With 70 Million Subscribers and a Risky IPO Strategy, Is Spotify Too Big to Fail?

Spotify IPO Making Waves
Charles Williams for Variety

Manhattan’s Chelsea neighborhood has served as the home of Spotify’s U.S. headquarters since 2010, but not for much longer.

Later this year, the streaming music company plans to move most of its 1,200 New York-based employees into 14 floors at 4 World Trade Center in the rejuvenated Financial District. As part of the deal for the 15-year lease, New York is granting an $11 million rent reduction in exchange for keeping more than 800 jobs in the state and adding 1,000 more employees.

But Spotify will make its presence felt in Lower Manhattan in 2018 in more ways than one. Sometime in the coming months at the New York Stock Exchange, just blocks away from its new home, the company will embark on what’s known as a direct listing, an unconventional initial public offering method that has never before been attempted on such a large scale.

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The Voorhes for Variety

Spotify and Wall Street aren’t the only ones that will be anxiously watching; count the music industry in as well. Its fortunes are largely bound with Spotify, which is becoming the industry’s top music distributor. Should the Sweden-based firm’s bold move backfire, its partners at the major record labels will feel the pain too.

“Just think about their depth of influence in the world,” says Capitol Music Group chairman-CEO Steve Barnett of Spotify. “[A recent Nielsen] report noted that Americans are spending more than 32 hours a week listening to music — up from [23.5] hours in two years. That tells you, for all the mistakes the industry made over a long period of time, things have been corrected.”

But as Spotify increases its lead over even bigger rivals like Apple and Amazon, the direct listing is raising concerns that the company could experience the kind of turbulence currently rocking another digital-media darling, Snap.

“That’s a pretty bad scenario,” says a major-label executive who has worked with Spotify for many years. “The music industry is back to growth, and you can feel investors saying, ‘Let’s take another shot at music.’ If it crashes and burns, Wall Street and the investment community might say, ‘Even this second chance didn’t work’ and become paranoid.”

A Spotify rep said its executives are prohibited by SEC regulations from discussing the direct listing or the company’s business plans.

Spotify co-founder and CEO Daniel Ek has seen his company’s valuation grow to $19 billion from $13 billion just four months ago.
Vesa Moilanen/REX/Shutterstock

Spotify’s recent growth has been nothing short of explosive. Founded in Sweden in 2006, launched in Europe in 2008 and in the U.S. in 2011, it announced in January that it had passed 70 million paying subscribers and 140 million active users (the latter category defined as free or paying users within the previous 30 days). The service is available in 61 countries.

The company has managed to avoid the kryptonite that felled or foiled many of its predecessors — opposition from Universal, Sony and Warner, the three major music groups and the world’s primary music-rights holders — by making them partners on multiple levels, including giving them a piece of the action in the form of a combined interest in Spotify that has been reported to be as high as 18%, although knowledgeable sources tell Variety it is actually “much lower.”

In recent years, the economic catchphrase has held true: As Spotify goes, so goes the music industry. With streaming leading the way, the music business is projected to post its third consecutive year of growth. This success follows 15-odd years of a brutally demoralizing, illegal-downloading-induced downturn that saw global recorded-music revenues plunge from $23.8 billion in 1999 to $14.3 billion in 2014, according to the Intl. Federation of the Phonographic Industry. Today, estimates of Spotify’s market valuation are $19 billion, up from $16 billion in September. “It’s the golden boy, the ‘Star Wars’ of the music industry,” says Santosh Rao, head of research at Manhattan Venture Partners, who has been covering Spotify for several years.

If there’s one golden boy in the picture, it’s Spotify co-founder/CEO Daniel Ek, whose business credentials have drawn enthusiasts and investors like Sean Parker and Scooter Braun (manager of Justin Bieber and Ariana Grande, among others) into his orbit. Ek’s low-key demeanor belies his swagger: His 2016 wedding was held on the shores of Italy’s glamorous Lake Como; Chris Rock officiated, Mark Zuckerberg attended and Bruno Mars performed at the reception.

But Spotify’s expansion strategy has come at a cost. The streaming giant is losing hundreds of millions of dollars every year. For 2016, its net loss was $601 million; $206 million the year before. Its 2016 gross profit was just $502 million. Its headlong rush to market dominance has been fueled by liberal spending on staffing, marketing and product development — not to mention those new offices. Artists and songwriters complain loudly about what they consider Spotify’s low royalty rates. The company has been dogged by lawsuits from music publishers and songwriters — including a $1.6 billion suit earlier this month from Wixen Music Publishing — which get a much smaller slice of the royalty pie than labels. And five days into 2018, its chief content officer of three years, Stefan Blom, who negotiated many of those deal renewals with the majors and led the move into video, surprisingly announced he was stepping down.

“Americans are spending more than 32 hours a week listening to music. That tells you for all the mistakes the industry made over a long period of time, things have been corrected.”

Rather than filing for a traditional IPO, the company in December secretly filed for a direct listing of its shares, a process in which no new stock is issued — and no money is raised — but existing investors and insiders can trade their shares on the open market. The rarely used process allows Spotify to skip the multi-week “road show” of sweet-talking key institutional investors. It also won’t need to enlist and pay investment banks to underwrite the offering, and longtime employees and other shareholders won’t be under a lock-up period; they’ll be able to trade their shares on day one.

