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Spotify Hits 10 Million Paid Users. Now Can It Make Money?


Spotify CEO Daniel EkPhoto Illustration by 731; Ek: Art Streiber/AugustSpotify CEO Daniel EkDaniel Ek has devoted most of his waking moments over the past few years to evangelizing about the glories of streaming music. He’s well suited to the task. In addition to a forbiddingly deep reservoir of knowledge about every genre and subgenre to emerge from his native Sweden, Ek, 31, is the co-founder and chief executive of Spotify, the first company to make streaming so easy that downloads quake in its presence.

Competition was inevitable in such a popular space, but when Beats Electronics launched its own subscription service, Beats Music, in January, it seemed more like a validation of Spotify’s model than a threat. The two companies offer the same basic service: a $10-a-month subscription that gives users the ability to stream songs from the company’s servers. Beats, started by Jimmy Iovine and Dr. Dre, doesn’t offer a free version, whereas Spotify has one supported by ads. The music industry, weary from decades of being tortured by consumers, has greeted streaming with skepticism. But in its tradition of acquiescing to the latest consumer demand and asking questions later, it’s also signed enough deals to make Spotify’s library pretty comprehensive.

Spotify will announce today its 10 millionth paying subscriber, and an additional 30 million people listen for free. Ek says that as long as Spotify accomplishes its main task—getting people to stream more music—free users will continue to upgrade to paid subscriptions. “We know if you do that, you’re going to be like, ‘Hey, 10 bucks is nothing. It’s like two beers,’” he says. “In Sweden, it’s actually less than one beer.”

But the abundant reports (still unconfirmed) that Beats is close to signing a $3.2 billion deal to sell itself to Apple (AAPL) have cast doubt on the inevitability of Spotify’s rise. A union with Apple could go a long way toward boosting the subscriber base of Beats Music and potentially transform the market for streaming services. (Beats didn’t respond to a request for comment, but estimates of its user base range from 110,000 to 200,000.) All of this puts more pressure on Spotify, which has been great at getting people to pay for subscriptions—and not at all successful at turning a profit.

Scale is a magic word for so many cloud-based companies and services, but Beats and Spotify operate differently. Their margins don’t improve as they get larger. If Spotify bought the rights to songs for a flat rate, then every subscriber it adds would mean free money for the company. But that isn’t what it does. Instead, it spends a fixed proportion of its total revenue on royalties. So if Spotify doubles its subscriber base, it doubles the amount of money it pays out. It may be that Spotify will gain some power over the royalties it pays once it has a critical mass of customers, but right now, many people think it can never get ahead of its costs.

The worst-case scenario for Spotify isn’t losing to Apple. It’s discovering that its prize is insolvency. According to a report published by Generator Research last November, the current business model for streaming music is “inherently unprofitable.” Andrew Sheehy, the main author of the report, concluded: “Our analysis is that no current music subscription service—including marquee brands like Pandora, Spotify, and Rhapsody—can ever be profitable, even if they execute perfectly.”

Spotify has lost a total of $200 million since it was founded, according to a report last year based on its financial disclosures written by PrivCo, a firm that studies private company performance. Spotify declined to discuss its balance sheet.

The company does say its contracts are structured so about 70 percent of its revenue goes to royalties; any other costs of business have to be covered by what remains. In theory, once Spotify has enough subscribers, its 30 percent cut could be enough to pay the bills and post a profit. Roger Entner of Recon Analytics says streaming music services should be sustainable when they reach 10 million paying users. Ek dismisses the idea of such a threshold, although he does think the company’s relationship with the music industry will get smoother with scale. “For us, it hasn’t been about that magic number,” he says.

It may be that streaming music companies will work better as parts of larger businesses, just as Apple has the iTunes Store and Amazon (AMZN) sells subscription video through its Prime service. “In many ways, the preferred solution [for Spotify] would be to get sold to someone,” says Mark Mulligan, an analyst who follows the digital music industry. “But they’ve gotten too successful.”

Spotify would be an expensive purchase; it was valued at $4 billion when it raised money in November 2013. And Ek rejects the idea of selling to one of Apple’s competitors. “I think it would be a terrible decision for music to be a loss leader for other businesses,” he says. “I think us and the music industry are aligned on that.” To avoid that fate, Spotify will have to prove that a streaming music company can be sustainable on its own.
 
 
There’s no desk in Ek’s office in Stockholm. There’s just a few plush chairs and a couch arranged around a glass coffee table designed to look like a set of turntables. A large flatscreen television and two powerful speakers sit against one wall, a guitar hangs from another, and a crate of records has been tucked quaintly into one corner. Aside from walls made from whiteboards, it feels like a place where people would go to sit around, smoke pot, and listen to John Legend.

“Just because you have a platform, it doesn’t mean that everyone who doesn’t is screwed.”

One morning in mid-May, a few employees gathered there to listen to a track by the Swedish producer iSHi, and the beat shook the walls. (As far as I could tell, no one was smoking anything.) Ek says he listens to a lot of electronic music but is mysterious about the artists he likes. “These days, I’m listening to a lot of stuff that isn’t released yet, so I can’t even talk about it,” he says. Ek, a mild-looking man who dresses casually and shaves his balding pate, says he loves having this kind of access. His personality is equal parts hip and square. Spotify’s rapid expansion inspired him to become a certified tour guide in Stockholm, so he could show potential hires around town. When asked what city sights a visitor shouldn’t miss, Ek suggests both a neighborhood where all the best designer boutiques are located and a building with an old cannon ball stuck in it.

