6:45am PT by Eriq Gardner
Can Spotify Pull Off Music's Power Move?
Nearly four years ago, an executive at Spotify, the Swedish music streaming giant, made what in retrospect may not have been the smartest statement. In a comment to the U.S. Copyright Office, James Duffett-Smith, the company's head of licensing business affairs, said it was not always "possible or economically feasible to identify each co-author of a copyrighted musical work."
Nevertheless, despite professed difficulty in complying with all the steps needed to secure the rights to stream songs, Spotify, founded in 2008, has marched forward to become the music industry's most important distributor. The company now boasts global subscription growth that surpasses Netflix's when its streaming service was the same age. As Spotify plots going public, investors are naturally intrigued. Netflix, after all, is now a $95 billion company, whereas Spotify, with its 70 million paying subscribers, is being valued at $20 billion ahead of its recently leaked plan to pursue a direct listing on the New York Stock Exchange.
But one thing that needs to be recognized about Spotify: It doesn't just stream. It is also a company that has streamlined. Cut corners, some might say. The problems on the song licensing front have led to lawsuits, including most recently a $1.6 billion complaint filed earlier this month by Wixen Music Publishing, which administers the song rights of Tom Petty and Weezer's Rivers Cuomo, among others. Or consider how Spotify is going public: It's skipping the typical IPO by cutting out the investment bankers, which has certain cost savings but could also invite volatility in its stock price. Clearly, Spotify is a company of great potential if it can figure out how to navigate the bumpy road ahead.
Spotify was founded by Daniel Ek, who before shepherding the now popular streamer, spent some time in the legally hazardous world of file torrents. Perhaps the experience in the cutting-edge realm of peer networks convinced Ek that entertainment was rapidly changing and there were advantages to moving quickly, gaining scale and offering consumers an easy-to-use interface to access a massive library of songs — plus a way to discover new music through algorithm-driven playlists. But it would be a mistake to characterize Spotify as not caring about rights holders. In particular, Spotify depends greatly on the grace of record labels. Spotify seems to have prioritized relationships with them, going so far as to give Sony, Universal and Warner Bros. big equity stakes and great upfront payments in addition to royalty arrangements. Today, Spotify spends about $2 billion, or about 70 percent of its annual revenue, to license rights to music.
Spotify has given consumers a reason to pay for music again (streaming now accounts for half of total recorded music revenues), although some recording artists like Taylor Swift still challenge Spotify's free tier and what it means for their royalty rates. Nevertheless, the record industry has been the beneficiary of being able to directly negotiate with Spotify.
Song publishers and composers, which are owed separate royalties for both the performance and mechanical reproduction of compositions, on the other hand, have been in a less advantageous position because Spotify can rely on consent decrees and compulsory licenses that limit the publishers' leverage to demand what they feel is deserved. Every now and then, rates are adjusted by a federal court, and a decision on what Spotify must pay for the performance of compositions is coming any day now. But without significant legislative change, the hopes of publishers to earn more are dim.
That's where Duffett-Smith's admission, the subsequent lawsuits, and a development in Washington, D.C., come into play.
The music publishing industry hasn't traditionally cared too much about the formalities involved in mechanical licensing (typically, record labels have done the chore without issue), but when Spotify admitted it had trouble identifying co-authors of songs for the purpose of sending out notices and making payments (Spotify has kept some of the due money in a reserve fund), publishers identified their leverage point. If Spotify isn't complying with the rules, that could mean the company lacks necessary licenses and may be willfully infringing copyrights. In the absence of being able to negotiate deals directly with Spotify, some publishers like Wixen are testing this notion in court.
"I think the lawsuits are driven by anger [over] licensing rates rather than licensing practices," acknowledges David Israelite, president and CEO of the National Music Publishers Association. "I compare Spotify to Grubhub, which picks up food prepared by someone else and keeps 10 percent of the payment. Who decided for Spotify that 30 percent was the right number?"
Yes, 30 percent is what's left over after Spotify spends 70 percent of its revenue on licensing (the bulk going for sound recording rights), but what also must be recognized is that Spotify currently is losing money. Last year, the company reported a net loss of $568 million, and while Spotify doesn't break out its operating costs, one can assume that in order to fuel its enormous growth among consumers, it is spending a mighty sum on marketing with endeavors like the Secret Genius Awards, which celebrates the songwriters and producers behind the biggest hits.
This dynamic sets the stage for Spotify's future. The company's path toward profitability will depend on continued subscriber growth, a reining in of administrative costs, and the great hope that royalty payouts don't escalate much beyond 70 percent.
What's the prospect for the latter?
Shortly before Wixen's $1.6 billion lawsuit came a potential breakthrough on the legislative front in the form of a bill titled the Music Modernization Act. Tech companies including Spotify gave publishers a right to audit their books and accepted a new standard to determine publishing royalty rates — one that would include evidence under what's called a "willing buyer/willing seller" framework. In return, song publishers would make it easy to identify song co-authors by providing a publicly accessible database of song ownership information. If passed, the legislation might save Spotify from more copyright lawsuits. On the other hand, Spotify would be at the mercy of rate courts. But that might be preferable to the risk of paying out damages for copyright infringement.
In the meantime, Spotify is doing what it does best — growing (it now has about twice as many subscribers as Apple Music), while figuring out what's truly necessary and what's merely a luxury.
Investment bankers are akin to song publishers in that Spotify has identified this community's needs as less relevant in the goal of world domination. "The cost of going public in terms of an expensive, splashy road show and issuances of stock would be 15 percent of its market cap," estimates Mike Vorhaus, president of the research-based consultancy group Magid Advisors. "That's a big bite. The great problem for Spotify is there might not be a big pop when the stock goes public, and the company won't have vested interest from banks to prop up its stock price."
Observers like Vorhaus credit Spotify with getting to the on-demand music market swifter than Apple and YouTube, but worry how Spotify could lose its balance upon any bad news that changes the perception of positive momentum. As for folks in the music industry, they talk about Spotify as both a great hope as well as a phenomenal concern. In short, Spotify's biggest advantage doubles as its greatest weakness. But that's what is to be expected from a streamliner.
A version of this story first appeared in the Jan. 25 issue of The Hollywood Reporter magazine. To receive the magazine, click here to subscribe.