Volume 13

Issue 3 September 2015

Legal and Profitable? Spotify: The Challenges of an Online Music Service Case1, 2 prepared by Joëlle
BISSONNETTE3 and Professor Eric BRUNELLE4

Foreword

Founded in Sweden in 2006, against the backdrop of a music industry plagued by illegal music
downloads and plummeting record sales, Spotify is an on-demand music streaming service. It offers
online music consumers legal access to a repertoire of over 30 million pieces of music, which varies
by country. Its mission is to let people listen to the music they want, when they want and where
they want. To accomplish this, the company offers a legal alternative that is superior to piracy, via a
simple, clear and rapid platform, making listening to and sharing music easier than ever. But the
company still faces major challenges. It has to respect intellectual property law, which requires
adequately compensating the rights holders to the music it disseminates, while trying to become
profitable and differentiate itself from the competition. How will Spotify position itself to meet the
needs of online music consumers better than other online music services, while respecting the law
and turning a profit?

1. Background: A Music Industry Between Crisis and Opportunity

1.1 Music and technology: a longstanding relationship

Since its beginnings, the music industry has undergone many technological transformations that
forced it to rethink how it does business. The introduction of cassettes in the 1960s made it possible
to create copies for private use and led to a crisis with fine-groove records. When compact discs
(CDs) hit the market, dethroning the cassette, almost 20 years of growth in sales of recorded music
followed; it was a golden age for the music industry, reaching a peak toward the end of the 1990s.

1 Translation from the French by Rhonda Mullins of case #9 40 2015 015, “Légal et rentable?
Spotify : les défis d’un service de musique en ligne.”

2 This case was prepared on the basis of public documents, i.e., articles, records and interviews in
the media and sectoral studies of the digital music market. It is also a direct observation of Spotify’s
Internet activities up until September 2015.
3 Joëlle Bissonnette is a doctoral student and research professional at HEC Montréal. 4 Eric Brunelle
is an associate professor in the Department of Management, and Director and Editor-in-Chief of
Gestion, at

HEC Montréal.

© HEC Montréal 2015 All rights reserved for all countries. Any translation or alteration in any form
whatsoever is prohibited. The International Journal of Case Studies in Management is published on-
line (http://www.hec.ca/en/case_centre/ijcsm/), ISSN 1911-2599. This case is intended to be used as
the framework for an educational discussion and does not imply any judgement on the
administrative situation presented. Deposited under number 9 40 2015 015T with the HEC Montréal
Case Centre, 3000, chemin de la Côte-Sainte-Catherine, Montréal (Québec) Canada H3T 2A7.

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

During the same era, the emergence of high-speed Internet connections and the mp3 file format –
which has become the official file format for digital music – led to transformations that still have the
industry trying to find its way, upsetting the foundations on which its performance is based. The mp3
file format can compress files to almost 12 times the size of the original, with no real audible loss of
quality. With households adopting Internet technology, particularly high-speed Internet connections,
these files could circulate efficiently. Digitized, compressed and stored by individuals, music started
to be exchanged for free and with no restrictions on the Internet, without the authorization of the
rights holders in these musical works and without providing them the compensation that is theirs by
right.

1.2 Illegal downloading: from Napster to peer-to-peer

In 1998, the first free sites for downloading mp3 audio files appeared, including Napster in 1999,
which made it possible to easily share file directories between Internet users. In under three years,
60 million users illegally exchanged over 1.5 billion titles (SODEC, 2002, p. 22). However, Napster’s
limitation lay in its centralization. Since the data it contained was not replicated anywhere, the
operation of the network depended on the central server. If it failed, community members had no
way of establishing a connection with other members. So in 2001, when the courts found for the
music industry majors,1 who saw the sharing system as a threat to their control over music
distribution, Napster was forced to get rid of its central server, provoking the collapse of its Internet
community. In the meantime, Internet users came up with alternative solutions. To avoid repeating
the Napster experience, Internet users created sharing systems using multiple servers, ensuring that
they remained independent of one another. In the event of an attack on one server, the community
could remain connected via the remaining servers. The idea was refined and developed, from the
principle that having more servers ensures a robust network, leading to the complete
decentralization of sharing systems: peer-to-peer.2 With this decentralized method of sharing, illegal
downloading took off, was refined and diversified, to the point that it became completely
uncontrollable.