The flip side is that forgoing a conventional IPO initially won’t allow Spotify to raise new capital. And without underwriters to calm the waters, the stock could turn out to be a lot more volatile from the start, which is why Revolution Ventures managing partner David Golden is skeptical of the approach. “This is really a solution looking for a problem,” he says. An IPO would offer a lot more security for not that much more money, he argues. Golden believes that Spotify is out to “poke their finger in the eye of traditional Wall Street.”

Not everyone agrees. “If there is any private company to pull this off, it is Spotify,” argues Rohit Kulkarni, who has been following the service closely as managing partner of SharesPost, a marketplace for pre-IPO shares. Spotify has for years been operating much like a public company, he says. Incorporated in Luxembourg, the company has been filing detailed financial disclosure reports every year with local regulators.

“They’ve been very shrewd,” says a second major-label executive, who has worked closely with Spotify for many years. “The public listing is unusual, but from everything we’ve observed, people have a good understanding of the business, and they have a high degree of visibility and interest in the investment community.”

Spotify may draw some inspiration from Amazon, which lost hundreds of millions of dollars in its first few years as a public company, but investors stuck with the stock because the e-tailer reliably grew its business every quarter. On the other hand, Twitter and Snapchat stumbled not because of their monetary losses but primarily because of stalling user growth.

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“Trying to conquer a market, gain share and bet on the future seems to be the playbook of the 21st century,” says the second major-label exec. “There’s always the conventional investor skepticism about ‘Show me the bottom line,’ but that doesn’t necessarily seem to be the binding rule of law with successful enterprises these days.”

Investors may not insist on Spotify turning profitable for a few more years, but they do want to be assured it has a path to profitability. One way to get there would be more favorable deals with labels. Its business model calls for paying out around 70% of its annual revenue in royalties.

Sources tell Variety that when the company hits certain subscriber and revenue targets, its royalty rates will ease, and that its 2017 agreements with the big three music groups also came with lower rates in exchange for some concessions on “windowing” new releases from its freemium service (which rights holders loathe but many insiders say has helped persuade millions of people to become paying subscribers). The new rates have helped to improve Spotify’s gross margins from 15% in 2016 to 22% in the first half of 2017, according to SharesPost estimates.

But many rights holders who aren’t major record labels say Spotify’s rates remain unfairly low — while there is no clear-cut number, the company reports that it pays out between $0.006 and $0.0084 per stream, which works out far better for a superstar artist than a smaller act.

“I’m looking at what we pay out every single day, and it’s a lot,” maintains Spotify global head of creator services Troy Carter, former manager of Lady Gaga and Meghan Trainor. “I think there’s a level of complexity to payments: Either an artist doesn’t have the audience at scale on the platform, or the way their deal is set up with their distributor or label means the money isn’t trickling down to them. I’m seeing artists who are generating gross revenues in eight figures, so the payments are being made — it’s just a matter of who’s receiving them.”

And while Spotify and the majors often spar over rates and terms and percentages, last year the company struck new licensing deals with all three, as well as with the independent-label collective Merlin. Spotify secured a $1 billion loan in 2016, and in December, it announced a stock swap with Chinese internet goliath Tencent’s music division. Not only does that give Spotify an additional financial cushion, but the two companies complement each other geographically: Spotify is strong in Europe and the Americas; Tencent dominates in Asia.

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But Spotify has to look for other ways to improve its margins. One obvious area is its ad business, which hasn’t been profitable either. Another is infrastructure. Spotify struck a big multiyear deal with Google for the use of the search engine’s cloud services in early 2016, and may be able to marginally improve its cost structure when it renegotiates that agreement down the line. Sources also tell Variety that Spotify is aggressively exploring ways to monetize its data.

Finally, Spotify could be looking to grow other sources of revenue that aren’t dependent on music royalties. This was one of the reasons the company ventured into original video in 2016. However, it quickly realized it had bitten off more than it could chew and scaled back its video efforts a year later. In September, Disney exec Courtney Holt was brought in to restart efforts on that front (see sidebar).

Spotify is still experimenting with some video formats and has been doubling down on audio podcasts. Kulkarni says he wouldn’t be surprised if the company eventually adds other forms of non-music audio, but he also cautions to not expect too much from these side projects: “It is still an experimental revenue stream for Spotify.”

Investors may not necessarily be spooked by Spotify’s losses as long as the company’s user base continues to grow at a strong pace. Of streamers who subscribe, which make up 80% of all on-demand audio streaming in the U.S., according to BuzzAngle, Spotify leads its nearest competitor by 40 million paying users (Apple Music has 30 million).

The music business seems to be riding Spotify’s coattails; U.S. spending on music surged 17% to almost $4 billion in the first half of 2017, and streaming grew 48%. Streaming now generates more than half the entire U.S. music industry’s revenue.

All sources generally agree that “it would be a massive speed bump if Spotify did a faceplant,” as the second exec puts it. “But does that ultimately mean it derails the music business? No. In terms of the ‘too big to fail’ question, at the end of the day Spotify’s sails are full of the wind of the mega-trend that is the mass migration of consumers to the cloud. It’s the same thing that’s fueling Netflix’s growth and causing disruption across the media landscape.”

Less convinced is music industry attorney Chris Castle. “There are some companies that just aren’t supposed to be public, and I think [Spotify is] one,” he says. “They’ve grown by seeding their business with venture money and their topline is considerable, and there’s nothing to suggest they have any intention of getting their costs under control. If they’re trying to say that they can’t run their money-losing business without having those expensive offices in the World Trade Center, OK, but don’t come crying to me about royalty rates.”