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Why Spotify Should Ditch Its Free Tier, Add Streaming Fees

Spotify’s financials for the year 2016 highlight the company’s split personality. On the one hand, there is a rapidly growing subscription business that generates decent gross margins and 90% of its revenues. On the other is an unprofitable and small ad-based service. It’s time for Spotify to ditch the free tier and go all in on paid streaming.

Whereas paid subs generate the lion’s share of Spotify’s revenue and have a 15%-20% gross margin, the company’s free users generate just 10% of revenue and have negative 10%-20% gross margins. The ad-based tier accounts for more than 60% of Spotify’s total users, helping it to surpass 100 million total users, but it generates minimal revenue and loses money even before operating costs are taken into account.

More important, the free tier is a point of friction in Spotify’s relationships with the major labels, which see free streaming as unsustainable. As such, dumping free streaming would not only lighten Spotify’s profit-and-loss statement but also ameliorate its relationships with major stakeholders and partners. Apple Music has a paid tier only, and has much better relationships with artists and labels as a result.

sources: Spotify financial filings, jackdaw research analysis

Spotify’s renegotiated deal with Universal Music forced it to consider more windowing of new music through its paid service, breaking its long-held principle that both tiers should get access at the same time. The model is starting to crumble, and Spotify should kill off ad-supported streaming as it prepares for its IPO, which would also improve the company’s financial prospects.

Why wouldn’t Spotify eliminate the free tier, given all this evidence? The biggest reason is that the tier is the company’s entry point for winning paid subscribers. The barrier to the streaming music market is extremely low for that free tier, but it demonstrates the value of subscription streaming, while the frequent ads slowly push at least some users to eventually pay.

sources: Spotify financial filings, jackdaw research analysis

Yet Spotify already spends nearly half a billion dollars a year on sales and marketing, so it’s not as if the free tier provides all the promotion the company needs — indeed, it spends more on traditional marketing than it earns in revenue through free streaming, so it could simply divert some of the money it uses to prop up the free tier into more traditional marketing and still come out ahead. It’s already signing partnerships left and right with everyone including wireless carriers to sell discounted subscriptions.

And Spotify isn’t even the largest in free streaming -— that would be YouTube, whose 2016 revenues from the ad-supported stream were more than four times Spotify’s. If Spotify cuts off its free service, it would put more pressure on YouTube to play nice with the labels, which could even shift the industry balance of power toward Spotify.

Jan Dawson is the founder and chief analyst at Jackdaw Research, an advisory firm for the consumer technology market.

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