1.3 Plummeting CD sales

At the same time as illegal sharing networks were being developed, CD sales in all markets went into
freefall. For example, in the U.S., the largest music market in the world, CD sales dropped from 730
million units in 2000 to 206.4 million in 2013, a decline of almost 72%, according to

1 “Majors” refers to international record companies that assume, in whole or in part, the technical
and financial responsibility for producing, manufacturing, promoting and distributing recorded music
(Ménard, 1998, p. 36). Until very recently, there were four majors, who together accounted for three
quarters of music industry sales worldwide, even over 80% in Europe and the U.S.: Universal Music
Group, Warner Music Group, Sony-BMG and EMI Group (Curien and Moreau, 2006, p. 23). In
November 2011, Universal Music Group and EMI Group merged, further increasing the level of
concentration. However, this oligopoly now has a major competitive fringe made up of thousands of
small independent producers.

2 In peer-to-peer networks, members play the role of both client and server. As files are downloaded
by a user, they become available for download to other users. The particularity of files that circulate
on peer-to-peer platforms, .torrent files, is that they are broken down into small pieces. Once users
receive a piece of a file they are downloading, they immediately and automatically start sharing this
piece with other users. Each new download of a file increases its availability so that other members
of the community download it, thereby creating a vicious circle of downloading. Sharing is done
directly between users, who have access to all files downloaded by each of the other members of
the peer-to-peer community. Controlling the files available on these systems is therefore impossible,
given the fragmentation of servers that make them available. The only limits to sharing are the size
of the community and the number of files all members have.
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Legal and Profitable? Spotify: The Challenges of an Online Music Service

Nielsen SoundScan data (Statistic Brain, 2014). According to the same data, in Quebec, where the
decline in CD sales hit later and was less pronounced, from 2004 to 2013, sales dropped by half,
going from 13 million units sold in 2004 to 6.1 million in 2013. Across Canada, CD sales went from
36.6 million to 11.7 million during the same period, or a drop of 68% in nine years (Fortier, 2014).
While the drop in CD sales cannot be directly linked to illegal downloads because too many variables
were at play,1 the fact remains that one of the foundations of music industry revenue was
challenged, at the very time the Internet and digitization came on the scene. As a result, the music
industry needed to look at the fit between how they meet consumer needs ‒ in other words,
creating value for them with recorded music ‒ and how they generate revenue for themselves.

1.4 The digital music market

In response, new ways of creating value for consumers are emerging, such as the sale of digital
tracks and albums and continuous or on-demand streaming of music. They are inspired by new
music consumption habits that are developing online and the opportunities of digitization. These
initiatives led to a 1000% increase in the market value of digital music between 2004 and 2010
worldwide (IFPI, 2011), and this market continues to grow year after year (figure 1).

Figure 1: Increase in global revenues in digital music from 2008 to 2013 (IFPI, 2014)

In 2013, revenue from digital music accounted for 39% of all global music revenue (5% more than in
2012 and 10% more than in 2010) and even represented the majority of this revenue in three out of
the ten largest music markets. In comparison, in 2013, revenues from CD sales accounted for 51.4%
of music revenue, almost 5% less than in 2012 (IFPI, 2014). This growth trend in digital music
revenue is still far from compensating for the drop in revenue from CD sales of the past 10 to 15
years (figure 2).

1 On the question of variables at play in the drop in CD sales, readers can refer to Curien and
Moreau (2006, pp. 63-67).
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Legal and Profitable? Spotify: The Challenges of an Online Music Service

Figure 2: Drop in revenue from CD sales compared with revenue growth from digital music,
worldwide from 1997 to 2012 from 2013 IFPI data (King, 2013)

1.4.1 Music file sales platforms and music streaming services

Among the legal initiatives behind the rise in sales of digital music, there are platforms for the sale of
digital albums and tracks, such as iTunes and Amazon MP3, as well as music streaming services,
which include Spotify, Deezer, Rdio and Apple Music, to name just a few. According to IFPI data, in
2013, 67% of worldwide revenue from digital music was generated by downloading music files, from
platforms that sell albums and tracks, compared with 27% for music streaming services. Music
downloads therefore remain the main source of global revenue for digital music. However,
streaming services are gaining in popularity on all markets. Their revenue rose 51% between 2012
and 2013 (figure 3), growth that shows no signs of slowing. These services offer online music
consumers access to a vast online music library, anywhere, any time and on any platform. Because of
the growing popularity these services are enjoying and the approach to consuming music they offer,
they are seriously undermining the illegal offer, which some observers see as hope for the music
industry.

Figure 3: Online music streaming services (IFPI, 2014)

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

In some markets, music streaming services even outperform the downloading of tracks and albums,
such as in Sweden, France and Italy. The clearest example of this is Sweden, where 94% of digital
music revenue comes from these services, mainly from Spotify (IFPI, 2014). Of these services, Spotify
is garnering attention for its positioning with online music consumers, differentiating itself in a
number of markets from other streaming services and even from music downloading services, and
for the way it has worked with music rights holders to make its music library legally available. The
magnitude of the challenges the service has to tackle in terms of profitability and compensation for
rights holders make it even more interesting.

