Spotify Needs Big Funding To Pay Big Content’s Tax On Success

There’s a fundamental problem with startups that depend on premium licensed content: If you succeed, the content owners will jack up their licensing fees. This is why Business Insider’s rumor that Spotify is raising a big round of funding makes sense.

In the seven months since Spotify launched in the U.S. it’s made huge strides, signing up over 3 million paying  subscribers, and hitting 17.4 million monthly and 5.3 million daily users. Even though the record labels own a stake of the company, Spotify’s success make it a lucrative target for extortion.

Unfortunately, this is why investing in Spotify may not be wise and why firms like Andreessen-Horowitz may have passed. It’s a great service with a big lead on other music streamers. But as it scales and gains traction, the record labels will increase their tax. There’s no way Spotify will pay the same fees if it hits 15 million subscribers as it does now. That will make it harder for Spotify to return the multiple most investors want any time soon.

In most industries, if a partner charges you too high a licensing fee you can go to one of their competitors. That’s not how it works in music. You can’t get a cheaper equivalent to Michael Jackson or Lady Gaga like you could for enterprise software. If you want “Thriller” you have to pay whatever the labels ask. And even if it does, Spotify isn’t getting exclusive access to that content. CEO Michael Robertson writes for GigaOm that Spotify’s deal with the record labels likely has some terrible terms already. Spotify may be paying a pro-rata share of $X per subscriber, or $Y per song streamed, or Z percent of total revenues — whichever’s highest. Whether subscribership explodes, free ad-supported listening booms, or Spotify finds another revenue stream, taxes increase.

Spotify subscribers and free listeners pay their money or attention to get on-demand access to the world’s music. A year from now it will be very difficult to tell them “Hey, 1/4 of your favorite songs are going to disappear because we refused to pay the rising fee.” Spotify is therefore seriously disadvantaged in licensing negotiations.

The hope for Spotify comes at truly massive scale. It needs to survive until MP3 downloads die off. Meanwhile it has to grow so big that it becomes both a significant direct source of revenue to the labels via licensing fees, but also a crucial discovery and awareness tool that inspires concert ticket and merchandise sales that labels take a cut of in new 360-deals.

At that point, some of the power will shift back to Spotify and it may be able to secure a more reasonable fee structure. That’s years away, though, so Spotify needs the runway of a big funding round.