It should have been Daniel Ek’s victory lap. On the eve of the Grammy Awards in January, the founder of Spotify sat in a sun-drenched Tribeca loft, where rising stars such as Alessia Cara took to the stage to entertain some of the most influential figures in the music industry. In attendance were executives from Amazon, Apple, Google and Facebook.
Mr Ek, clad in his signature T-shirt and Nikes, was holding court. His invention has injected billions of dollars back into the music business and he was sitting back to enjoy a performance of “Despacito” by Luis Fonsi — the most streamed song of all time. “The music business is back where it should be,” declared Nas, the rapper who dominated hip-hop when the compact disc was king in the 1990s, “with artists getting paid”.
Just minutes later lawyers representing songwriters announced a victory in a Washington court battle over royalty rates. The court awarded songwriters across America their largest ever pay rise, adding tens of millions to Spotify’s annual streaming costs. If Mr Ek was jolted by the news, he didn’t show it.
David Israelite, chief executive of the National Music Publishers’ Association, the trade body, called it “the most exciting 24 hours” of his career. Mark Mulligan, analyst at Midia Research, says the decision will partially undo Spotify’s work in shoring up its finances before its unconventional direct listing, expected to take place in the first week of April.
That the streaming service was dealt a blow from a royalty payments system that dates back to 1909 illustrates its unforgiving business model, just weeks before it is expected to go public in what could be the biggest media IPO since Netflix in 2002.
Spotify in numbers
With 6.3bn streams Ed Sheeran was the most streamed artist on Spotify in 2017
€4.1bn
In revenues earned by Spotify in 2017, although losses rose to €324m
¢79
Per $ of revenue that Spotify paid to rights holders last year, down from ¢88 in 2015
25
Hours the average user listens per month in Q4 2017, up from 19 in Q4 2015
€5.32
Average revenue per Spotify user in 2017, down from €6.84 in 2015
In the internet age music has become more commoditised — streaming trained consumers to expect all the world’s songs for a low price, or no price at all in the case of YouTube. Yet Spotify also has to pay most of its sales out in royalties to access that music; although revenues have more than doubled since 2015 to exceed €4bn, its losses have continued to grow and hit €324m last year.
With Spotify required to meet quarterly earnings expectations once it goes public the pressure on it will intensify. “That battle for margin between Spotify and rights holders is going to be a difficult dynamic,” warns the chief executive of one of Spotify’s four big music suppliers, which control 87 per cent of the songs streamed on its service. “The music industry is cyclical. Next year we might not have an Ed Sheeran. I do worry about whether there is a natural compatibility between music and the stock market.”
Spotify’s dilemma was laid bare in a 200-page filing last month to the Securities and Exchange Commission in preparation for life as a public company. It has a customer base that any Silicon Valley company would envy: red-hot subscriber growth, fewer cancellations and sales growth of 40 per cent a year. Crucially, people are spending more time using Spotify: the average customer streams 25 hours on the platform a month, up from 19 hours two years ago.
The company has been credited with clawing the music industry out of near- extinction and towards a brighter — if imperfect — future. And it has fended off competition from the richest technology groups in the world, convincing 60,000 new customers a day to pay about $10 a month. Its influential playlists have taken on the same role as powerful radio stations in dictating pop hits.
Mr Mulligan calls this Spotify’s “soft power . . . It is equivalent to what Apple had at the peak of the iTunes store, and Amazon at the peak of CDs,” he says. But he adds the caveat: “In actual revenue power, [Spotify] may never get there [to profitability]”.
The Swedish start-up has never made a profit. It is dependent on a maze of licensing negotiations, leaving its fate in the hands of the big music companies that have a direct interest in Spotify’s success, but will also look to sap as much in royalties from the service as possible. Spotify admits to its problems in a 40-page section in the filing titled “risk factors” that highlights its tangled royalty payments and widening losses.
“We have no control over the providers of our content,” the company warns. “The music industry has a high level of concentration, which means that one or a small number of entities may, on their own, take actions that adversely affect our business.”
