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Why Spotify can never be profitable: The secret demands of record labels

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Imagine a new hot-dog selling venture. Let’s also say there’s only one supplier to purchase hot dogs from. Instead of simply charging a fixed price for hot dogs, that supplier demands the HIGHER of the following: $1 per hot dog sold OR $2 for every customer served OR 50 percent of all revenues for anything sold in the store.In addition, the supplier requires a two-year minimum order of 300 hot dogs per day, payable all in advance. If fewer hot dogs are sold, there is no refund. If more than 300 hot dogs are sold each day, payments to the supplier are generated by calculating $2 per customer or 50 percent of total revenues, so an additional payment is due to the supplier. After the first two years, the supplier can unilaterally adjust any of the pricing terms and the shop can never switch suppliers.

Would this imaginary hot dog establishment be able to generate a profit? Never, because the economics are one-sided. The supplier will always elect the formula that captures the largest amount of money for themselves, completely disregarding the financial viability of the store. If the store miraculously managed to generate a profit, the landlord would simply raise the rates after two years.

Such economic demands may be imaginary for the hot dog business, but they are the stark reality that every digital-music subscription service such as Spotify, Rhapsody, MOG, Rdio, and others must confront. These details aren’t well-known because digital music service deals are always wrapped tightly with strict non-disclosure agreements.

For the first time, people are talking, and these previously secret demands are being made public. The specifics are even more onerous than the hot dog example cited above. Together they doom online audio companies to a life of subjugation to the labels, as you will learn below.

Here are some specific demands that digital music companies are compelled to agree to:

  1. General deal structure: Pay the largest of A) Pro-rata share of minimum of $X per subscriber, B) Per-play costs at $Y per play, C) Z percent of total company revenue, regardless of other business areas. As stated previously, this means labels de facto set retail price (they also regularly negotiate floors on price, giving even less wiggle room), which limits the ability of the music service to develop ancillary revenue streams that aren’t siphoned off by the labels.
  2. Labels receive equity stake. Not only do labels get to set the price on the service, they also get partial ownership of the company.
  3. Up front (and/or minimum) payments. Means large amounts of cash are necessary to even get into the game. In my experience, this further stifles innovation in services and business models.
  4. Detailed reporting, including monthly play counts. This seems rational enough — you would assume this information is necessary to pay artists and make other business decisions. The problem is, the labels each make additional demands, including providing additional reports unrelated to payment, including overall market share of sales in various categories. I doubt that, for example, phone manufacturers demand Best Buy provide the percentage of sales of competitors’ phones. The labels effectively offload their business analysis (and the cost of such analysis) onto the music services. I can’t think of another industry where that is standard practice.
  5. Data normalization. Labels all provide their data and files in different formats. That data is constantly changing as labels make available new material and make unavailable old material. This might seem trivial. It’s not. Without standard naming conventions and canonical methods for referencing artist, tracks and albums (ISRC and UPC don’t cut it), the services are left to try and match artist, track, album names provided by one label with those of another. It’s incredibly inefficient, as each service must undergo this process separately (although there are now companies that provide a service for doing this for the retailers).
  6. Publishing deals. Once you’ve signed deals with the labels, you then need to cut deals with the publishers. Determining ownership is a complete nightmare and there are huge holes in the licensable catalog. The data issues here are worse than with the labels. The long and short of it: Although you may have the rights to stream from labels, you sometime can’t get the rights to stream from the publisher, or worse, even find the publisher.
  7. Most favored nation. This is a deal term demanded by every major label that ensures the best terms provided to another label are available to it as well. This greatly constricts the ability to work out unique contractual terms and further limits business models. It is a form of collusion since each label gets the best terms the other label negotiates. It’s also why it’s easy to get one label (typically EMI) because they’ll provide low-cost terms knowing that others will demand higher rates, which EMI will then garner the benefit from.
  8. Non-disclosure. Every contract has strict language prohibiting the digital music company from revealing what they pay to the labels. If they speak publicly about any of the licensing terms, they jeopardize invalidating their license which would torpedo their business. Since labels license on behalf of the artists any payment to the artist comes from the labels not the digital music company. This is the main reason music services, not the labels, have been getting heat from the artist community. Music services can’t defend against accusations about low artist payments because they pay the labels who don’t disclose what they’re paying to the artists.

With most other businesses, if a supplier makes unreasonable demands, a retailer can turn to other providers. Since copyright law gives record labels and publishers a government-granted monopoly, no such option is possible with music. Digital vendors have only two options: Accept the terms or not include those songs in their offering.

The sale of EMI to other music companies means there will shortly be only three major labels. If a music service rejects terms offered by a label, then that service’s offering will have an enormous hole in their catalog of 25 percent or more of popular songs. In the business world, a monopoly leads to lopsided economics, and the subscription digital music business is a poignant illustration of that.

Final note: Online radio services such as Pandora take advantage of a government-supervised license available only to radio broadcasters thus sidestepping dealing with record labels. While the per-song fees are daunting, they bypass virtually all of the terms listed above.

A 15-year veteran of the digital music business, Michael Robertson is the founder and former CEO of MP3.com and is currently CEO of personal cloud music service MP3tunes as well as the radio recording service DAR.fm. He can be reached at [email protected]. He would like to thank Paul Petrick for his contribution to this piece. 

