If you have read anything about digital music recently, you have probably encountered two names over and over: Spotify and Pandora. Both offer an abundance of free listening on easy-to-use interfaces, and music fans have embraced them. At least 33 million people have tried Spotify, more than 150 million have registered for Pandora.
Those are extraordinary numbers for any online service. But even at their level of scale and hype - and despite having very different business models - Spotify and Pandora exemplify the business challenges for digital-music companies. Both are losing money, and for largely the same reason: the cost of music royalties.
Pandora, which went public last summer, has never had a profitable year, and in its most recently reported quarter lost $20 million on $81 million in revenue. (Its next earnings announcement is Wednesday.) Spotify's accounts for the last year, recently filed in Luxembourg, show t hat it lost $57 million in 2011, despite a big increase in revenue, to $236 million.
The companies license music differently, but both wind up paying a majority of their revenue to music companies. Pandora does not negotiate with record labels to use their songs. Instead, it operates under the compulsory licensing provision of federal copyright law, which allows it to use any song - with some restrictions - and sets royalty rates by federal statute.
For its revenue, Pandora, which has free and paid tiers, relies almost entirely on advertising. Yet it has been unable to sell enough advertising to offset its royalty costs. Last year, Pandora paid $149 million, or 54 percent of its revenue, for “content acquisition,†otherwise known as royalties. No wonder the company has been active in Washington lately to try to push for lower rates.
Spotify, on the other hand, made 83 percent of its revenue from subscriptions, according to the filings in Luxembourg, whe re its parent company, Spotify Technology, is incorporated. Now available in 15 countries, Spotify had a total of 32.8 million registered users by the end of last year. Recently it reported that 15 million people log on at least once a month, and four million pay the subscription rate of about $5 to $10 a month.
Spotify negotiates with record companies and music publishers directly, a process that can be arduous and costly - discussions with labels delayed its arrival in the United States by nearly two years. That means that its royalty rates vary from label to label, and are private: Spotify has never said how much it pays labels for its streams, although the Internet is full of people who have done back-of-the-envelope calculations based on stray royalty statements.
Spotify's chief executive, Daniel Ek, has said that the company had paid in its history about 70 percent of its income “back to the industry.†But a closer look at its recent financial statements shows that the ratio may be even higher. Last year its “cost of sales,†which includes licensing fees and distribution expenses, was $229 million, or 97 percent of revenue.
On top of that it had more than $30 million in salaries, and more than $30 million for various other expenses. That is how you lose $57 million on $236 million in revenue.
It's possible that Spotify's licensing costs could go down in the future, as record labels monitor its progress; they could decide to make changes to ensure that Spotify thrives and can keep sending over its royalty checks.
For the moment, however, Spotify's investors are shouldering its losses, and music is still expensive. The company's annual report notes that the “future minimum royalties payable†for 2012 stood at $151 million.
With artists and labels hit hard by declining sales over the last decade, it's hard to argue for lower royalty rates. But the graveyard of fail ed digital services, and the financial struggles of Pandora and Spotify show that the music industry hasn't yet figured out the balance between licensing costs and how much money a digital service can make.
Ben Sisario writes about the music industry. Follow @sisario on Twitter.