2. Spotify’s Origins

The men behind Spotify are Daniel Ek and Martin Lorentzon, two Swedish entrepreneurs and music
lovers who have had successful careers in the Internet and information and communication
technologies. In 2006, at turning points in their respective careers, Ek and Lorentzon decided to
team up to find a technological solution for the music industry. They were concerned that the
industry was in crisis, at a time when people were listening to more music than they ever had and
when there was a greater diversity of artists than ever before. In fact, at the time, the Swedish music
industry, like the industry everywhere else, was in the midst of a decade of constantly plummeting
revenues. At the same time, the country had long been a hotbed of pirating. It is in Sweden that
Kazaa was developed, a peer-to-peer downloading software, and, more importantly, The Pirate Bay,
one of the largest platforms for illegally sharing music files. In the European elections of 2009, the
Swedish pirate party (Piratpartiet) even won 7.1% of the vote, earning it a place in the European
Parliament. Ek and Lorentzon wanted to offer something better than pirating: “Our idea was to
create something that would generate revenue for the music industry and that would work on any
terminal, that would be like water” (quoted in Beuth, 2011). Rather than dismissing piracy, they
drew inspiration from it. Daniel Ek describes his brief flirtation with the illegal downloading site
Napster at the end of the 1990s as being the experience that most changed him as a music
consumer. That was where he discovered his two favourite bands, The Beatles and Led Zeppelin.
Because of this experience, he also became part of the generation of 18 to 30 year olds who don’t
believe in paying for music, and who think that it should circulate freely on the Internet. In fact, in a
November 2011 article about Spotify that appeared in Wired, Steven Levy explains the influence
Napster had on this generation. He says: “Unleashed in a dorm room in 1999 and killed in a
courtroom in 2001, it taught a generation that music should be obtained with mouseclicks, not
money.” Having experienced it, Ek understands how Napster, The Pirate Bay and the other illegal
downloading platforms shaped the expectations of this generation when it comes to access to music,
its uses and how it is consumed. So rather than offering online music consumers the chance to buy
and own the music they listen to, he came up with the idea of offering them access to a vast library
of music, that would have all the characteristics of illegal downloading sites. He took as a given that
the best way to listen to music was to give the public unlimited access to an exhaustive catalogue of
songs, stored on servers and available online. This was similar to what Napster had been offering,
except the now-defunct service had used downloading rather than streaming, was
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Legal and Profitable? Spotify: The Challenges of an Online Music Service

slow and often experienced glitches, and users could be traced and prosecuted. So there was room
for improvement.

2.1 Drawing inspiration from pirating

Before improving on the pirating experience, Ek tried to keep what worked best on the top illegal
downloading platforms. So he built his service using the same technology as The Pirate Bay – peer-
to-peer architecture – which enables a very fast rate of transfer of music files. Spotify functions as an
application downloaded to the user’s hard drive rather than as an online service, and it draws on the
hard drives of all users. This increases the speed of the service and relieves the pressure on the
central servers by spreading demand over different connections.1

2.2 Improving on pirating

But Spotify does more than just draw inspiration from the best aspects of pirating platforms. Ek
wanted his service to do better than the most popular of these platforms, to be more efficient,
convenient and accessible. Illegal downloading platform interfaces are often not clear or inviting,
and users cannot always create their own accounts, adapt the platform to their preferences or use it
on any device. Plus the music offer is not always as diverse or complete as users would like. So
opening an account, downloading a program and being able to listen to any of the 30 million tracks
on Spotify is what differentiates the company from illegal alternatives. This is in addition to Daniel
Ek’s obsession to create an endlessly faster and higher performance platform, striving to keep
diminishing the time between click and sound. He combines a number of technologies to accomplish
this: a local cache memory, peer-to-peer sharing, as noted above, and traditional streaming. When
consumers click on a song, it plays immediately, as if it were already on their hard drive. In order for
listeners not to notice a delay between the click and the sound, songs have to be streamed within
200 milliseconds, or the time it takes for the human brain to perceive the slightest delay. When
building Spotify, Daniel Ek told himself that if he could manage to deliver this speed to consumers, it
would be as if they owned all the music in the world on their computer hard drive. With this superior
technology infrastructure and its presence on multiple platforms, including mobile platforms, Spotify
encourages consumers to abandon pirating and may eventually lead them to want to pay for the
service. In fact, Ek believes that “An entire generation had rejected the idea of ownership […] If not
files, maybe they would pay for convenience” (Greeley, 2011). But what distinguishes Spotify from
pirating platforms is also, and most importantly, the ability for Internet users to get unrestricted
access to music online, without breaking the law.

