“In an event some giddy Americans liken to music’s equivalent of the Second Coming, Spotify Ltd. will launch in the United States this year, or so the Scandinavian-born, London-based company says. Wildly popular in certain European countries, Spotify offers (usually) free, legal, on-demand digital music streaming to the tune of more than 4 million tracks. Daniel Ek, Spotify’s 26-year-old, brashly confident CEO, predicts 100 million listeners, of which tens of millions will pay for the privilege, hundreds of millions of dollars in revenue and a stock-market listing. Others counter that the bigger Spotify’s audience grows, the more difficulty it will have surviving. “If it gets really popular, 50, 100 million users, it may well go broke just paying for all the music licenses,” says Gerd Leonhard, who has written and lectured extensively on the future of music.
So goes the digital-related music business: huge numbers, lots of hype, a surfeit of hope and a major chance of failure.
“This is a very seductive space,” says Leonhard, who a few years back tried his own hand at digital distribution of music with a company called Sonific and failed.
Spotify has ears buzzing. So does Pandora Media Inc., which has attracted more than 40 million users, often-zealous American listeners, to a customized, radiolike service that many industry analysts now believe has as good a chance as any for financial success. Pandora CEO Tim Westergren says the service was profitable in the fourth quarter and chalked up revenue in excess of $40 million, more than double 2008.
A company called Mog Inc. launched its on-demand, paid-subscription service in early December with a robust dollop of popular excitement and a new venture round led by Menlo Ventures. “We blow Pandora out of the water,” claims its CEO, David Hyman. He believes the $5-a-month fee is reasonable enough to attract “tons of young adults.”
Another long-anticipated, all-you-can-listen-to offering called Rdio appeared on selected iPhones mid-December to the delight of the cognoscenti. Rdio Inc. is the brainchild of Janus Friis and Niklas Zennstrom, who started the Internet telephone company Skype Technologies SA as well as the notorious music file-sharing service Kazaa.
Hundreds of lesser-known startups are vying for a piece of the business as well. A compilation by the London-based digital music business research firm Musically Ltd. identified 200 digital-music-related startups in 2008, with a further 150 or so in 2009. These include everything from two competing services that recognize songs when hummed through a mobile phone to a site that allows users to remix songs of major artists.
Investors have poured in. Venture-backed companies range from Spotify and Pandora, which appear to have raised more than $50 million each (they aren’t disclosing figures), to at least 100 others that have each attracted anywhere from $2 million to $10 million. A back-of-the-envelope calculation suggests at least $1 billion has been invested in digital-music-related concerns over the past five years.
“Music is such a basic element in people’s lives. It’s a core piece of people’s behavior, so it’s natural that lots of money follows it,” says Timothy Komada, co-founder and managing partner of venture capital firm Deep Fork Capital, which has invested in digital-music service Amie Street Inc. “What does surprise me is that some of the business models are inherently economically unfeasible. And they’ve been financed with tens of millions of dollars.”
One likely explanation: All these startups and the concurrent investment are functions of something that may be fundamental to our existence, but as a business is chaotic, dysfunctional and in the midst of major upheaval. Of all the industries out there, few engender more passion or more anxiety than music.
“It’s completely unsettled and more and more fragmented,” says Jeff Fagnan, a partner with Atlas Venture, which has invested in a music player company called Songbird. “The rules of the industry and the economics of the industry have completely changed.”
Music is more ubiquitous now than it’s ever been. Technological advances offer more and more delivery mechanisms, user options and wizardly new features. The ability to cache thousands of songs on an individual mobile phone, for example, is something Hyman declares “a game changer.”
However, just who can make money off all this is almost as uncertain now as it was five years back.
“The general mechanics and value chain for digital music are starting to converge,” says Bob Borchers, a general partner with Opus Capital who headed Apple Inc.’s iPhone worldwide marketing. “What the players will be, what their roles will be — there’s still a lot of room yet to go.”
That gives startups the impetus they need. “It’s wide open,” says Laurent Kratz, CEO and co-founder of the Luxembourg-based service of independent music, Jamendo.
