How Spotify's Business Works

daniel ek spotify

Illustration: Ellis Hamburger

This note is from BI Research, a new tech-industry intelligence service. The service is currently in beta and free. To learn more and sign up, please click here.Spotify, the hot European music service coming from Europe, has generated a lot of critical acclaim for its excellent product.

But can it make money?

At first glance, it may seem not: the company lost $42 million in 2010.

To some, this is not surprising, Spotify bears say it’s just impossible to make money from digital music, at least if you’re not also selling beautiful high-margin music players to go along with it (like Apple).

We disagree. We think Spotify will be a big moneymaker one day. 

To explain why, let’s first look at Spotify’s financials and how the company generates revenue.

Spotify, which is incorporated in the UK and so has different disclosure requirements than US companies, published its income statement for the year 2010. Note that these financial statements are from before Spotify launched in the US, where it is experiencing strong user and subscription growth. This is what they look like (amounts in GBP):

Spotify 2010 revenue and losses

Photo: via Music Ally

It’s not a pretty picture. Spotify lost more than $40 million last year.

On the positive side, the loss as a percentage of revenue was much smaller than the prior year. This suggests that, as Spotify gains scale, it is also gaining leverage, which bodes well for future profitability.

And what about the details? What is Spotify spending all that money on?

The biggest cost item is “Cost of sales”, which includes music licensing costs. 

Indeed, music licensing costs were bigger than revenue. This means that even before paying for its actual business costs–offices and salaries and servers–Spotify has spent more than it takes in.

There’s good news in that sea of red ink, however:

  • Spotify’s growth is through the roof. Revenues grew a stunning 458% from 2009 to 2010. That’s impressive for any business, but even more so from one that starts from an already relatively high base of eight figure revenues.
  • Spotify’s losses are narrowing. Losses were an eye-watering 147% of revenue in 2009. In 2010 they were 42% of (fast-growing) revenue–still very scary, but a narrowing gap nonetheless.

Even more encouraging, while the biggest cost item, licensing fees, grew a lot between 2009 and 2010, it grew 345%, or less fast than revenue. Still very big, but costs growing less fast than revenue suggests there might be a light at the end of the tunnel.

In fact, we think Spotify will likely at one point see profits. But to show why, we have to explain how Spotify’s business works.

How Spotify Makes Money
Spotify has a mixed advertising/freemium business model. Specifically, there are three pricing tiers (see chart below for details):

  • Free. You can download and listen to Spotify for free. In exchange, there are ads (audio and display), listening time is limited to 10 hours a month, and you can’t take your music mobile. 
  • “Unlimited,” $4.99/month. Unlimited listening time, without any ads. 
  • “Premium,” $9.99/month. Unlimited listening time, no ads, and the ability to take songs mobile on other devices. (This is the option this writer has happily subscribed to for years.)
spotify pricing

Photo: Spotify

 Even though Spotify won’t say it, we’ve heard several times from industry folks that Spotify ads are extremely cheap and bring in little money, and are mostly there to annoy people into buying a subscription.

So Spotify should really be analysed as a subscription business.

What It Takes To Make “Freemium” Models Like Spotify Work
We’ve already studied what makes the freemium business model work (or not!). This is a framework we can apply to Spotify. 

Successful freemium businesses generally show the following characteristics:

  • A large free user base
  • A low marginal cost to serve each new subscriber
  • A product whose value to the user increases over time.

How does Spotify fare on these metrics? 

It already has a huge free user base. Spotify already has many millions of free users (see chart below). Its product is highly critically praised. What’s more, Spotify has been a large beneficiary of Facebook’s new platform product, which allows music services to turn users’ activities into viral social signals. Unless something unforeseen happens, Spotify’s user base should only increase from here. 

spotify users

Photo: Business Insider Research

Spotify also appears to have a low marginal cost per subscriber–although the details here remain a key question. The key cost-per-subscriber is the royalties Spotify must pay to content owners. It does not cost Spotify much to “serve” each additional subscriber, in part because its product uses a (mostly) peer-to-peer architecture so Spotify’s own servers have to stream little data. But Spotify does have to pay fees to record labels. And it’s not clear exactly how these royalty payments are calculated–and, specifically, whether they are 1) fixed payments (regardless of usage), 2) fixed payments per subscriber (regardless of usage) or 3) per-use payments.

