High royalty rates prevent profitable businesses from emerging

Since 1997, according to PitchBook, approximately 175 digital music companies were created and funded by venture investors. Of those, approximately 33 were acquired by larger companies, often for less money than their investors put in. Of those who have exited, I believe only seven achieved meaningful venture returns for their investors by returning more than $25 million in profit to their investors (Last.FM, Spinner, MP3.com, Gracenote, Thumbplay, Pandora and possibly The Echo Nest), representing an investor success rate of only approximately 4%—far below that of other internet and technology market segments.

Only two have achieved an IPO, and at least 15 companies have resulted in a distressed exit and/or filed for bankruptcy so far, for an 8.6% failure rate to date. Given that I know of no profitable standalone webcasting or digital music companies, I believe this failure rate will only worsen over the coming years as the remaining companies in this space continue to struggle.

The section above comes from my U.S. Copyright Royalty Board testimony in front of the Library of Congress in May of 2015 as part of the Web IV rate-setting proceedings.

This bleak outlook for profitability among standalone digital music companies is a direct result of the high royalty rates incumbent upon startups who wish to license digital music for use in their apps. Whether you negotiate voluntary agreements or avail yourself of the existing compulsory licenses, you will not turn a profit. At least, no one ever has. The few that refused to pay these rates were often sued out of existence.

Given these facts, digital music startups are unlikely to survive and thus unlikely to attract meaningful investment. The failure rate in this market segment dramatically exceeds that of SaaS, eCommerce, and mobile, to name just a few. More importantly, the success rate of digital music companies (4%) is far less than these other segments (mobile at 26.5%, SaaS at 28% and eCommerce at 23%).

It is no surprise, then, that far fewer digital music companies get funded. Only about 175 have been venture funded since 1997 by my count, compared to 5,175 (mobile), 7,987 (SaaS) and 1,800 (eCommerce).

The end result of these perilous market conditions is that the only companies who can afford to be involved with digital music are the internet giants prepared to subsidize their digital music services with profits from their other businesses. The high royalty rates and up-front cash advances required by the record companies prevent profitable, sustainable businesses from emerging. As a result, the recorded music businesses is left only with these giants: Amazon, Apple, YouTube and, to a lesser extent, Spotify and Pandora.

The music industry complains loudly about the “leverage” these giants have over them. First they criticized Apple iTunes for not agreeing to raise prices above $0.99, then they went after Pandora and other webcasters by insisting webcasting rates were too low, then they attacked Spotify for not paying them enough, then they insisted Apple Music pay them more than Spotify did, and now, just as the YouTube licensing agreements are coming up for renewal, they complain YouTube doesn’t pay them as much as Spotify.

But this is a “crisis” of their own making. Many of us argued for years that it was in the industry’s best interest to create a healthy ecosystem of hundreds or thousands of successful companies, all enjoying successful businesses around music. But those arguments fell on deaf ears, and instead the industry fought repeatedly to raise royalty rates over and over again, despite evidence that not a single company ever achieved profitability.

In my mind, it would have been in the best long-term interests of the recorded music business to enable the widespread success of thousands of companies, each paying fair but not bone-crushing royalties back to labels, artists and publishers. But the high royalty rates imposed upon startups, even after clear signs over the past 19 years that the strategy killed companies, has prevented a healthy ecosystem from emerging. It’s a bed the music industry made for itself, and now it is left to lie in it.

Unfortunately, the jury is still out on the few startups who have survived. I love Spotify, too. It’s an amazing service. But to my knowledge, even at 30 million paying subscribers, it remains unprofitable. It exists, at least at this point, thanks to the largess of its investors. It’s hard to build profitable businesses when your gross margins are in the 20s (%). More than 70% of all of Spotify’s revenue is paid out to rights-holders. And still, many complain Spotify isn’t paying enough.

Pandora is the largest internet radio company, with more than 81 million monthly active listeners. Even with this extraordinary scale — more than one-quarter of all Americans listen each month — the company is unable to generate a profit. And while many of its investors have made large returns on their invested capital through stock sales at higher prices than their cost basis, the company continues to remain unprofitable, even at the very large scale it currently enjoys.

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The Music Startup Meltdown

Note: The data cited above comes from PitchBook. The search criteria and functions in the database allowed me to compare the performance results for the mobile, Software-as-a-Service (“SaaS”) , eCommerce , and digital music sectors. To determine the number of VC-backed companies in each sector, I used the “VC-backed” company universe search criteria. I next determined outcomes for each sector — i.e., whether profitable for the investors or simply a distressed/bankruptcy exit. In that regard, I used an “exit type” search where “Public Investments, Acquisitions” indicated a profitable outcome and “Distress” indicated either a distressed exit or bankruptcy. The searches were performed as of October 2014. I have not re-run them recently, but I don’t have reason to believe the results would vary all that much.

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The Music Industry Buried More Than 150 Startups—Now They are Left to Dance with the Giants was originally published in pakman.com on Medium, where people are continuing the conversation by highlighting and responding to this story.

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