The debate is still mired in some of the same competing viewpoints: music as a service versus music as a product, own versus rent, advertising-supported versus paid subscription, doing deals with major labels or not. The most fundamental question remains just as germane today as it did at the start of the last decade: How does a business make money? “Everyone is gambling there will be a way to monetize distribution of recorded music,” says Peter Strand, a Chicago-based entertainment lawyer. “But no one has come up with the solution.”
“It’s very tricky to say what’s going to work and what’s not,” Atlas Venture’s Fagnan continues. “But I can tell you only a handful will be successful.”
Last year’s great hopes are this year’s busts. Witness music-centered social networks, which 18 months ago were poised to dominate both listening and investment activity and now seem like a quaint echo of fashions past. A few months back, News Corp.’s MySpace Inc. picked up for little more than a song — maybe $1 million — one of the biggest music-related social network sites, Imeem, which claimed 16 million monthly listeners. That low price tag wasn’t a surprise. Imeem backers including Warner Music Group Corp. had months earlier written off their entire investment.
“The music space in general has been very disappointing,” says Elias Roman, co-CEO of Amie Street, which offers dynamic pricing, where the greater the demand, the more music costs. “There have been so many digital-music carcasses.”
Venture capitalists are most attuned to the fact that there have been “so few successful exits,” says Borchers. “That puts the bar higher.” He attributes this dearth in part to the lack of willing buyers. “Part of the challenge is that the folks who are significant players in the ecosystem are not being acquirers.”
It doesn’t help that the few high-profile financial exits that have occurred have been subpar, Fagnan says. Apple last month acquired Lala Media Inc., which hosts a music library based on what customers have in their hard drives, allowing access on mobile phones and other devices. Apple has declined to say how much it paid, and estimates vary from $17 million to $80 million. But even that upper-end figure isn’t all that great, considering Lala had $14 million in cash, raised $35 million in venture funding and was once valued at $180 million.
The one successful sale — from the seller’s perspective, not the buyer’s — took place when CBS Corp. paid $280 million for a Pandora-like service called Last.fm Ltd. That was 2-1/2 years ago. Last.fm has languished.
“There’s a hope, quite honestly, of an exit, almost despite the fact that [the model] is uneconomic, before anyone realizes it,” says Komada.
This less-than-stellar track record is translating into growing wariness by VCs. It isn’t nearly as easy as it was before last year’s financial meltdown to get venture capital backing. Initial rounds tend to be smaller. “There’s been a very, very steep decline” in funding, Roman says, quickly adding that his company was able to close a $3.88 million round in September.
A surprising number of investors, however, continue to write checks. Companies and their backers seem to sprout up everywhere. “It’s a question of hope springs eternal,” says Larry Marcus, a partner at Walden Venture Capital, an original investor in Pandora. Adds Pandora’s Westergren: “For the person who figures it out, there’s a big reward.”
It’s an international quest. In October, for example, a music video site called Vevo attracted an undisclosed sum from the Abu Dhabi Media Co. That same month, a French music streaming site called Deezer picked up €6.5 million ($9.3 million) from AGF Private Equity and CM-CIC Capital Privé. And Ecast Inc., a San Francisco-based company that makes digital jukeboxes for bars and nightclubs, announced $17 million in new funding from four VC firms and South Korean consumer products giant LG Electronics Inc.
While newly minted companies bank funds, post “for hire” notices and look for bigger digs, just as many three- or four-year-old “veterans” fire their employees, lock the doors and toss the keys back to their landlords. Last year witnessed some very high-profile failures. Music search engine SeeqPod, which boasted 45 million monthly visitors but fell afoul of major labels, went bankrupt, as did SpiralFrog Inc., which offered free music downloads. For reasons best known to itself and its hedge fund backers, SpiralFrog for a time filed quarterly reports with the Securities and Exchange Commission, revealing some of the industry’s crazier economics. Two years ago, it reported quarterly income of just $20,000 after expenses of $3.4 million, not exactly the calculus to ensure long-term survival.
“Music is part of our DNA. Interest in music is insatiable,” says Michael Dougherty, CEO and co-founder of Jelli Inc., a startup that combines terrestrial radio with a Web-based interaction in syndicated programs. “But with monetization and rights, there’s still uncertainty. The investment community is having a hard time at the end of the day.”
It’s been a decade since Napster upended the industry with file sharing and illegal music downloads. The illegal Napster is long gone — retailer Best Buy Co. now owns a legal subscription service of the same name — but the dislocation continues. By some estimates, illegal downloads still account for 95% of all recorded music obtained by listeners.
