Spotify is a money pit but doesn’t have to be
A long, slow decline awaits Spotify unless they follow Netflix’s lead and go all in creating their own content.
In 2011, my brother, a friend and I tried to build an on-demand music streaming service. We raised some seed money and quickly attracted senior executives from UMG, Sony and the RIAA to be on our advisory board. We got some great advice. So great, in fact, that we decided to get the hell out of streaming music!
We acknowledged that we would have trouble raising the necessary capital to license the content. But we also realized––more importantly––that the unit economics of streaming music are comically upside down, and it boils down to one simple economic convention: substitute goods.
Here’s an over-simplistic explanation: a consumer typically buys Product A, but when Product A isn’t available or becomes too expensive, consumers are inclined to switch to Product B since it’ll satisfy the same needs as Product A. Bottled water is a good example of this. Most people will buy whatever bottled water they encounter since it all gets the job done.
Music is different. You can’t swap out Yoncé or T Swift with some discount generic. You gotta have the real thing. And since the record labels are the gatekeepers of the (legal) distribution channels, they hold all the cards. Streaming services like Spotify have to go hat in hand to the labels and pay hefty sums to get distribution rights. The labels can charge steep — entirely reasonable to them — prices because Spotify can’t go anywhere else.
All of this equates to perpetual losses for Spotify. In fact, as they continue to scale and acquire more users, it just means they lose more money. Does that sound like a good business to be in? Apple, Google and Amazon don’t really care about these money problems because they’re sitting on giant mountains of cash. These payments are a drop in the bucket for them so they can stomach the licensing costs far easier.
So how does Spotify get profitable? Let’s look at their costs.
Yes, you’re seeing that pie chart right. They pay out a crap load in royalties to the labels. Assuming their overhead sans content costs is somewhat in line with industry norms, it’s unlikely that major cuts there will move the needle much toward profitability.
So it’s pretty apparent that they need to aggressively figure out a way to reduce their content costs. And they need to look to Netflix, which has experienced similar pains of being handcuffed to onerous content licenses. Netflix shrewdly started cutting out content owners and creating their own hit TV shows. Now they’re in a much healthier financial position as a result.
What Spotify needs to do is go out and start snatching up quality indie labels and popular artists whose contracts are up for renegotiation or expiration. A massive effort needs to be put into competing with the labels directly.
Could Spotify upset the labels by doing this and jeopardize their content access? Possibly, but Spotify is such a sizable chunk of music industry revenues that the labels are not likely to raise too much of a stink. It is also possible that the small but no insignificant ownership stakes that the labels have in Spotify have their hands tied. If that’s the case, then they need to work to consolidate board control.
Spotify is surely in a tough position and it’s easy to sit behind a keyboard and cast stones, but it’s either get into the content business like Netflix has or prepare for another 5 to 10 years of valuation haircuts and ratchets till there’s no longer any internal enthusiasm. For the sake of music lovers and artists, I hope that Spotify will make bold moves to shore up their foundation for the long term.
