The Planets Align for the Music Industry. Will it Be Enough?

In our last post, we examined the overlapping music-licensing regimes to explain, in part, why it took Spotify two years to get licensed in the U.S. We also looked at the music industry’s unhappy history with the internet, which also helped explain Spotify’s licensing struggles.  We now look at what Spotify means to the music industry’s future. A lot might be riding on Spotify.

For all the technology firms looking to make money from music, consider how few of them even get as far as Spotify in being able to present the music industry a comprehensive internet-based scheme. A couple spring to mind: Rhapsody in 2001, and Apple in 2003.* This means that, when Spotify came calling, the industry actually had little practical experience on which to base a very perilous decision: how much to charge for music. Since the royalty rate is by far the biggest cost incurred by online music service providers–Rhapsody is said to pay 60% of its revenues in royalties, Pandora 50%–the royalty rate demanded by the music industry pretty much dictates the price of the product. Set it too high, and the service will founder (as happened with Rhapsody). Set it too low, and you not only feel like a chump but you just devalued your main product (as happened with Apple).**

* Pandora doesn’t count because it didn’t need to negotiate with the music industry.

** This is actually counter-intuitive. If a manufacturer badly underpriced its product, it should be able to raise the price over time to reach the optimum price. Supply and demand. Because music is so easily copied, though, the supply is theoretically infinite, so mistakes by the music industry are not so easily fixed through ordinary market dynamics.

Adding to the difficulty, Spotify had some important differences from Rhapsody, the service it most resembled. Most important, Spotify wanted to have a free service. After the music industry’s experience with peer-to-peer file-sharing services, free was probably not a word the industry was excited to hear. I like to imagine the parties had a conversation that went something like this:

Spotify: We really need for there to be a free component to our service.

Music Industry [alarmed]: Free did you say?

Spotify: Sure. All the cool kids want freemium these days. “Freemium,” get it? Free plus premium?

Music Industry: So you mean to give the service away for free for a limited time, then start charging a subscription fee? Like Rhapsody?

Spotify: Er, no. The cool kids don’t like that.

Music Industry [taking a deep breath]: Well, how to you propose to make money from this free service?

Spotify: Oh, that’s easy: advertising.

Music Industry [sighing]: That’s what everyone says. It’s like snake oil that sometimes works, but never for us. How much advertising revenue do you expect to make? That’s sort of important for us to know, so we can set an intelligent royalty rate.

Spotify: Ummmmmm…. Well, in Sweden

Music Industry: This ain’t freaking Sweden! If you can’t tell us, you’d better have a plan for converting free users to premium users.

The other difference was that Spotify’s client software looked a lot like an improved version of iTunes and integrated with each user’s iTunes database. On the one hand, the industry was probably pretty excited to stick it to Apple. On the other hand, iTunes was a steady revenue stream. Would Spotify just cannibalize revenue from Apple?

I hope you can appreciate why it might take two years for Spotify to get fully licensed. Fortunately, Spotify could afford to wait. It was already very successful in several European countries, so the U.S. wasn’t an immediate priority. The European experience also gave it something of a track record, which provided some hard numbers (my “This ain’t freaking Sweden” crack notwithstanding) on which to base a deal. Most startups aren’t going to have that luxury. If it takes two years to secure all of the necessary permissions, you’ll go bankrupt first. As one academic has pointed out, most startups will seek forgiveness rather than permission, i.e., risk infringement, then secure licenses as part of a settlement, like Grooveshark.

At the same time, larger companies like Apple and Amazon, that can afford to negotiate for two solid years, aren’t always the best partners for the music industry because they have their own core businesses that they are seeking to promote and protect. For example, in 2003, Apple was negotiating with the music industry for iTunes not primarily to make money from music downloads (although, shockingly, it did) but to create a viable market for the iPod. That gave Apple all kinds of incentive to keep the price per track as low as possible.

It is fashionable among us technocrati to criticize the music industry for having “broken” or “outdated” business model. And that criticism is well-taken, as far as it goes. But do you think the music industry hasn’t known this for years?* It knows that the golden era of charging $17.99 for a CD is long over.** But recognizing that an old system is broken solves only 5% of the problem (albeit a crucial and necessary 5%). The remaining 95% is figuring out what the new system ought to look like. Rhapsody presented one vision. Apple another. Spotify yet another. Rhapsody’s vision isn’t working as well as hoped. Apple’s is working better than anyone hoped but the music industry feels a bit abused (and laments the passing of the album as a creative unit).

* I suppose one could criticize the industry for not seeing these changes coming in, say, 2000. But (1) no one ever really sees them coming, and not every prophet of doom is correct; (2) even if it did, there’s no way the industry could have acted quickly enough.

** Speaking for myself only: I resisted buying CDs for a long, long time, until I was reduced to buying vinyl records at scuzzy record stores in the Haight-Ashbury, which were hard for me to get to. Also, my sister would borrow them and return them either scratched up or without the inner sleeve. I objected to paying a $10 premium for music in a format that cost less to produce (even with the significant costs of re-mastering). But CDs looked so futuristic, were so convenient relative to vinyl, and sounded so much better than cassette tapes, that nearly everyone was willing in 1985 to pay the premium. My objections notwithstanding, that’s the market for you.

What’s scary is how much could be riding on Spotify’s success. How many times will the planets align this way? Spotify has a model that gives customers most of what they want. It’s an ideal parter for the industry because they had the wherewithal to negotiate for two years, but its interests are more aligned with the music industry’s than the big players’. Yet, there’s nothing like a guarantee it’ll work out. Will enough Spotify customers switch to the premium service in six months? How many mis-steps, like the Facebook integration defaults, can Spotify withstand before it loses its cool-factor?

If Spotify fails, how confident are we that something even better will come along? Will the music industry be stuck between settling with the Groovesharks and genuflecting to the Apples and Amazons?

Thanks for reading!