The Real Problem With Music Streaming

Although debates over music streaming generally revolve around the meager incomes which they often earn for artists and songwriters, there may be a larger issue at stake concerning the overall commercial sustainability of these services.

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Guest Post by Mark Mulligan on his Music Industry Blog

Much of the debate around the sustainability of streaming has understandably focused on artist and songwriter income and transparency.  It is a debate that I have contributed to frequently.  But the more fundamental structural issues are whether the business models are commercially sustainable and if they are, what the implications are.  Music consumption is inarguably moving towards access based models so the question is not whether streaming should happen or not, but how to make it work as well as it possibly can for all parties.  As unfair as it might seem, the baseline issues regarding creator income could go unchanged without streaming business models falling apart.  But, as I will explain, if broader commercial sustainability issues are not fixed then many streaming businesses will collapse leaving just a couple of companies standing.  And that scenario would almost certainly be worse for creators than the current one.

The Steve Jobs Revenue Share Legacy

As I revealed in my book ‘Awakening’, when Steve Jobs struck the original iTunes Music Store deal he walked away a happy man despite having given the major labels the big revenue percentages they wanted.  Why?  Because it meant that it was really hard for anyone without ulterior business aims like Apple had, to make money from selling tracks as a standalone business.  The revenue shares negotiated back then set the reference point for all digital deals since.  The fact that streaming services pay out more than 70% of revenues to rights holders can be traced back to that deal.

The Great Role Reversal And The De Facto Label Monopoly

In the digital era the record labels undisputedly hold the whip hand, and some.  In the analogue era the roles were reversed.  Retailers were the dominant partners and they knew it.  Record labels actually paid retailers for placement to promote new releases.  Compare and contrast that with labels contractually compelling services to provide placement.  Both models are wrong and both engender corrosive behaviour.  Because the major labels account for the majority of music sales it is nigh on impossible for a non-niche music service to operate without all three on board.  This gives each label the effective power of veto.  So even though no major label is a monopoly in its own right each has an effective monopoly power in licensing.  These factors give labels the strength and confidence to demand terms that would not take place in an openly competitive market.  This, for example, is very different to how digital deals are done in the much more fragmented TV rights landscape.

Loading The Risk Onto Music Services

Why all this matters for the sustainability of streaming services is because of how it manifests in commercial terms.  Recent contract leaks have revealed to everyone the details of what insiders long knew, that labels and publishers front-load deals.  Services both have to pay large amounts up front and agree to guaranteed payments to rights owners regardless of how well the service performs.  (Some labels proudly state they don’t charge advances but instead charge a ‘set up fee’ for every track in their catalogue. Call it what you like, making a music service pay money up front is an advance payment.)  Even without considering the entirely intentional complexity of details such as minimas, floors and ceilings, the underlying principle is simple: a record label secures a fixed level of revenue regardless, while a music service assumes a fixed level of cost regardless.

Labels call this covering their risk and argue that it ensures that the services that get licensed are committed to being a success.  Which is a sound and reasonable position in principle, except that in practice it often results in the exact opposite by transferring all of the risk to the music service.  Saddling the service with so much up front debt increases the chance it will fail by ensuring large portions (sometimes the majority) of available working capital is spent on rights, not on building great product or marketing to consumers.

Skewing The Market To Big Tech Companies

None of this matters too much if you are a successful service or a big tech company (both of which have lots of working capital).  Both Google and Apple are rumoured to have paid advances in the region of $1 billion.  While the payments are much smaller for most music services, Apple, with its $183 billion in revenues and $194 billion in cash reserves can afford $1 billion a lot more easily than a pre-revenue start up with $1 million in investment can afford $250,000.  Similarly a pre-revenue, pre-product start up is more likely to launch late and miss its targets but will still be on the hook for the minimum revenue guarantees (MRG).

It is abundantly clear that this model skews the market towards big players and to tech companies that simply want to use music as a tool for helping sell their core products.   Record labels complain that they don’t get enough value out of big companies like Google and Samsung, but unless they make the market more accessible to companies that are only in the business of selling music they can have no room for complaint.  The situation is a direct consequence of major label and major publisher licensing strategy.

Short Termism And From Evil To Exceptional

Matters are compounded by an increasingly short term outlook from label licensing divisions, with the focus on internal quarterly revenue targets, or if you are lucky, annual targets.  The fact that much of label and publisher digital revenue comprises guarantees and advance payments means that their view of the digital market is different from how the market is performing.  If our small start up that pays $250,000 in rights payments doesn’t even get its product to market, the rights holders still see that digital revenue even though the marketplace does not.  (One failed music service that didn’t even launch went into bankruptcy owing two major labels $30 million).

This revenue comfort blanket insulates labels and publishers from much of the marketplace pain.  So if/when things go wrong, they feel it later, delaying their response.  There is also a cynicism in much deal making, with rigid templates applied to deals and a willingness to compromise principles if the price is right. The latter point was illustrated by the leaked negotiations between UMG and industry bête noir Kim Dotcom in which former digital head Rob Wells referred to being able to ‘downgrade’ Dotcom from ‘evil to bad’ and then from ‘bad to good and from good to exceptional partner’.  The message is clear, if there is enough money on the table, anyone can be a business partner whatever the implications might be for the rest of the market.

Wafer Thin Margins, Deep Pockets And The Innovation Drain

Current licensing strategy biases the market towards those with deep pockets and fatally compromises profitability.  Once all costs are factored in, a music subscription can theoretically have an operating margin of between 3% and 5%. Though only if it doesn’t invest sufficiently on marketing, customer retention and product innovation. But of course the streaming market is in early growth stage so every service has to spend heavily which means that profitability becomes a hostage to fortune. No wonder Daniel Ek is clear that Spotify is a growth business rather than on a profit crusade.

The market dynamics also create an innovation talent drain.  If you were a would-be start up founder the huge up front costs, non-existent margins, and complex time consuming licensing do not exactly make building a music app a welcome experience.  Building a games app however is an entirely different proposition: you own 100% of the rights, you don’t pay a penny to 3rd party rights holders and consumers actually pay for your product.  Music is already a problematic enough sector as it is without burdening it with a punitive licensing framework.

These are the structural challenges that could yet bring down the entire edifice of the streaming music economy.  The irony is that if Spotify has a successful IPO (sans profit of course) it will trigger a wave of copycat services and investment that will perpetuate the status quo a little further.  But it will only be a temporary delay.  Sometime or another the hard questions must be answered.

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