3. Legal Constraints

Daniel Ek couldn’t have launched Spotify without entering into agreements with the rights holders to
the works his service would provide access to. He wanted to demonstrate that it was possible to

1 This approach has allowed Spotify to build and grow, and, in April 2014, the company announced
that its even higher performance servers could gradually replace peer-to-peer technology.

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

work with the companies that represent rights holders. But after his company was launched, he met
with resistance from record companies, which were not taking him seriously or buying into his
model. But Daniel Ek was 23 years old at the time and was confident no challenge was too great. So
while he thought it would take him less than three months to negotiate an agreement that would
authorize him to use all European music, it was only in October 2008, more than two years after
Spotify was founded, that it was finally launched in Norway, Sweden, France, the U.K. and Spain. Its
launch in Finland, Denmark and the Netherlands followed soon after. It took almost three more
years to finalize agreements with rights holders in the U.S., which was accomplished in July 2011,
two years later than anticipated. And legal issues again meant that it took until November of the
same year for the service to be offered in Austria, Belgium and Switzerland, and until March 2012 for
it to be available in Germany. In Canada, Spotify only managed to reach an agreement with copyright
lobby groups to launch its service in September 2014. These groups believed that the service
devalued music and asked for a higher rate each time music was streamed. The rate negotiated is
not as high as the lobby groups would have hoped, but is comparable to what was negotiated in
other countries – for every 1000 streams, rights holders receive 10.2 cents – and Spotify committed
to promoting Canadian talent on the Canadian version of its platform. A channel specializing in
Canadian content was created to do just that.

4. Spotify’s Strategies

Spotify is not the first or the only legal music platform on the Internet, nor is it the only service that
offers access to an online repertoire of music. It faces competition in every market. The French
company Deezer, its main competitor in France, and the American platform Pandora, which still
beats out Spotify in the U.S., along with Rdio, KKBOx, WiMP and Tidal, to name just a few, all offer
online music services that, while markedly different, are interchangeable for consumers (exhibit 1:
Comparison of the Main Online Music Streaming Services). What’s more, in recent years, the
Internet and electronics giants, particularly Amazon, Google and Samsung, have launched music
streaming services of their own, the most recent addition being Apple with Apple Music, which was
released in June 2015. Apple Music presents a real threat to Spotify. Both services, which are
available for the same price, have a comparable offering: their musical repertoires are similar in size,
the two companies offer a radio service as well as features for sharing and discovery. However, while
Spotify has an established reputation in the world of music streaming, Apple Music has a
considerable advantage in its dealings with record companies, its availability in 110 countries
(compared to 58 for Spotify), its 800 million users already acquired via iTunes and greater risk
tolerance afforded by its position in the Apple family. As the service is still in its free trial period, it is
not possible to comment on its performance, but it is clear that Apple Music will be a force to be
reckoned with in the online music services sector. And this is in addition to the omnipresence of
iTunes, which is substantially different from Spotify in terms of how its users listen to and buy music,
but whose offer clearly competes with Spotify’s. To stand out in a highly competitive market, Spotify
needs to be in line with current practices, while demonstrating originality.

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

4.1 The “freemium” model

Spotify’s service falls under the “freemium” model. Users can access music in the catalogue for free
and listen to it on a phone, tablet or computer, in return for being exposed to sound and visual ads
for a few minutes every hour. Users previously had a ten-hour monthly listening limit and could only
listen to a track five times, but Spotify recently lifted the restrictions on this free option to get an
edge over its serious online music competitors. Users can also access the Premium service for $9.99
per month, with no further commitment. They enjoy unlimited access to the Spotify catalogue,
without ads or interruptions. The music is available with superior sound quality for listening on
computers, phones, tablets, and, since 2013, televisions. In addition to being available on all
platforms, Spotify is also optimized for the most popular electronic environments. Since 2011,
Spotify users have also had access to Spotify radio, which encourages discovery by playing music
based on the user’s preferences. Recommendations systems (like the “Discover” page, which offers
users new titles based on the music they listen to and favourite artists) and thematic playlists are
also available on Spotify to personalize the use of the service and promote exploring the repertoire.