New money spinners Podcasts
The company describes podcasts as a “significant opportunity”, and the company has invested in original shows, in addition to distributing a number of popular programmes from other companies. In January it joined forces with media companies including BuzzFeed to produce a daily newscast. The project, called Spotlight, would air short segments about news and politics, featuring work from BuzzFeed journalists. The move would help Spotify compete more directly with terrestrial radio — which draws $28bn in advertising globally, and $14bn in the US, according to BIA/Kelsey. In its regulatory filing, Spotify says “a migration away from radio broadcasting is likely and it will benefit both consumers and artists alike”.
When Mr Ek first hatched plans for Spotify in 2006, there were about 30 tech companies promising music executives that they knew how to save their business. Mr Ek stood out because he “wasn’t another brash guy flying in from California, telling us we were screwed”, says one executive involved in the discussions. But he still had to spend two years reinforcing his message before the labels agreed to give Spotify a chance.
In 2010, when Spotify was worth about $200m and had not yet launched in the US, the 27-year-old Mr Ek told a journalist that eventually Spotify would be worth “tens of billions” and that there would only be “four or five players left” in the market.
Few believed him but he turned out to be right. Digital distribution is dominated by Spotify, Apple, Amazon and YouTube. Facebook has cut a series of music licensing deals in recent weeks in a bid to become a more formidable force in music video. While some retailers threaten to abandon CDs as soon as this summer. Spotify has recently been valued at up to $23bn according to private trades.
New money spinners Advertising
Spotify’s justification for offering a free, ad-supported service has been that it would lure people into the platform, then help convince them to sign up for a full subscription — the real moneymaker. More than half of Spotify’s users have the ad-supported version, but advertising makes up only 10 per cent of sales. It has been trying to make itself more valuable to brands by rolling out new opportunities, such as sponsored playlists, which brands including Disney Pixar and Victoria’s Secret have participated in.
The music business, which spent much of its previous life fighting providers of pirated music in court, remains cautious — but the scepticism has lifted a little since the cheques began rolling in. Over its lifetime Spotify has paid more than $10bn to the industry, according to regulatory filings. Vivendi-owned Universal Music, Sony Music and Warner Music — the “big three” labels — have seen their revenues jump 10 per cent a year, as subscription streaming sales have risen up to 50 per cent.
Even some of the Swedish group’s loudest critics have come around. Scott Borchetta, chief executive of Big Machine Label Group, pulled Taylor Swift’s music off Spotify in 2014, sparking a debate over whether the service benefits musicians. Three years later, Ms Swift’s latest album was withheld from Spotify for just a few weeks — illustrating how the distribution strategy has changed even for the biggest artists.
“We have to be where the fans are,” Mr Borchetta says. “Physical is almost done. We can now see the finish line,” Spotify’s public offering is “critical to our wellbeing . . . it’s far too late to turn back”, he adds.
New money spinners Video
Spotify has vacillated on its video strategy. The company has produced a handful of original shows, but none has yet caught on meaningfully with users. Last year it looked to overhaul its video strategy, cancelling some shows that had been in development. It has also been injecting video into its most popular playlists, such as RapCaviar, with interview clips or music videos, as it aims to make subscribers more aware of video on the platform.
At Spotify’s US headquarters in Manhattan’s Flatiron District, chief financial officer Barry McCarthy has been doing the groundwork on the listing. Known internally as “Professor Barry”, he guided Netflix through its IPO in 2002 before joining Spotify in 2015.
Working alongside Mr Ek, he reformulated Spotify’s cost structure through painstaking negotiations with the big music companies, which agreed to accept lower royalty payments on the condition that Spotify keeps adding subscribers rapidly.
The results were immediate: Spotify last year paid about 79 cents of every dollar it makes back to rights holders, down from 88 cents in 2015. Yet that is still well above Netflix, which paid 66 cents for every dollar of revenue last year. It also converted debt to equity for its lenders, TPG and Dragoneer, while swapping shares with Tencent Music, the leading Chinese digital music company. Spotify says it now has no outstanding debt.
“It did everything possible to make its metrics look perfect for the [listing],” says Mr Mulligan. However, the songwriting ruling “could well offset much of the savings impact” in the US, he warns. Anthony DiClemente, analyst at Evercore, estimates it will immediately increase Spotify’s costs by $40m a year, and eventually by an annual $100m.
