Streaming Sustainability?

01/10/2013 18:40 BST | Updated 01/12/2013 10:12 GMT

New kids in the playground tend to get attention. Unfamiliar, intriguing, a little bit different, they often attract crowds curious to see what the fuss is about - at least at first.

Spotify still plays on its 'new kid' reputation, even though it's five years old. Not only that, the Swedish music streaming business is the darling of the tech industry and self-appointed saviour of the music industry.

A quick Google search yields numerous, almost daily reports of the latest Spotify developments, controversy or debate. Ministry of Sound recently became part of one debate after beginning legal proceedings against Spotify over the protection of our intellectual property.

However, notwithstanding our own battle, I'd argue that there are bigger, fundamental questions to ask about Spotify - questions which affect our industry as a whole.

Spotify needs cash. Having burnt through $206million since its launch in 2008, it's been reported in Sweden that the service is seeking a new round of funding, allegedly valuing the business at $5.3billion. To put that in perspective, that's nearly double what Universal Music Group paid for EMI, and nearly as much as Microsoft paid for Nokia.

How did Spotify reach these lofty heights?

Over the last 15 years the music industry has been decimated by piracy. Napster, the original file sharing service, allowed fans to download songs from each other's computers, removing record companies from the equation and teaching a whole generation that music was free. The music labels didn't know which way to turn and scrabbled around trying to launch their own digital services.

Enter Apple and iTunes. The record industry was wooed by Steve Jobs but relegated to a supplier of software. Apple controlled the hardware and the distribution. iTunes was a loss leader - Jobs was happy to hand over 70% of revenue to music companies because it was their content that made Apple's hardware so compelling. Apple made its vast profits on sales of the hardware.

Today, with 575million customers and $23billion in sales ($7 billion of which is reportedly music), iTunes is the biggest music store in the world and profitable in its own right. It's the largest source of income for every record company on earth.

Streaming technology developed in the mid-2000s. Originally pioneered by Real Networks, the experience wasn't for music lovers. Poor quality audio was sent through the web directly to PCs, it was like listening to a crackly AM radio. But inevitably the technology improved as broadband was introduced and internet connections sped up.

Spotify, although not the first, was the most ambitious music streaming service to emerge. When it launched in 2008, founder Daniel Ek knew he needed the key music executives on side. He understood what motivated them. Cash.

Record company heads, like heads of many businesses, are rewarded with healthy bonuses for hitting targets. When your industry is constantly contracting these become impossible to achieve. In addition, when it's time for your contract to be renewed, questions are asked about your remuneration in light of collapsing sales and profits.

Increasingly desperate, senior executives reach for any short-term fix to help clear these hurdles. So when Spotify promised them a new revenue stream, healthy royalty payments, big cash advances and even an equity stake should the business be sold or float for an enormous valuation, the decision was a no-brainer. Happy days!

Spotify's problem, however, is that its business model is not like Apple's. Its free/advertising supported service, which accounts for more than 80% of its users, burns through cash. The paying customers don't bridge the gap. Unlike Apple, Spotify doesn't have other revenue streams to support it.

Non-profitable business models are not unusual in the tech environment. Number of users and growth rate are equally compelling, sometimes even more so. If a business can demonstrate a rapidly growing and loyal customer base, the general principle is that it will eventually work out how to make money. In any event, if a business has hundreds of millions of users it may be an attractive prospect to someone - either as an acquisition or through an IPO where the public will be able to speculate and profit from its growth or sale. The tech industry is a modern day frontier, but instead of precious metal it's a gold rush for online customers.

Spotify has six million paying users, a respectable number. But does this customer base make it a long-term viable business? Given its license deals require it, like iTunes, to pay 70% of revenue to the music companies, and that it has to subsidise four times as many free customers, how long can it continue to borrow money from investors on the promise of a lucrative exit?

Also, does Spotify really make that big a contribution to music industry coffers? Ek recently claimed payments to record labels have totalled nearly $500million since its 2008 launch, a not inconsiderable sum. But Enders Analysis reports global music industry revenues of $20.7billion in 2012 alone.

More worrying is the myth Spotify propagates. By allowing its users to believe a free legal music service is sustainable, it has helped to reduce piracy. But it has also lured in traditional music buyers who no longer believe they need to pay a penny for music.

It's always unpopular to talk about money in the same breath as music - art and commerce are uncomfortable bedfellows. It's also unpopular to criticise technological progress. But it's a simple fact that music isn't free. Artists, songwriters, publishers, promoters, record companies and radio stations are all part of an established business which finds, invests in and develops talent, eventually delivering it to market.

Some believe that's an outmoded concept and in this Internet empowered age the cream will rise to the top of its own accord. But, in reality, a significant artist on a global level has yet to emerge without the backing of a big music company.

Here's the conundrum. Users want free music. Record companies want cash. Spotify delivers both. But that can't work. Is Spotify a second Apple? Will it sit astride the music industry for decades to come? Or is it a case of the Emperor's New Clothes?

Does it really make sense for the music industry to place such a big bet on Spotify purely for short-term gain, when it could ultimately do more harm than good?

Suddenly the new kid doesn't seem so popular. Businesses that are too good to be true generally turn out to be just that.