Spotify and the Great Leaps of Faith

spotifiedLast month at The Europas – TechCrunch Europe’s version of the Crunchies – a lot of impressive start-ups were honored. But one was clearly cleaning up: Spotify, the sexy online music app that has music lovers in Europe swooning.

Each time the company won, you heard two reactions from the crowd: fan boys screaming with joy and other companies’ founders groaning. “Too big for their boots,” was a phrase heard muttered a lot.

But player hating is just part of life as a hot start-up right? Of course – but Spotify is living in a particular dual reality. It’s caught between the rapture of music lovers who say it’s the site they always dreamed could exist and the cruel reality of the online music business.

And that meant there was a lot more drama than immediately meets the eye behind that reported $50 million funding and $250 million valuation. As one investor who ultimately passed on the deal told us, “This was one of those where you hold your nose and just pay up. Before you’ve done anything the majority of the economics are right out the door to the labels. You need huge scale to pay for all that, and then you’re still in bed with a bunch of numb nuts.”

Someone in the comments of TechCrunch’s previous Spotify story said it was Europe’s YouTube. We don’t know if they meant that in a good way or a bad way—but we agree on both. The problem with the comparison? YouTube found Google; a deep-pocketed public company that was also trying to build a video offering online and was willing to pay top dollar for YouTube’s streams, and their associated business model challenges.

Several VCs we talked to used the words “leap of faith” over-and-over again in describing the decision to invest in Spotify or not. In reality an investor has to take multiple leaps of faith to do this deal, especially at a $250 million valuation. Looking at those leaps explains why so many VCs who were awed by the product ultimately passed – and yet why a few ballsy investors saw the elusive upside worth the role of the dice.

Leap of Faith #1: The Labels Want an Apple Alternative.
This seems like common sense, right? But how often do music labels act according to common sense? There’s a whole Internet graveyard full of online music start-ups that VCs invested $20 million or more in, cut deals with labels and the labels happily sucked them dry. It’s a good sign that the labels have been taking equity investments in Spotify, but that hardly makes it certain they’ll support the company. It’s common for big public companies to invest an immaterial amount in a promising start-up in order to keep a close eye on it.

According to people close to the company, the deals being negotiated with labels are similar to past subscription deals. There’s a minimum in royalties that has to be paid, and once that’s cleared there’s a more reasonable revenue share. But that minimum bar is so high, that’s where most subscription services have died. “The labels are entertaining how to work with them in a way everyone can make money, but they’re still clearly taking a pound of flesh,” said one person with knowledge of the negotiations.

Leap of Faith #2: Audio Advertising Will Shift from Radio to Online. So far, the money Spotify is getting from audio ads is likely to be “chump change – less than you could earn from those crappy ads at the bottom of instant messenger clients,” according to one industry expert we talked to. For the service to still have a free element, a larger-than-just-Spotify industry shift is going to have to occur where audio ads move from terrestrial radio to the Web in material amounts. We’re knee-deep in that shift in print, and only beginning to see it in online video. Will it happen in audio? Probably, but not next year.

Leap of Faith #3: Millions Will Pay for Subscriptions. That means the real opportunity for Spotify to build a business is the subscription model – something no online music company has succeeded at to date. Right now the company claims it has “just under 100,000 users” paying $10 a month. Other sources confirm that it’s growing at a fast clip. While impressive, the onerous costs from the labels mean that revenue – $12m a year, before that “crappy” audio ad money –  is not nearly enough. For this business to work Spotify needs millions of paying subscribers.

The fact is, Spotify is not only trying to break the online music subscription curse, they’re trying to do something few have done on the Web. To date people have shown themselves unwilling to pay for content and premium services en masse. Even the mighty Netflix only has 10 million subscribers; has less than 1 million. And again, thanks to the pressures from the labels, Spotify doesn’t have years to get there.

Leap of Faith #4: Apple Won’t Kick Spotify Off the iPhone; Other Mobile Carriers Will Champion it as an iTunes Alternative. Apple isn’t open. It’s territorial. And with good reason—it owns the dominant mobile Web and music platforms. Why on earth would it allow Spotify’s offline music player app to compete on its own hardware with iTunes?

That leaves other mobile devices to champion Spotify as an iTunes/iPhone alternative. That strikes us as highly likely. What’s more: People are more willing to pay $10 a month for a music app that’s not tethered to their computers. This would seem to be the company’s best bet to solve its business model woes and get enough future investment to hit scale.

Leap of Faith #5: US Launch Goes Well. Spotify is saying it will launch in the US by early 2010. That doesn’t seem feasible, given their business model challenges and the fact that this round was only 50 million. Investors who looked at the deal confirmed they’d need a much larger war chest to make that happen. Also, there is some confusion over whether the round is even closed at all – with some close to the company saying it’s still open but the company itself saying it has been closed for two weeks.

Much seems to depend on just how much demand there is to invest in Spotify, which is hard to read. The company claims that it got nine term sheets and a 20% premium on what we understand was a requested €150 million valuation. The latter appears to be true, but we know that the bulk of the major European VCs—including names like Balderton and Index that don’t normally balk at price if a company is good enough—turned down Spotify or offered a term sheet at a substantially lower valuation, due to all these leaps of faith. And, we contacted six of the top US consumer Internet partners who said they weren’t even pitched. This leaves us wondering from where these nine competitive term sheets came. In addition, the deal took a reported five months to close– unusual for a “hot” company.

There are certainly billions in cash in the world of private equity for promising companies, even in this economy. But it’s unclear how much more there is for Spotify while all these questions remain.

Leap of Faith #6: If All the Above Fails, Someone Buys the Company for $100 Million. In other words, what are the odds the incoming investors lose money? We think chances are good they’ll at least make their money back. After all no one disputes the beauty of the product or how many people love it. That’s clearly worth something even in a worst-case, fire-sale acquisition. Any investor worth their salt would have insisted on a liquidation preference given the risks and the high valuation attached to the deal.

It bears noting that while Spotify has been wildly promoting themselves in off-the-record conversations with the press (including us) they have been less than forthcoming with information publicly. In several weeks of reporting this story in the Valley and in London, we talked to more than a dozen people including investors who looked at the deal, people close to the company and other people in the online music industry. We’ve found a host of troubling contradictions that we tried to comb through for this story, with little help from Spotify.

We sent two emails to the company detailing the discrepancies we were hearing on both sides of the pond and got little back but a note saying the founders “wouldn’t comment on financial matters” and “didn’t like (our) tone.” This after their representatives had been providing us, off the record, with hype about subscription numbers and claims about term sheets and increased valuations.

Given the mass of uncertainties in the business and how many users love the service, it’d be nice to see the company be a bit more forthcoming about its future.

[Photo credit: Dirk Lindner for TechCrunch Europe]