Presumably, Spotify has priced its subscriptions so that most of them are nicely profitable relative to the amount of music the subscriber listens to. And, on average, these profitable subscribers probably offset the costs of those who consume music 24 hours a day. But the details of these royalty payments will determine how profitable each incremental Spotify user is, and, therefore, how profitable the company can eventually become.

Right now it can easily raise money privately and seems to have good relationships with the music industry, but this high cost base is going to be a problem for Spotify.

The final question is whether Spotify becomes more useful to users over time–and the answer is yes.  And this is important, because it will allow Spotify to convert more free users to paid users over time.

Spotify actually boasts a high conversion rate on active users, around 15% (see chart below for comparison). A plugged-in person familiar with Spotify’s situation and many other startups said they had “never seen conversion rates that high.”

spotify comparison rate

Photo: Business Insider Research

The key, this person explained, is that Spotify creates an “emotional connection” between the user and the product (and it is, indeed, a very pleasing product to use).

Spotify investor and technology visionary Sean Parker has put it slightly differently: once a Spotify user has connected with their friends and built playlists into Spotify, “we’ve got you by the balls.” The playlists are inside Spotify, and to put them on their mobile, that person has to pay up.

The underlying idea is the same: freemium products that succeed do so because their value to the user increases over time. 

To a user, at first, Spotify is just music. Then it becomes music, plus their playlists, which they have taken a lot of time to put together, plus their friends’ playlists, which they can access easily in the software thanks to Facebook integration. Once the “emotional connection” with the product is accomplished (or once Spotify has “got you by the balls”…) it becomes much more compelling to pay up. 

Why Spotify Should Be Nicely Profitable… Eventually.
Look back at that seemingly dreadful income statement. Losses are eye-watering. Licensing costs are enormous, and growing very fast.

But, crucially, revenues are growing faster than costs. As well they should be. 

As we wrote above, the freemium business model works by converting users from free to paid over time. As Spotify grows and cohorts of users stick around, more and more of them are converting from free to paid. And because subscription revenue is recurring, revenue from increasing numbers of paid users grows faster than the costs of licensing streaming all that music for the free users. 

Which means that, at some point in the future (probably not tomorrow, but some time), the revenue line should climb above the cost line. 

The Bottom Line
The bottom line is that under the ocean of red ink Spotify actually has a very promising business model:

  • The product quality and deep social integration make it viral, which brings in the free users;
  • As it gains scale, Spotify will gain negotiating leverage with content partners, which should allow it to keep the marginal costs for each new subscriber low;
  • Spotify draws you in and gets you to pay a subscription fee once you’re hooked;
  • Because subscription revenue is recurring and more users are converting to paid over time, at some point the business should be sustainably profitable.

It’s not just a classic freemium play, it’s an excellently executed one. And subscription revenue seems more likely to make tons of money for the company and the music industry over the long run than either ad-based models like Pandora’s or sales like iTunes and Amazon MP3. And the latter models, in any event, are not how people, especially young people, increasingly consume music these days.

Spotify’s product is the best of all worlds: the free product has more convenience than either piracy or iTunes (search for a song, hit play, and it starts playing instantly), and the subscription almost certainly brings in more revenue over time. 

Right now, Spotify is still small, and its costs are high. It needs to grow a lot more to make its business work. But if anyone can make serious money sustainably from digital music, it’s Spotify. 

This note was published as part of BI Research, a new industry intelligence service from Business Insider. The service is currently in beta and is free. To learn more and sign up, please click here.

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