By Adam Hayes, CFA
Spotify, founded in Sweden, is one of the world's most popular music streaming applications with over 100 million active users as of June 2016. Spotify evolved from the idea of combating music piracy. Founders Daniel Ek and Martin Lorentzon developed the idea and started the company in 2006, and is rumored to go public through a direct public offering (DPO) in late 2017, or early 2018.
Its business model was welcomed by the music industry which has suffered losses in revenues and album sales due to music piracy over the Internet. Spotify allows users to either stream music for free if they are willing to listen to advertisements, or pay a subscription fee for a premium service, meanwhile paying royalties due to artists and record companies.
The Impact of Illegal Music Piracy
According to a report by Institute for Policy Innovation (IPI), global music piracy "causes $12.5 billion of economic losses every year. This includes 71,060 U.S. jobs lost, a loss of $2.7 billion in workers' earnings, and a loss of $422 million in tax revenues." Since the founding of Napster — a peer-to-peer file sharing service — in 1999, legitimate music sales in the United States dropped 47%, from $14.6 billion to $6.3 billion in 2009.
Though millions of dollars more are spent each year by law enforcement and in the legal system, finding and prosecuting illegal file sharers rarely becomes a reality.
Legal Ways to Listen to Music Online
Services such as Spotify, Pandora, Apple iTunes on the other hand, are licensed, secure online music streaming services that allow users to listen to music legally. In fact, today there are more ways than ever to download or stream almost any song legally and legitimately.
For example, Spotify has paid out over $5 billion in royalties to the music industry since its inception till September, 2016. Because recording artists and record labels are being compensated, there is nothing illegal about it. Downloading or streaming music without paying for it in any way would constitute stealing.
Spotify's Model and Reducing Online Piracy
Spotify works a bit differently from many of these other online music services and it employs several methods to smoothly deliver music to users with no delays or latency. Spotify stores all of its music on its own servers, but individual users keep temporary copies of recently played tracks on their computers in a file called a cache. If you want to re-play a song, it is not re-downloaded but played locally from that file. Spotify also uses social networking and searches for nearby users running Spotify to see if their caches contain the song being requested and enables those other computers to serve you the music. This way, the main servers are never overloaded and music can be played 24/7 uninterrupted.
Spotify makes money from two sources – a free tier supported by advertising and a paid subscription premium tier. The free version allows users to play any song in their catalog on demand, but users are required to view and listen to advertisements that interrupt their listening. Their mobile app has more restrictions on the free version. Advertisers pay Spotify for exposure, which in turn fund the royalties that Spotify pays out.
As of March 2017, the company boasts of over 50 million subscribers. Spotify’s Premium tier gives advertisement free access to unlimited music across all of their devices including smart phones, tablets and televisions. Users can also temporarily download songs to their devices for listening offline, and play music at the very highest quality. Subscriptions are offered at varying rates- $4.99 a month for students, $9.99 per month for a regular account and $14.99 a month for a family account.
In 2015, Spotify reported annual revenue of $2.18 billion according to filings accessed by Music Business Worldwide. The same filings show that Spotify which pays royalties for all of the streaming and downloading of music distributed nearly 84% of all the revenues received back to the owners of the music – record labels, publishers, distributors, and independent artists themselves — but also took an almost $200 million loss.
The availability of services such as Spotify to obtain access to a huge catalog of legal music-on-demand has reduced music piracy. Legal video streaming services such as Netflix and Hulu are doing much the same for video and movie piracy. In 2011, Sandvine’s Global Internet Phenomena Report estimated peer-to-peer file sharing at less than 10% of total daily internet traffic in North America. The report also noted that "file sharing continues to disappear from many fixed access networks across the globe as Real-Time Entertainment options are providing subscribers a wealth of content at reasonable prices." (For more, see: 5 Expensive Music Licensing Deals.)
Today, over half of all internet traffic in North America can be attributed to the streaming of real time entertainment.
Criticism Over Unfair Royalty Payouts
Despite its claim that it is fighting online piracy and offering the music industry a new revenue stream from the Internet, Spotify has been accused repeatedly of failing to compensate artists fairly. Bands such as The Black Keys, Radiohead and The Talking Heads have all criticized the service for underpaying artists, especially independent musicians.
In November of 2014, award winning artist Taylor Swift pulled her entire music catalog from Spotify after a dispute over streaming her album 1989. Swift argued that it was more lucrative for the artist to have an iTunes user pay to download an album than to take royalties from Spotify. The streaming service revealed in 2013 that it only paid record labels on average a fraction of a penny per play (somewhere between $0.006 and $0.0084) – and that's just the money going to labels, not the artists who receive even less. Artists like Swift believe that it is unfair for fans to go out and pay full price for a new album while others could listen to it virtually for free on Spotify.
Funding
While Spotify revenues have been rising, the fact that most of the money gets ploughed back into royalty payments means it still isn’t making any money. The 2015 financial filings reveal a net loss of $194 million. Having said that, it expects to start generating profits in 2017, Par-Jorgen Parson of Northzone, a venture capital fim and the second largest shareholder in Spotify, told Reuters in December 2016.
The company closed a big $1 billion round of debt funding last year, giving investors like private equity firm TPG and hedge fund Dragoneer Investment Group and option to convert this debt into equity when Spotify did go public. In 2015, it had raised $526 million from a number of investors including Goldman Sachs, Discovery Capital Management. Peter Thiel’s Founders Fund, Accel Partners and Horizon Ventures are among other notable investors in the company according to CrunchBase.
In May of 2017, CNBC reported that Spotify will have a direct public offering (DPO) — a type of offering without intermediaries — in late 2017 or early 2018. The company is valued at $13 billion according to CNBC sources, and has a revenue growth rate of 43%.