4.2 Social media integration

In September 2011, Facebook integrated to Spotify and vice versa. The goal of this integration is to
allow Spotify users to share the music they listen to with their contacts via Facebook and to
encourage those who do not yet use Spotify to subscribe to it. Spotify users have the option of
automatically publishing what they are listening to in Spotify on their Facebook page, and this
information then appears on their friends’ news feeds. Their friends who use Spotify can then listen
to the songs, and those who don’t have an incentive to subscribe to the service. This partnership
also benefits Facebook, because exchanges increase when music is shared, as Daniel Ek points out:
“Facebook is the largest distribution platform in the world today. What Facebook enables is content
sharing. Mark Zuckerberg realized that Facebook’s value lies in interactions between people. And
music is one of the most social things there is” (Beuth, 2011). Music is also closely tied to identity.
People can express who they are by letting others know what they are listening to, whether by
wearing a T-shirt or a hat with the name of a band or artist or by sharing music on Facebook. To get
the greatest benefit from integrating music to its site, Facebook did not offer Spotify exclusive access
to the some 900 million users it had at the time; the popular social network has many other music
partners that are Spotify’s competitors. But Spotify seems to have made its presence felt. According
to Facebook vice-president Dan Rose, it has two advantages over other services. The first is that the
platform has taken the social network aspect the furthest, starting from its initial design. Sharing
music between users is encouraged in any form. The second is that the company has a business
model that fits perfectly with the sort of discovery that Facebook was designed to enable. If
Facebook users see through their news feed that a friend is listening to a song, an album or an artist
and they want to listen, they can easily do so by going straight to Spotify. The site, with its free
access to a catalogue of over 30 million titles, is designed to enable exploration, showcasing the
repertoire and the discoveries users can make. At the same time, its free offer is a catalyst for these
discoveries, because unlike platforms such as iTunes, where you

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

have to pay to listen to a whole song, there are no barriers of cost or access to the music experience
of Spotify’s free offer. In November 2011, two months into the partnership between the two
companies, some sources suggested that Spotify had gained some four million users in countries
where both services are available. In 2012, Spotify announced that users who link their Spotify
account to their Facebook account are three times more likely to become paying subscribers.

4.3 Creating value jointly with consumers

The social networks of Spotify, Facebook and Twitter are places for sharing many playlists created by
the company’s employees or users, based on a theme, genre or emotion. For example, when spring
arrived in 2014, Spotify asked its some 829,000 subscribers via Twitter what they were listening to
and encouraged them to share their current playlist, offering the incentive that this list could then be
promoted by the company. Spotify does the same thing on Mother’s Day, Valentine’s Day,
Halloween, on a sunny or rainy day – any occasion that presents itself. Spotify users share playlists
every day on Twitter. The company even opened a Twitter account with the name @SpotifyPlaylists,
where it shares its playlists and where users can share theirs. A group of those users, which adopted
this company-initiated practice, even created the hashtag #thursplay to encourage other users to
publish playlists every Thursday. These compilations give users the chance to discover new songs
and share their tastes. They also ensure that less explored parts of the repertoire are promoted,
because with a repertoire of over 30 million songs to choose from, users can have a hard time
figuring out what to listen to. It lets them discover other people’s recommendations, based on
criteria that appeal to the user, and to make their own recommendations, making them feel as
though they are playing a role with other Spotify users, while asserting their tastes, and, in turn,
their identity. For Spotify, this has reduced some of its operating costs, because the company does
not have to promote its repertoire on its own, and it also builds customer loyalty and commitment.
Spotify goes even farther in getting customers involved. In 2011, the company launched a
development platform that allows professional and amateur developers to create applications for
Spotify. Spotify already has a team of developers for such applications, but they thought it was a
good idea to get outside developers involved to generate new ideas and respond to needs that users
have identified, which the company never could have. Developers have access to a platform for
designing applications without worrying about getting the licences to access music repertoires. With
this obstacle out of the way, they can let their imagination run wild, to everyone’s benefit. TuneWiki
and MusixMatch, for example, provide users with lyrics to the songs available on Spotify. Songkick
creates a calendar of concerts likely to be of interest to users based on the music they listen to on
Spotify. MoodAgent offers instant access to playlists that match the user’s mood. The Complete
Collection displays album covers for music played on Spotify. Classify allows users to explore classical
music. These applications add to the value the company creates, because they are made available to
other users, once the company has approved them. They promote even more widespread use of the
music available on Spotify and a more thorough exploration of repertoires. A sure sign that they add
to

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

the value created by Spotify, in their first four months of existence, Spotify applications were used
for 13 million hours. For example, the playlist generator MoodAgent generated on average some 3.5
million playlists per week. On social networks, specifically Facebook and Twitter, users share
opinions about these applications. Spotify encourages these discussions about applications,
occasionally asking users for their favourite application. In being asked to share their opinion, users
help build the popularity of applications and even create value for the company. Spotify therefore
plays the role of facilitator for these activities and instigator for its customers, who are immediately
inclined to help create value for the company. It creates the mechanism, such as the platform for
developers or the use of social media, harnessing customer willingness to get involved in activities
that create value. These activities help Spotify improve, extend its reach, increase its popularity and
promote its music repertoire.

