How Spotify grew up before going public

It’s unconscionable in 2017 that the only publicly traded music streaming company is still Pandora Media Inc., an Internet radio provider which went public in 2011 and is trading below its initial public offering price. Hopefully, Spotify Ltd. will rectify the situation this year, even if that means it has to use a back door to an exchange listing. It’s an interesting back door for others in the tech industry, too.
The Wall Street Journal reports that the London-based company is considering a direct listing instead of an IPO. This is a path usually reserved for small firms looking to save money on investment bankers and keep more of the company’s value for the existing shareholders.
Instead of selling shares to major investors the night before going public at an ‘initial’ price, companies that directly list themselves on an exchange usually buy a smaller firm that already has a listing. Then, the company’s owners can immediately get the full market price if they want to sell some of their stock.
It’s often seen as a risky path since no money is raised before the market enters the equation, and there are no bankers to stabilize the stock for the first few — sometimes shaky — months of trading. The advantages, apart from not paying bankers, include not leaving any money on the table, as companies almost always do in an IPO to give the first investors an upside when the stock “pops” in early trading.
Spotify’s story is that of a typical tech disruptor: It developed a cool technology that allowed it to give away for free something that people used to sell, in this case recorded music. At the end of 2011, its third full year of operation, the company had 32.8 million registered users and only 2.8 million paying subscribers, who provided 80 percent of the company’s revenue.
The rest of the money came from advertising pushed to the free riders. To avoid the fate of Napster, the peer-to-peer music sharing service killed by intellectual property litigation, Spotify paid large fees to record companies that owned rights to music catalogs, resulting in a seemingly endless stream of losses. Spotify won the hearts and minds of music fans without figuring out how to monetize either.
Spotify probably still is not profitable — it hasn’t released its 2016 financials yet but 2015 saw strong top line growth and expanding losses — but at least appears to have figured out what to do. It’s committed to paying subscribers, not scaling its advertising base. At the same time, it wants better deals with music labels. In both respects, its recent licensing deal with Universal Music Group is a trailblazer. It allows the record company to release new music to paying subscribers only for the first two weeks, and it makes royalties dependent on the number of streams: The higher it is, the smaller percentage of revenue goes to the rights owner.
Universal has the highest share of music streams, about 30 percent. Now, Spotify needs to make similar deals with the other two majors, Sony Music and Warner Music, responsible for another 41 percent of the market.
Once that happens, the lead time to free release will probably grow longer, and the labels will be more amenable to sharing revenue with Spotify since they, and artists, will be reassured it’s not giving away their wealth and their work. Spotify now reports 50 million paying subscribers — up 10 million since September 2016, and about half the number of its registered users.
Spotify worked diligently on its business model, going from unrealistic expectations of ad revenue and volume growth to an understanding of how to convert free users to subscribers and what to ask of record labels. When Snap IPO’d with its advertising-based business model that’s not even close to covering costs, it was selling hype. Spotify’s selling a product that has matured through hard times.
There’s a lot of pressure on Spotify to go public this year. Financing its $1 billion of debt grows more expensive if it delays, and equity investors stand to increase their shares. It’s a credit to Spotify that it’s looking for the cheapest instead of the flashiest way to avoid these traps.
Whether that yields a high valuation — more than the $8 billion at which Spotify was valued in 2015 — remains to be seen. Having fought off a powerful challenge from Apple Music with its practically captive installed base, Spotify has at least a 43 percent share of the paid music streaming market. (Apple holds 21 percent.)
If Spotify goes the non-traditional route and all works out well, it’ll be an example for other tech firms still full of illusions about their business models. Giving away as little as possible may not sound romantic, but it’s usually sustainable, and it motivates a business to offer the best possible product. — Bloomberg

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru