. And the reason why we did that is, those guys are curators. They were telling people what was good. In summer of this year, the conversations really picked up around, how can you connect with some much bigger websites? We’ve been talking to Facebook for almost a year about how to take advantage of all the amazing social features they have on their site. It’s been an ongoing process.

You’re going to be selling 10-cent song streams and 99-cent downloads. Right now you deliver about 5 million songs a month. What do you expect these new partnerships to do for your business?

It takes music and makes it a new product, in the same way that ringtones did. You buy ringtones to tell everyone else what you like, not for your own personal listening. So I describe it as jewelry, in a way. Gifting is like that. It’s a really cool way of expressing how you think.

We think what’s exciting about gifting is, people don’t have to even give us money. They can use the payment system already built into Facebook, which people are already using for everything from games to personal gifts already. It’s kind of like a greeting card. When you get it, it’s inside of your feed and you can listen to it.

So the social aspect is what makes this different from iTunes.

It is. We live in this age that I think is the best time for music, ever. It’s so much easier to create music because there are digital tools like pro audio. There are really no limitations for distributing your music like there used to be. You really don’t need a label or a studio to get your music out there. But iTunes doesn’t help you find out what to listen to. It just gives you the top lists. [Editor’s note: The latest versions of iTunes actually do include “genius” song recommendations based on your interests.]

Why are virtual gifts such a big deal?

Gifts are driven by events. I can give someone a song because I want to say something to them, personally. We think it’s so much more targeted than just browse and collect your music. It’s a very personal thing. And what’s nice about it is, it’s already happening. It’s not a new business model. Virtual gifts on the web are actually a really big business. It’s everything from what Facebook’s doing to Zynga with games. We think giving music is so much more tangible. People might not know what a virtual carnation is, but they definitely know what a song is.

How will the economics work for Lala? How much will you make from each sale?

I got in trouble for talking about it. I’m not allowed to talk about it anymore. But we’re happy with the relationship. One of the unique things about the Facebook relationship is they’re handling the billing and the credit card transactions. It’s a great deal. We’re really happy about it.

I’ve seen you quoted as saying it’s similar to the split that Apple does on apps in iTunes, so you get 70%, Facebook gets 30%.

I’m really not allowed to talk about it anymore.

You’ve also been working on some mobile stuff. What can you tell me about the iPhone app?

That’s a really good way to segue into some of the things we’ve been doing. On a mobile, it’s really not easy to get a song over the air. There are no free streaming services on the mobile platform [for streaming specific songs]. When you buy a song on Lala, whether it’s Facebook or anything else that we do, that music will be instantly available on a mobile device. That will be beginning with the iPhone.

It’s streaming. You’re hardly going to know the difference between that and an MP3 file. It’s flawless. There’s smart cacheing so it’s available offline for you if you’re in a bus or lose the connection. It’s pretty amazing.