4.4 Brand partnerships

To increase revenue, Spotify also partners with companies that will pay for access to its consumers
and their attention. First, advertisers can disseminate messages via the service, in a number of audio
and visual formats.1 In addition to offering an environment that is advertising friendly, Spotify offers
advertisers the ability to target their potential consumers from data the company has collected
(demographic and geographical data, and data on their musical tastes). The company also provides
advertisers tracking functionality and detailed reports on how their ad was used. Second, sometimes
Spotify has closer and more intimate relationships with brands, as is the case with Lucozade, Coca-
Cola, Reebok, Volvo and Ford (see exhibit 2: Spotify’s Commercial Partnerships). In such cases, both
the partner brand and Spotify benefit from the other’s audience. Spotify has gained many customers
through these partnerships that it wouldn’t have reached otherwise.
5. A Meteoric Rise

Spotify has had a meteoric rise since it was founded thanks to its functionality and partnerships.
From the end of 2012 to the middle of 2015, the company expanded its network from 13 to 58
markets, including Germany, France, the U.K. and the U.S. – four of the largest music markets –
along with the Scandinavian countries, Turkey, Taiwan and Australia. In 2015, it had 75 million active
users, including 20 million paying subscribers. The company, with headquarters in the U.K. and
Sweden, and offices in 18 countries, had 300 employees in 2012 and now has over 1200.

5.1 A strong influence: from ownership to access

This meteoric rise is proof that the company has effectively responded to the needs of online music
consumers. Spotify’s rapid adoption by millions of Internet users has had an impact on the entire

1 Here is how the Spotify website sells the benefits of buying ad time or space on its service:
“Everyone listens to music. You can be sure your customers do too. But unlike commercial radio,
Spotify makes it possible to listen to music instantaneously. At any time of the day, anyone can listen
to the music that makes them happy. Our audience knows that ads are what fund our legal, free
online music service and that allow us to compensate the artists they love. Without advertisers,
there is no free music. Does this sound like an environment for your brand?”

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

music industry. In fact, Spotify offers a different approach to consuming music that is gradually
taking over. With services like iTunes, people acquire ownership of a piece of music, while with
Spotify, people acquire access to a song, a bit like renting it. In the U.S., in 2010, before Spotify came
on the scene, almost 80% of music industry revenue from the digital market came from the sale of
songs and albums, mainly from iTunes. In comparison, in Sweden, two years after Spotify was
launched, the sale of songs and albums represented only 20% of digital music revenues, while 60%
came from on-demand music streaming, mainly from Spotify. In 2013, 94% of digital music revenue
came from music streaming services in Sweden. With the popularity of this approach to
consumption, digital music now accounts for 70% of music industry revenue, and Spotify has
become the leading source of music revenue in this country (physical and digital media combined).
Clearly this approach to consuming music is a better fit for the expectations and needs of online
music consumers. In Sweden, apparently no one brings a computer or hard drive to a party
anymore. They just connect to Spotify from any terminal with Internet access. The Scandinavian
countries (Denmark, Norway and Sweden) have demonstrated the streaming model’s potential to
revitalize the music industry. In 2013, the Swedish music market saw growth of 5.7% attributable to
streaming revenue, Denmark’s grew 4.7% and Norway’s grew 2.4% (IFPI, 2014).

6. The Problem of Monetizing Music

While Spotify has grown since it was founded, particularly since entering the U.S. and striking up its
partnership with Facebook, and while it plays a decisive role in the entire music industry, the
company is not yet profitable. It does create value for over 75 million online music consumers in 58
countries, but its costs still exceed revenues.

6.1 Spotify’s net revenue

Spotify reported earnings of 747 million euros in 2013, an increase of 73.6% compared with the 430
million euros earned in 2012. However, its losses also increased by 16.4%, rising from 80 million
euros in 2012 to 93 million euros in 2013, according to Spotify’s most recent consolidated financial
statements. Its net losses can be represented in the following graph (figure 4) as declining from 87
million euros in 2012 to 58 million euros in 2013, but this is largely attributable to its 39 million euros
in stock options. According to experts, operating losses, which were 93 million euros in 2013, are a
better indicator of Spotify’s performance (Dredge, 2014). In other words, Spotify had a deficit of 93
million euros in 2013.

