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Spotify, Napster and The Quest For Premium Music Dollars

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This guest post on the struggles of online music services to reach profitability is written by Michael Robertson, the founder of music sites MP3.com and MP3Tunes, as well as a number of non-music related startups like Gizmo and Dealipedia. As one of the first entrepreneurs to battle the music labels over an online service, he has a unique perspective on the scene.

A new music service called Spotify has attracted millions of users in a short time with the enticing lure of listening to any common song on your computer free. Meanwhile, the digital music grandpa Napster has quietly launched a $5 service that offers unlimited streaming plus free MP3 files.

A closer examination reveals that Spotify has raised tens of millions of dollars, given equity to the record labels, is under constant attack by hackers, uses clever P2P technology, is accruing enormous per song royalty obligations and has the seemingly impossible task of figuring out how to generate enough money from a free ad model to satisfy the music companies.

Here’s my admittedly biased look at both companies:

Spotify:

Spotify is a music service to browse and play songs from a library of 3.5 million songs. Users can create custom playlists, culling out their favorite songs and the service generally gets high marks for an intuitive user interface and peppy performance. It is a free ad supported service in which users get banner ads and audio ads. There’s also a $13/month premium level which gives you an advertising free experience. The service is available in U.K., Sweden, Norway, Finland, France and Spain and the premium service is available in other EU territories. U.S. access is not available although company representatives are saying it is coming.

Technology:

Unlike other web based services like imeem and Last.fm, Spotify requires a downloadable client available for Mac or Win computers. When songs are requested they are delivered from either the Spotify central servers or other users computers using P2P (peer to peer). This means Spotify will use your bandwidth even when you’re not listening music to service their other customers. They have filed a patent for this technology. Music is delivered using the Ogg Vorbis q5 codec at around 160Kbps which sounds nice and is also speedy to load.

Background:

Spotify was founded in 2006 by serial entrepreneurs Daniel Ek (previous CTO at Stardoll, founder of Advertigo and Evertigo among others) and Martin Lorentzon (one of two co-founders of Tradedoubler, the largest European online affiliate advertising company). Spotify is based in Luxembourg to avoid taxes although most of its employees are in Sweden, the UK and Romania.

Finances:

While Spotify has been tight lipped about financing amounts and sources details have leaked out and they reveal that Spotify has raised millions from its wealthy founders and tens of millions from venture capitalists. Similar to imeem, Myspace Music and Lala, the major labels own part of Spotify.

Financing for Webcasting/On-demand Digitial Music Companies
Amount
Myspace Music
$45,000,000
Pandora
Spotify $28,000,000
Slacker $65,000,000

Security:

Since Spotify has 3.5 million songs it is an obvious target for hackers. There’s a battle pitting Spotify programmers against net hackers trying to decipher how the technology works. Code within the Windows version attempts to block debuggers so the Mac version is a more easy target. Several software programs have been released which download tracks from Spotify such as spotifysave and despotify. Spotify has is available in a limited number of countries, but its been well documented that the only check is on the initial signup page and its trivial to bypass. Users can easily bypass this by going to http://www.defilter.co.uk/ and entering the signup URL: https://www.spotify.com/en/get-started/ A UK mailing code like W1T 3EF  is required but users simply look those up athttp://www.postcodesearch.org.uk/

Economics:

The Spotify CEO boasted they have spent just £5,000 ($10,000) in total marketing the Spotify service in the UK and attracted 1 million users doing 10 million streams making it the cheapest and most effective service launch since Google. Missing from the calculation is the royalty obligation. Like all webcasters, Spotify must pay a per song fee for every song they play. These range from 1 cent per play (for interactive playback) to 0.2 cents (radio experience). While the rates seem modest they add up quickly. 10 million streams per day translates to $100,000 per day, $30mm/month and $360 million annually in royalties – just for the UK operation. Royalty rates are similar in other countries and its Spotify claims 1mm users from Sweden as well. Advertising from audio and banner ads cannot generate even a sizable fraction of these royalty obligation.

Spotify is a on quest to get paid monthly subscribers and has launched a $13/month service. They join a crowded field of competitors including Napster who recently relaunched their subscription service moving from $12.95 down to $5/month. The Napster service includes unlimited streaming like Spotify but also 5 free MP3s to add to your permanent collection each month.

Napster:

Literally weeks before the economic meltdown Napster was sold to electronics retailing giant Best Buy. Best Buy’s plan is to cost effectively market the Napster service to their large customer base. To achieve this, Napster had to move away from their limited Microsoft orphaned DRM service to a MP3 service. This would allow the service to work with all devices sold by the big box retailer. Recently, they announced a $5/month service where you can stream any song – much like Spotify – but you also get 5 free MP3s per month to add to your personal collection. Since most newer MP3s are $1.29 this is a cost savings in itself and the unlimited free streaming is a bonus. Users paying for an annual service can immediately download 60 tracks plus a bonus 10 making the cost of tracks 85 cents.

Like AmazonMP3 and itunes, Napster has a rich uncle to lean on to not only promote their service, but add other business segments to rationalize a low or no-margin digital music business. Apple sells ipods, Amazon sells other stuff while you’re shopping for MP3s and Best Buy can send you home with electronic gear they profit from selling. Using this financial flexibility Napster is able to offer an industry leading price point for a full streaming and MP3 service. This renders other services seem overly expensive and uncompetitive.

Premium Music Services (Ad Free)
Monthly
Streaming
Devices
Mobile
Region
Other
Napster
$5.00
Interactive
Net radios
-
US, expected in UK, Germany shortly
Includes 5 MP3s/month
Pandora
$3.00
Radio
-
iphone, Blackberry, J2ME version for other phones
US
Huge userbase, but struggling to get per stream royalty rates changed in Congress.
Rhapsody
$12.95
Interactive
Net radios
-
US
Windows Only
Sirius
$12.95
Radio
Car radios
-
US, Canada
iphone app promised
Price raising $1.95/month end of July
Spotify $13.00
Interactive
-
-
EU, Scandinavia, US promised
Android app previewed, but not released
Slacker $3.99
Radio
Net radios
iphone, Blackberry
US
#1 music app on Blackberry. Rumored to be considering a MP3 store.

Future

Users have largely rejected paying a monthly fee for music subscriptions. The masses have ignored subscription services like Napster and Rhapsody which offer similar catalogs, some music portability and limited device support. Cheaper radio services like early paid Pandora have also been failures (although a desperate Pandora is bringing it back to try again). There’s little reason to believe that customers are willing to pay $13/month to stream music mostly to their PC. (Even Pandora estimates only 3% will pay a monthly fee.) This leaves Spotify with strictly an advertising-based business. Ad rates cannot generate revenues sufficient to pay even the mandated royalty rates much less all the costs of running a high tech business. Publicly Spotify is promising a US launch and mobile clients (iphone andAndroid) however this completely ignores the incongruity of the underlying economics. Current royalty rates are too expensive by 10-100x for an advertising business to work. This is why Youtube dropped music videos in the UK. Getting more users will not improve the upside-down economics.

Napster’s new service has lowered the bar dramatically to a modest $5/month for unlimited streaming and personal MP3 collecting. It’s not clear that Napster can generate a profit from this service, but as a tiny division of Best Buy it’s not clear they are required to. What is clear is the $5 price point means financial pressure on standalone digital music companies. The music selling and radio business is increasingly being commoditized. Profits are being squeezed to the point of unsustainability. This spells pending doom for imeem, Pandora, Myspace Music, Slacker and the newest entrant Spotify unless there is an industry-upheaving royalty rate change.

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