“The reality is [illegal] peer-to-peer is kicking our asses every day. Both hands are tied behind our back,” says Amie Street’s Roman, a 20-something who admits he and his friends were as guilty in college of stealing music as anyone.
For the new generation of music consumers — if that’s even the right word these days — “free is the industry standard,” says Jamendo’s Kratz. The key, Kratz, for one, believes, is working within that reality and still finding ways to sell products and services at acceptable margins. For Jamendo, that means giving away music to consumers but selling a rights-cleared music service to businesses. Kratz says revenue now tops €100,000 a month and margins are a predictable 50%. The company is just closing its second, €3 million round.
While new companies scrap and scramble for a piece of the action, music’s traditional power centers often appear like dazed, aged prize-fighters, rocking on their heels. Global recorded music sales in 2008 totaled $18.4 billion, according to the trade organization International Federation of the Phonographic Industry, or IFPI. In 2000, by contrast, revenue reached nearly $31 billion. Specialty brick-and-mortar retail outlets such as Tower Records have pretty much disappeared.
Record companies fight rear-guard battles to keep fast-shrinking revenue from collapsing further, while most analysts predict the major labels will become increasingly marginalized, since their whole reason for being — marketing, promotion, distribution — is being disintermediated. One of the four remaining majors — EMI Group plc — looks like it will have a difficult time surviving (see story, page 12).
Radio conglomerates teeter as well, although that’s really a combination of decreased advertising revenue coupled with ill-conceived acquisitions financed by heaps of debt. In a 24-hour period in mid-December, radio owners Citadel Broadcasting Corp. and NextMedia Group Inc. both filed for Chapter 11.
The biggest technology players haven’t done much better in music-related offerings. Finland’s Nokia Oyj, for example, launched Comes With Music in late 2008, bundling unlimited music downloads with high-priced handsets. By all accounts, the effort has failed miserably, and while Nokia maintains a stiff upper lip, rumors persist the handset maker will shutter the service this year.
The only major music-related company that continues to flourish is Apple. The company’s iTunes Music download service is now the biggest purveyor of recorded music, according to the market research outfit NPD Group Inc. Apple sells 25% of all recorded music in the U.S. Wal-Mart Stores Inc. is second with 14%.
However, Apple’s primary business is selling devices. Apple has become the modern-day equivalent of the Victor Talking Machine Co., which made the Victrola phonograph.
For most other digital music endeavors, revenue streams remain both shallow and murky. Because they must pay the labels every time a track is played, on-demand services including Spotify can’t survive on ad sales alone, so they bank on a paid-subscriber base to augment revenue. (In Britain, Spotify charges £9.99 [$15.93] a month for its premium service, which allows 3,333 songs to be cached on a mobile device for listening. It won’t say how many of its 2 million subscribers in Great Britain are paid.)
The problem is that to date, no streaming subscription service has taken off. “Consumers aren’t going to pay,” Leonhard asserts flatly. Rhapsody is the largest and it only had 700,000 subscribers at the end of the third quarter of 2009, a drop of 100,000 from the first quarter, according to the quarterly report of main investor RealNetworks Inc. Westergren says the number of paid subscribers on Pandora is “really not that significant,” even after it limited free usage to 40 hours a month.
While major record labels witness their dominance lessening practically by the day, they still play the role of the great spoiler in music’s digital assault. “It’s been very difficult to build a business that’s win-win with the record industry,” says Walden Venture’s Marcus.
After a years-long battle, Internet radio services like Pandora finally escaped the labels’ suffocating grasp. Last July, Internet radio extracted from the Copyright Royalty Board a standard revenue-sharing arrangement in the U.S.: Basically, 25% of revenue goes to royalties, which is automatic; no record label permission is necessary. Westergren terms the arrangement “survivable, but awfully hard.” Pandora this past year paid more than $20 million in performance fees, he says.
(No such agreement exists elsewhere, which is why Pandora is shut out of Europe.)