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

Figure 4: Spotify’s revenue and net income from 2008 to 2013 (Statista, 2015)

6.2 Capital investments and cumulative losses

Since its beginnings, Spotify has accepted close to $300 million in outside capital from investors such
as Horizon Ventures, Li Ka-Shing, Northzone, Creandum, Wellington Partners, Sean Parker, Founders
Fund, Goldman Sachs and Coca-Cola. However, it has accumulated losses of over $200 million,
according to the firm PrivCo, which studies the performance of private companies. Its losses are
indeed growing and accumulating, but there is also growth in revenue, and investors continue to
believe and invest in the project. In an industry as early in its development as music streaming, some
experts are even talking about progress (Brustein, 2014).

6.3 Spotify’s revenue and cost structure

To understand Spotify’s inability to reach profitability and the losses that are piling up year after
year, one needs to understand its revenue and cost structure. Of the 747 million euros in revenue in
2013, 91%, or 679 million euros, came from subscriptions to the Premium service. The remaining 68
million euros are from advertising revenue attributable to users of Spotify’s free service. Given that
the company ended 2013 with 36 million active users, 8 million of whom subscribed to the Premium
service and 28 million of whom subscribed to the free offer, 91% of the company’s revenue comes
from 22% of users who pay for the service. On the cost side, to legally offer such a vast repertoire of
music to Internet users, Spotify must pay rights holders of this music: lyricists, composers and other
intermediaries involved in creating, producing and promoting musical works. According to Spotify,
70% of its gross revenue goes directly to rights holders. This has amounted to $3 billion since the
service was launched (including $500 million in 2013 alone). Spotify’s other most significant costs are
technology related, i.e., the cost of hosting and storing data and the cost of the bandwidth required
to stream such a large volume of music on demand. These costs vary depending on the number of
users, and fortunately they increase in line with revenue growth. This is in addition to the fixed costs
of developing the

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

on-demand music streaming service and the underlying infrastructure. These are expenses related
to programming and maintaining the streaming platform, the database of over 30 million songs and
the company’s websites, as well as costs related to its offices in 18 countries and salaries for 1200
employees.

6.4 Streaming versus downloading: the rights holders’ cut

Despite the fact that Spotify hands over a seemingly generous 70% of gross income to music rights
holders, what ends up in their pockets each time a song is heard is a micro payment. It is hard to
accurately establish the amount distributed to rights holders when their songs are used by Spotify. In
December 2013, the company announced that it had paid music rights holders between $0.006 and
$0.0084 every time a song was heard, or between $6 and $8 when a title was heard 1000 times,
depending on the country where the Internet user listened to the music, the type of subscription
(free or paying) as well as Spotify’s sales figures. How this amount is distributed among the rights
holders of the title in question (the producer, lyricist, composer and performer) and other
intermediaries varies according to commercial practices in each country and the contracts signed
between the lyricist, composer, producer and/or record company. The amounts paid by Spotify are
similar to, and even higher than, the royalties paid by comparable music streaming services, such as
Rdio, Pandora and Deezer (see exhibit 1: Comparison Table of the Main Music Streaming Services).
In 2013, Pandora paid 48% of its $600 million in net income to rights holders, with an estimated rate
of $0.0011 each time a song was streamed. Like Spotify, Pandora is not profitable. While
competitive, the royalties paid by Spotify are very low compared with those paid by certain local
services, as shown in figure 5, which was prepared by an independent record company to show what
it earns from music streaming, and lower still than revenue from digital music downloading
platforms, such as iTunes:

Figure 5: Music streaming service payouts, according to an independent record company (Resnikoff,
2014)

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

In comparison, iTunes, for example, where the price is a standard $0.99 per track, pays $0.69 for
each title sold, which is split among intermediaries and rights holders (digital distributors, record
companies, producers, performers and songwriters). The figure below (figure 6) shows the number
of titles that have to be streamed on the different music streaming services to equal the sale of a
single title on iTunes, in terms of revenue for the same record company. According to this data, a
track would have to be heard around 135 times on Spotify to equal it being downloaded once from
iTunes. Figure 6: Number of times a track needs to be streamed to equal the sale of a title on iTunes

(Resnikoff, 2014)