Spotify’s market debut will look different to its tech predecessors. The company is rejecting a formal IPO process, instead choosing to go public without issuing new shares — unprecedented for an entity of its size. Spotify does not feel it needs to raise money, and will save $70m in fees that it would have paid to underwriters. Instead, a direct listing allows it to go public without relying as much on the Wall Street machine and still meeting the obligations of its 2016 $1bn refinancing.
While the idea came from Mr McCarthy, it resonated with Mr Ek. “He’s not going to be on the cover of business magazines,” says one personclose to the chief executive. “He doesn’t want to ring the bell [on Wall Street].”
It raises the question of whether Spotify will turn into a Netflix or a Pandora? The music business is hoping for the former, as Netflix has become one of the most successful stocks on the S&P 500 index, while Pandora, the only digital music company on the public market, has seen its shares halve in the past year.
Netflix and Spotify are pioneers of digital streaming and the darlings of their respective sectors — and similarly compete against larger Silicon Valley players. Unlike Netflix, Spotify’s costs balloon along with its revenues, and crucially it does not make its own content.
“The problem with audio streaming is you need to have 100 per cent of the content rights in the world for music, otherwise nobody buys your product,” says Matt Pincus, chief executive of music publisher SONGS. Streaming has so far proved to be a punishing business. SoundCloud and Pandora have both flirted with bankruptcy in the past year, while Deezer scrapped its IPO plans.
Spotify’s strategy has been to become big enough that the labels need it. “Initially, it was a fight pretty much every time they wanted to change the terms to be even slightly better,” says PJ Parson, a Spotify board member until last June. According to its SEC filing Spotify now commands 42 per cent of music streaming globally. “The power structure has changed,” adds Mr Parson. Once Spotify reaches 100m subscribers, the balance may tip further — it has 71m today.
Timeline:
How Spotify changed the music game
April 2006
Daniel Ek and Martin Lorentzon found Spotify in Stockholm
October 2008
After two years of negotiations with the largest record labels, Spotify officially launches in Europe
March 2009
Spotify reaches 1m users, all of them in Europe
March 2011
Spotify reaches 1m paying subscribers
June 2011
The company raises $100m — valuing it at $1bn. Enough to fund its leap into the US
September 2011
Facebook and Spotify combine to launch newsfeeds that show people what their friends are listening to on Spotify
November 2014
Taylor Swift removes all her albums from Spotify describing the company as a “grand experiment” that doesn’t fairly pay artists
June 2015
Apple launches its rival streaming service. Spotify announces it has lured 20m paying subscribers
March 2016
Spotify raises $1bn in convertible debt from lenders including TGP and Dragoneer. Streaming overtakes downloads to become the biggest revenue source for the US music industry
July 2017
Spotify says its number of paying subscribers has leaped to 60m
December 2017
Spotify privately files to list its shares on the New York Stock Exchange
But it is not yet too big to fail. That it loses money while holding a commanding lead “begs the question just how dominant it needs to be to break even”, says Laith Khalaf, analyst at Hargreaves Lansdown, warning that Spotify “must be viewed as a high-risk investment”.
Other analysts warn that Apple could become more of a threat. It launched Apple Music in 2015, and has amassed a respectable 38m subscribers. Spotify has held its first-mover advantage, while Apple has a conflict of interest because it still wants to attract people to buying digital downloads on the iTunes store.
One solution is for Spotify to become something more than a streaming company. It could invest further in content such as podcasts, videos or advertising, which makes up just 10 per cent of sales at the moment. It might even invade the space occupied by traditional music companies. “It’s probably inevitable that Spotify will start doing things that record labels do,” as it works more closely with artists, says Mr Mulligan.
In a letter to investors, Mr Ek makes it clear that he wants to be much more than a pipe that zaps songs into smartphones. “The old model favoured certain gatekeepers. Artists had to be signed to a label. They needed access to a recording studio,” he said. But in this “cluttered landscape”, he added Spotify empowers artists to “break through”.
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