Spotify is riding the third wave of digital music habits. First came piratical file sharing, which was good for teenagers with limited allowances but bad for musicians. Apple’s introduction of the iPod and the iTunes Store in 2001 started the second wave. When it made music easier to pay for, people resumed doing so. Ek and Martin Lorentzon founded Spotify in 2006, offering subscriptions as an alternative to downloads for customers. For a music industry that was still adjusting to iTunes, Spotify was doubly threatening, offering fractions of a penny per streamed song instead of a few quarters per download.

Streaming has been controversial among musicians from the beginning. Some artists, such as the Black Keys, now refuse to make new music available through streaming services. One oft-repeated criticism comes from Radiohead’s Thom Yorke, who called Spotify “the last desperate fart of a dying corpse.” The situation is even worse for less-prominent musicians. Last year, folk rocker Damon Krukowski concluded that a song of his would have to be played 47,680 times on Spotify or 312,000 times on Pandora (P) to bring in as much money as he’d get from a single album sale.

As more people pay for streaming music services, the kitty available for royalties grows. The result has been that rates have increased from the infinitesimal to the tiny. Nielsen (NLSN) says the average royalty rate per stream in the first quarter of this year was 0.5, up 33 percent from 0.375 a year earlier.

Music fans seem unmoved by the plight of their favorite artists. Last year digital music downloads decreased for the first time, with sales of digital tracks falling 5.7 percent. Streaming consumption increased 32 percent, to 118 billion songs, in 2013, according to Nielsen.

Apple’s interest in Beats is an acknowledgment of the changing times, says Rich Karpinski, a senior analyst at the Yankee Group. “Everyone is waiting for Apple to make its move,” he says. “In some ways this validates the area.” Apple declined to comment. The acquisition could tilt the balance of power in several ways. Apple could use its market power to force labels to accept lower royalty rates or entice its customers to subscribe to Beats by pre-installing the app on every device, dropping the price, and promoting it heavily through the App Store.

This would be bad news for Spotify, although Ek says it was inevitable that the two companies would compete directly. He calls his relationship with Apple a good one, though not a deep one, and notes that Apple recently included Spotify in CarPlay, its operating system for automobiles.

But Ek also worries that he could find himself in a difficult position in the near future. The recent debate over Internet openness in the U.S. has centered on federal rules that keep Internet providers from favoring one service over another. Ek thinks regulators should also be on the lookout for anti-competitive behavior from companies such as Google (GOOG) and Apple that own both applications and the operating systems they run on. “If someone uses their platform powers in ways that disadvantage others—which hasn’t happened yet, to be clear—if someone does that, it’s really, really bad, not just for Spotify but for the whole app economy,” he says. “That I’m concerned about.”

Ek doesn’t seem concerned about a Beats by Apple product being better than Spotify’s own service. Apple’s eye for industrial design has never developed into an ear for music services. In 2010 it started a social network for music called Ping; it fell flat. Apple also launched iTunes Radio in 2013, putting it in direct competition with Pandora, the Internet radio company. Eight months later, Pandora’s user base has grown by 4 million. “The preferential treatment didn’t help Apple radio,” says Recon’s Entner. “It’s not a guarantee for success.”

While Apple, Amazon, and Google seem to want to corner the market in any potential technology service, Ek is confident that consumers won’t cooperate. He cites the example of Dropbox, the file management company. Amazon and Google each offer competing products, but Dropbox continues to perform well and has attracted 275 million users. Companies focused on music will always offer better services because their attention isn’t divided, argues Ek. “Just because you have a platform, it doesn’t mean that everyone who doesn’t is screwed,” he says.
 
 
As for the existential question of can, or will, anyone make money from streaming, Spotify’s solution is to grow its way out of trouble. To do so, it needs to persuade people to pay for a monthly service at a time when many other forms of Internet-based entertainment are free, which is no small feat. Spotify has looked to do this by bundling music subscriptions into people’s phone bills. It has signed 30 such deals, and recently signed its first major one in the U.S. with Sprint (S). Sprint will offer discounted Spotify subscriptions to subscribers of its “Framily plans” and advertise the partnership heavily. For Ek, the appeal is simple: more growth.

Sprint struck some as a strange choice of a partner, given its recent struggles. “For Spotify, partnering with the third or fourth—probably the fourth—most interesting carrier in the market is nothing to brag about,” says Karpinski. “I would have to think that Spotify would have preferred to cut a deal with Verizon Communications (VZ). They have more subscribers and a healthier brand.”

Ek says he’d been talking to all four major carriers for several years and never felt that any of them were serious about music. Genuine enthusiasm, he says, was the only trait he was looking for in a partner. Spotify had all but given up on Sprint in March when Ek got a call from the company’s CEO, Dan Hesse. Ek was in the Bay Area and preparing to head back to Europe, but Hesse insisted they meet immediately. Within hours Hesse was on a flight from Kansas, where Sprint is based. He and Ek met at SFO. “It was obvious to me after 20 minutes that this was it—this was the partnership,” says Ek. The two companies announced a deal six weeks later. At the time, Ek called it the biggest deal Spotify had ever signed.

While the U.S. and the U.K. are Spotify’s biggest markets, the company plans to expand into developing economies that have major barriers like a lack of infrastructure and little history of online commerce. Spotify is launching its service in Brazil in late May, which will be its 57th country. It’s also looking to expand into new countries in Asia and for the first time into Africa.

This isn’t a plan likely to result in profit anytime soon. But Ek insists the company is headed in the right direction. While Spotify’s losses are growing, revenue is growing even more rapidly. In 2011, Spotify posted a net loss equivalent to 24 percent of its $245 million in revenue, according to Generator. The following year, it more than doubled its revenue to $558 million. Losses increased, too, but totaled only 13 percent of overall revenue. In the streaming music industry, that’s progress.

Brustein is a writer for Businessweek.com in New York.

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