Spotify is gearing up for a fight.
The popular music-streaming service is soon expected to announce its latest round of funding, an anticipated $400 million from investors at a valuation of $8.4 billion. The deal would catapult the Swedish company into the top ranks of the highest valued private tech companies worldwide alongside companies like Square, Dropbox, and Airbnb.
The enormous financing round and mysteriously massive valuation are surprising. While Spotify is hugely popular with music fans, it remained unprofitable globally in 2013, though its more recent finances are still private. And although the company pays a huge chunk of its revenue to record labels, the music industry---especially its artists---remain unhappy with the service for what they say are its scant returns.
Beyond its own finances, the competition in streaming music is intense. In particular, Apple's impending relaunch of Beats' streaming service means Spotify will have a new, well-supported rival already built into millions of users' phones.
Nevertheless, streaming is still the future of recorded music, and investors are willing to bet Spotify stands to play a central role in that future. If Spotify can hold onto its popularity among users, and if it can beat Beats, it could sell itself to the highest bidder or---with enough time, cash, and users---streamline its way to small but real profits all on its own. Someone has to win at streaming music. And that victory will be worth billions.
As it stands now, Spotify brings in cash from its more than 15 million users who pay for premium subscriptions. Additional money comes from advertisers who pay to reach the 60 million more users who opt for a free version of Spotify with ads. But even with more than a billion dollars in revenue in 2013, Spotify reportedly lost millions. Compared to other startups, its year-over-year growth margins, while improving, remain small, analysts say. (A spokesperson for Spotify declined to comment on reports about funding for this article.)
Spotify's business model also isn't easily scalable. For most startups, as more users join the network, the service becomes more efficient and costs go down. But for Spotify, more users mean increased costs. The company pays a licensing fee to record labels and music publishers for every song played. That means that if Spotify’s users skyrocket, so do its costs. Spotify itself says 70 percent of its revenue goes to paying royalties to labels, publishers, and distributors---in other words, a lot.
What's more, Spotify's product is far from unique. Music-streaming is a crowded space: Pandora, iHeartRadio, and Rhapsody offer radio-like alternatives. Jay-Z's artist-owned streaming service Tidal launched last month. And Apple’s acquisition of Beats last year means Spotify will have a new competitor with endless cash behind it. If that weren't enough, Google offers Google Play Music All Access; Apple has iTunes Radio; and Amazon offers streaming music to its tens of millions of Prime subscribers.
So how, despite all these challenges, does Spotify still stack up to $8.4 billion? It's not that the number is tied to some precise mathematical formula. As with many tech startups, the valuation is more of a ballpark figure created by investors lobbying for equity, not an exacting reflection of the company's current worth. In fact, total digital music revenues globally last year only reached an estimated $6.9 billion (of which Spotify is only one part). Publicly-traded Pandora is itself worth $3.6 billion---less than half of Spotify's expected valuation.
So how is such a high number still justified for Spotify?
"These numbers are a game for investors," explains longtime music industry analyst Mark Mulligan. "What we're talking about here is not profitability, but Spotify's ability to change the market."
What that means is that even without profits, Spotify is in a pretty great place---and investors know it. Consumers love the product. Subscriptions are growing. For most artists, there’s not much of an alternative (other than pulling your music, say, if you're Taylor Swift). And, despite the competition, when it comes to on-demand music subscriptions, Spotify remains the king.
That could all change soon, which is why Spotify is raising funds now. With the impending launch of a newfangled Beats under parent company Apple, Spotify will need to use the cash to keep its user base growing.
"It'll have to learn how to compete," Mulligan says. "Apple has so much in its favor coming into the market. It has a platform Spotify depends on. It has users' credit card info. It determines how easy it is to find apps on the App Store. And Apple is already the largest source of digital music with iTunes."
So while Spotify dominates the streaming market now, it may need to spread itself even farther, for example by introducing its service in emerging markets, to get ahead of Apple---or at least offset users who desert to Beats.
Once the streaming giant does close this expected round of financing, the battle is on. “It’s a very finely balanced business. You may have to pour in a lot of money over a long time, and one day it might be profitable," says Andrew Sheehy, chief analyst at Generator Research, which is releasing an updated report on the state of music streaming services this week. “Spotify could get to the point in the future where the very small amount of profits its making per user would be enough to cover the costs.”
And if it doesn't? Investors may still recoup their capital through a strategic acquisition. "Spotify wouldn't necessarily need to be profitable as long as it isn't losing too much money," Sheehy says. Big tech companies are paying top dollars for app acquisitions these days, most notably with Facebook's purchase of WhatsApp for $19 billion. "Samsung, being Apple's major competitor, is going to be de-positioned because they don't have a music service after Beats launches. I wouldn't be surprised if they're considering a move on Spotify," Sheehy says.
If Spotify does keep plowing ahead slowly and steadily, it may also find profits in new places. The company could use some of its cash to start introducing new services, such as interviews with artists, livestreams of shows, instrumental music written by robots, or playlists created by an AI. (The latter of which doesn't seem all that crazy considering Spotify acquired music intelligence platform The Echo Nest last year.) Users might pay more for extras like these, meaning one day Spotify may profit from cheaply produced premium services.
For now, investors may not be looking too far ahead---the service works, users love it. And the most important thing remains: music streaming isn't going anywhere. Now that users are acclimated to all-you-can-eat music, they're never going back to à la carte.
