Online music licensing: The good, the bad and the ugly

Rumour has it that Spotify is looking around for yet another huge round of investment, one that would take the company’s valuation from around US$1-billion to over US$3-billion. One might ask why a company that seems wildly successful to most always needs new investment. How, with over 2-million paying subscribers, does Spotify continuously end up far in the red? How much in the red you may ask? 2010 saw it post a reported loss of US$42 million… (up from US$26 million in 2009).

The numbers aren’t out for 2011 yet, but it’s expected that the losses are still increasing. It is one major expense that causes these losses. Its suppliers charge exorbitant prices that the service cannot afford, yet holds such a monopoly over the supply that the business would not be feasible without it.

I am alluding to the major label catalogues that most music stores and services license. The major labels charge huge licensing fees for access to the massive library that they own, a library that generally includes the vast majority of popular music. For a service like Spotify — whose offer is essentially “pay us $10 and stream any music you want within our app” — not having access to major label content is not even an option.

Spotify is reported to have paid upwards of US$60-million in licensing to record labels during 2010. In fact, Spotify already makes a yearly loss based solely on revenue to cost of sales (before operating expenses, administrative expenses and distribution costs). And this is not an exclusively Spotify problem. Overly expensive licensing fees have been the bane of online music stores and especially streaming services (see the dramatic and embarrassing collapse of Beyond Oblivion). The major labels know that they hold the monopoly over 80% of the most sought-after music, and what with this whole new fangled piracy thing, they’re not keen on losing any more ‘potential revenue’.

So the question that emerges here is simple… how on earth does one go about creating a profitable music business in such a landscape. Well there are essentially 3 different approaches:

1. Bite the bullet and do it

License major label content and pay the steep prices they demand. Sure, you need either a ridiculous amount of capital (which in Spotify’s case includes major labels themselves, oh yes… you see how this works) or… well that’s it. I mean, it’s worked for Pandora (only just)… sure it left Beyond Oblivion bankrupt with US$500-million in debt. You have to take risks in business! Oh yes, and licensing is also region specific… hence not even iTunes is available in certain markets. You’ll have to pay a whole lot more for every region you go into.

2. Throw up your middle finger and do it

This is the approach of places like original Napster, The Pirate Bay, Limewire, Megaupload and Grooveshark. Use their music (usually through user upload) and just don’t pay them. Let them sue! The aim is to grow big quickly enough that your own success protects you. Maybe then you can renegotiate with them, or at least pay the legal fees. Unfortunately, major labels and the RIAA don’t take too kindly to this, in fact, they’re particularly unforgiving.

The attitude of Major Labels pretty well summed up in this comment by a Universal executive in reference to their lawsuit against MegaUpload.

“They want to pick up right where they left off with Limewire, and go after individuals,” one connected executive told Digital Music News. “They want to make entrepreneurs think very carefully about f–king with their copyrights.”

As a result, few of the mentioned sites still exis. Most have had the pants sued off them. Napster, Megupload and Limewire all folded under legal action, and Grooveshark is currently facing massive lawsuits by all the major labels.

3. Get around them and do it

The final option is to simply not use their licensed music. This is the approach of Bandcamp, Soundcloud, Airborne and a host of others. Create a platform that allows Artists themselves to sell/earn directly, rather than buying bulk licenses from labels. This allows music services to develop without the unmanageable demands of major licensing, however without being able to access the most of the “Top 40” Artists.

So there is essentially a trade-off between having access to the Top 40 Artists and having your bottom line crippled by licensing, or foregoing the most “in demand” music and having the freedom to work out your own margins and pricing, without having the intense “sink or swim” pressure. Spotify, as an example, are now stuck in the position where they have no choice but to become the primary mechanism of mass music consumption… or die trying (assuming that the continuous rounds of investment will stop somewhere). The labels, on the other hand, get paid either way.

Spotify has positioned itself as the forward facing bastion of the major recording labels against piracy. That seems to be where they’ve placed their bets. Of course, they are the only ones making money from it (Artists earn a pittance, and Spotify itself isn’t making any money), and if Spotify folds because of it, it will be all the other investors that suffer rather than the majors (the investment is essentially being paid back to them in licensing). Spotify will sink or swim based on what happens in the next two years, but the labels will survive it.

Meanwhile with the combination of enormous licensing fees and a heavy handed legal approach, the question that emerges is to whether new music entrepreneurs will want to go near these licensed catalogues. If you’re trying to do anything innovative and experimental, is it really worth the risk. And if music entrepreneurs start veering away from major catalogues, it suggests that the most imaginative and progressive new approaches and Artists may very well be independent.