Image courtesy of Flickr user walknboston

114 Responses to “Why Spotify can never be profitable: The secret demands of record labels”

  1. The Music Industry and the Law should continue to target Companies the likes of Megaupload, Rapidshare, fileshare that have been built on providing services for “Uploaders” who generate cash from Advertising placed next to the uploaded links, some of these Companies even pay on a “per download” basis and the down-loader is often not even aware they’ve helped generate revenue for people that have nothing to do with the creation or release of the music. It’s not a “loophole” it just hasn’t fully “Outed” yet, what they are doing is still illegal and they know it What they are doing doesn’t just hurt the Corps but also the Independents, and they know it!

    Friends sharing a tune over the internet? This May be also “illegal” but no different than “making a tape” from music us 30 and 40 years olds purchased as kids and passing it on to friends. This actually helps the industry and helps people discover Artists and tracks via the “word of mouth” model and ultimately encourages people to purchase music, merchandise and go to concerts! People currently tune in to listen to tracks on YouTube, some go on a buy, some go on and download illegally from the sites that need shutting down as mentioned above, so again let’s target those sites and dodgy “Uploaders” for Copyright infringement NOT the end users!

    Spotify, Rara and the other bunch of new model army, self proclaimed saviour’s of the Music industry seem nothing more than an attempt at a legal version of the above illegal business model but cut out the dodgy Uploader that used to get a share of the Ad revenue. Yes, they have sort legal consent off the MAJOR-ity with HUGE ADVANCES paid to the MAJOR LABELS but certainly have not cleared all of the Copyright from Owners as mentioned in section “6” of above article so mostly publishers and in some cases owners of Sound Recordings that have been licensed to 3rd parties without written consent for this kind of commercial exploitation but will and have already found their way on to these streaming networks.

    This new business model for the music industry is unlikely to solve the problem of generating revenue for Independent Artists and Musicians JUST REPLACE IT WITH A NEW ONE.
    Neither will it solve the long term revenue issues for Major Labels. These models will not attract the so called “illegal” downloaders and people who share files “illegally” with friends for free as claimed by Spotify but most probablly attract a huge percentage of the CURRENT MARKET OF EXISTING BUYERS WHO LEGALLY PURCHASE DIGITAL MUSIC. Why? because initially it seems like a legal “Too good to be true” offer. The bigger picture is the streaming services WILL REVERSE THE CURRENT TREND OF GROWING DIGITAL SALES, further more streaming services such as Spotify and Rara will not benefit from the amazing INDEPENDENT MUSIC that get’s released from day to day because Independent Artists and Labels will remove their content from these services once they see they are getting no meaningful share of revenue.

    Our Company is an Independent Music Company that Publishes lots of Music and has released lots of recordings. We have never knowingly granted rights to any third party to exploit our music via the Streaming business model.

    Digital shops selling music ,yes.
    Digital shops selling music and providing services for storage from purchased Tracks or Albums, yes.

    A massive free for all, too good to be true business model where Artists and label share a monthly subscription per user of £10 minus the streaming companies costs and cut, No thanks!

  2. Thomas Weilby Knudsen

    The analysis in the article is interesting, but lack a very important component: The balance of negotiating power. Once the online music services have millions of monthly subscriptions, the power balance changes. The labels cannot just increase prices (even though they may contractually have the option), since they are messing with their most important and only growing source of revenue, whereas their alternative (legacy) revenue sources are shrinking. So the threat os halting supply is theoretical, and artists would never accept it – established artists may even cut out the middleman and enter into an agreement with the music service directly. Consequently I believe that the analysis is correct, but the conclusion simplistic.

  3. rtpHarry

    I dont care who pockets the money, I just want access to the music. The sheer amount of music out there means that the way the world works means that even if I spent every penny I earned on music I would be able to hear about 0.1% of it.

    If the labels want to run a spotify service then they get 100% of the revenue which is fine by me.

    Just stop putting us all in a situation where we cannot access the music.

  4. There are a few (three?) major record labels. Somehow they all have the same pricing structure, licencing terms and never compete with each other. How is this not price fixing?

  5. Christina G

    Technology has developed rapidly, but the fact that the sale of music needs to be remodeled and repriced has been dragging on for so many years now – record companies demanding their old cut (which was never fair in the first place) is halting progression into something better. Now they’ve mucked up the face of the entire industry by meddling in privacy issues and the rights of every individual on the planet – and wasted billions of dollars that they so greedily coveted in the first place. Let’s be honest – if music wasn’t, in general, so grossly overpriced, the average downloader wouldn’t feel the need to pirate. These aren’t criminals and thieves with a “fuck you” attitude – it’s people who honestly found something as simple as a song has been deemed too valuable for them to afford.

  6. Eddie Schwartz

    Might be worth noting that the remuneration that actually reaches recording artists and songwriters is in the “little to none” range. Labels are not contractually obligated to distribute pro rata shares of the huge advances they demand to music creators, and the royalty streams are microscopic. Indie labels are pulling out, as are some artists, and the model is unsustainable as far as creators are concerned.