For on-demand models like Spotify, however, there’s no standard, compulsory or universal agreement comparable to what governs either radio or live performance. They must first gain permission from the labels and work out revenue-share and payment arrangements. Labels are in no hurry. That’s one reason Spotify has yet to appear in the U.S. after promising a launch by the end of 2009. That’s also the reason why in attempts to gain label approval, “many startups find themselves at the back of a very long queue,” says Paul Brindley, Musically’s CEO.
“A direct deal with a label is always starting from scratch,” Westergren says. “I don’t want to hire 30 lawyers to do 30,000 direct deals every 12 months.”
Agreements have been “bespoke,” in the words of James Glicker, founder and CEO of a U.K.-based classical music Web site called Passionato Ltd. Glicker has found the process taxing and frustrating even though almost all the music he sells is physical product.
That means major labels can, and do, demand up-front licensing payments, equity participation and whatever revenue share they can get away with. They can dictate how many songs are played before an advertisement appears or even, in theory, what percentage of play a particular label must get.
Major record companies can also be fickle. The often-expressed belief that the majors have finally and fully accepted the inevitability of a digital universe may be wishful thinking. Hyman describes investments in Mog by venture units of both Sony Music Entertainment Inc. and Universal Music Group, the world’s two largest recorded music companies. Those units no longer exist, and the individuals responsible for the investments “are no longer working” for the labels, Hyman says.
The advances to labels have created a sinkhole for investors. VCs “have wired money to startups, which have wired money to labels. Absolutely no value is built,” says Roman.
On-demand services are “still completely reliant on rights holders, which have a stranglehold on the business,” asserts Komada. He then asks a fundamental question: If the goal of on-demand services is to replace physical CDs and paid downloads, “what incentive do [labels] have to support a business model that if it succeeds would put them out of business?”
Critics like Leonhard, in fact, maintain that labels have rammed through a system that ensures that the most popular on-demand services self-destruct. According to his calculations, Spotify, for example, has to pay 1 cent every time a song is played. “If 100 million users play 10 songs, that’s 1 billion songs a day. They’ll have to pay $360 million a year,” he calculates, and that doesn’t include other costs such as hosting. In terms of advertising revenue, Spotify will “have to be as big as Google in nine months just to break even,” Leonhard says.
Spotify didn’t respond to requests for comment. Neither did its one known venture backer, Northzone Ventures. (Hong Kong’s most prominent businessman, Li Ka-shing, is widely reported to be an investor, although this isn’t confirmed.) A source with knowledge of the company who declined to be identified says the company and its backers are convinced there’s a “clear path to profitability” and that the major labels will move to a revenue-sharing model with Spotify, allowing it to survive.
One good way to divide digital-related music startups is to group those that are predicated on label deals and those that aren’t. Those that are, like Spotify or Imeem, tend to get more buzz, especially as they move toward musical consumption’s holy trinity: whatever, whenever, however.
Those that aren’t may be more attractive to venture funding these days. “The distinguishing factor of [new, venture-backed companies] are services that don’t require rights,” says Brindley. “We’re seeing more of those kinds of companies coming through, with value built around music.”
“We made a decision that we didn’t want to invest in music that had to cut deals with labels,” says Atlas’ Fagnan.
Jelli’s Dougherty, for example, purposely sought to fashion a business that doesn’t require label permission. “Jelli is building a company that is really cool in the business arena, where licenses are compulsory,” says the former Hambrecht & Quist Capital Management LLC investment banker. “The problem is the negotiated license.”
Another way to divide the startup universe is to differentiate between content services and technology that facilitates digital music distribution. Opus Capital’s Borchers describes this as “the building blocks that make the digital music experience work more smoothly.”
This could include everything from search engines and music recognition software to media players and storage.
TuneCore Inc., for example, distributes digital music to sites that range from iTunes to Rhapsody to MySpace Music. The four-year-old company now claims to be the biggest distributor of music in the world. It’s a “fee for service,” explains co-founder and CEO Jeff Price. Most importantly, the business model “isn’t predicated on what happens to the music after we sell it,” says Price, who spent almost two decades running an independent label. “I’m not picking and choosing.”
“It’s been a really good investment because they’ve been able to create a market,” says Borchers, whose firm invested $7 million in TuneCore in October 2008.
“You pick your spots and figure out how to get paid,” says Walden’s Marcus, when asked how to invest in digital music. That’s simple advice. The only problem is that so far, it’s proved far easier said than done.”