Some claim that the situation is even worse for emerging musicians. In 2013, folk rock musician
Damon Krukowski calculated that one of his songs would have to be played 47,680 times on Spotify
or 312,000 times on Pandora to bring in an amount equal to the sale of a single album (with 10 to 12
tracks), or between $10 and $15 (Brustein, 2014). Many music rights holders have criticized Spotify’s
compensation, and a number of leading artists, such as Adele, Radiohead, Black Keys and, more
recently, Taylor Swift, have refused to have their music on Spotify or on other music streaming
services, because what they earn each time one of their songs is played is much too low compared
with what they would earn if they sold the song. Taylor Swift, however, accepted that her 1989
album be made available on Apple Music, after managing to make the company go back on its
decision to not pay music rights holders during its free three-month trial period. Indeed, in an open
letter to Apple, in which she called out the injustice of a service that exists thanks to the work of
music rights holders but that refuses to compensate those same rights holders, Swift convinced
Apple to pay creators, producers and performers for the use of their music during the trial period. In
response to Apple’s decision, Taylor Swift agreed to make her most recent album accessible on
Apple Music, but this is an exception to the rule, in response to Apple’s reaction, as the artist
continues, like many others, to deny Spotify and other music services access to her music. Like Swift,
in November 2011, the British distributor

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

STHoldings, which represents over 238 independent record companies, decided to remove its entire
catalogue from Spotify, alleging that while on-demand music streaming services promote music to
millions of people, they bring in very little money, devalue music and are likely to cannibalize
traditional digital sales revenues, although no study has shown this yet.1 Without being able to
establish a direct causal link with the rise of streaming, one can observe that downloading music
tracks and albums has, for the first time since its beginnings, declined slightly since 2013 and the
decline continued in 2014. In 2013, revenue from downloading tracks and albums dropped 2.1%
worldwide, although it still accounts for 67% of digital music revenue (IFPI, 2014). To give just a few
examples, in Quebec, sales of tracks and albums declined 12.8% and 3.7% respectively between
2013 and 2014. Across Canada, the drop was in the order of 12.4% for digital tracks and 4.4% for
digital albums. In the U.S., it was 12.5% for digital tracks and 9.4% for digital albums (Observatoire
de la culture et des communications du Québec, 2015). Not escaping the trend, for the first time
Apple reported a drop in sales of digital music on iTunes of 13% to 14% (Karp, 2014).

The iTunes model, leader in legal music downloading In spite of this drop, iTunes is undeniably a
world leader in legal downloads of music. In 2003, the release of the iPod/iTunes duo allowed Apple
to quickly dominate the still emerging market of legal music downloading and become part of the
music consumption habits of millions of people around the world. Paying $9.99 for albums and $0.99
for tracks became the standard for most online sales platforms, a drop in price compared with
albums sold in physical format in the store, but an increase considering the competition iTunes
created for illegal downloading platforms, where all music was being exchanged for free. Since its
launch, iTunes, which is available in 147 countries and offers a catalogue of 37 million titles, has 800
million users registered with a credit card and has sold over 35 billion titles, the equivalent of 4.9
songs per person on the planet. It pockets 30% of the revenue from each title sold, paying out $0.69,
which is split among all other players in the supply chain, from the digital distributor to the
songwriter.

So in the world of digital music, making works available on Spotify, Rdio, Deezer, Pandora and other
platforms is not profitable for rights holders, not even for international stars, when compared with
selling tracks and albums on legal downloading platforms. But in a context where consumers are
migrating toward music streaming platforms because they feel they better meet their needs than
legal downloading platforms like iTunes – when they do not simply move on to illegal platforms –
many rights holders agree that having their work on Spotify is still better than being pirated. And it
has been proven that legal music streaming services, because they are similar to what illegal music
download platforms offer in terms of accessibility, put a substantial dent in pirating. Sweden’s GfK
Research showed in 2013 that 90% of Spotify’s paying users and 70% of users of its free service
download music illegally “less often” since joining Spotify (IFPI, 2014).

1 On the contrary, a March 2012 study conducted by Nielsen on the evolution of on-demand music
streaming since 2005 showed that the increase in this method of consuming music did not affect
legal downloads of albums and tracks. In other words, no correlation can be drawn between these
two uses of music (Pham, 2012).

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

6.5 Increasing revenues to offer better compensation for music, but how?

In spite of these benefits, music rights holders would like to be better compensated for the use of
their music on these platforms. If Spotify wanted to pay higher royalties, it would need to raise the
price charged to consumers. Yet by charging consumers more, competition from free illegal offers
would become stronger, and the company would lose market share. Striking this balance is a
constant challenge, one that the company has not yet managed to tackle. Spotify could also rely on
more paying subscribers, given that the Premium service is a much more substantial source of
revenue than ad revenue associated with the free service. Spotify’s share of paying subscribers
ranges between 20% and 27%, the peak of 27% being reached in the middle of 2015, when 20
million of the 75 million users paid to access the service. That means that the 55 million other users
are satisfied with the free offer. And rightly so. Users of Spotify’s free offer are among the most
spoiled of all music streaming service users. There are no limits on how much time they can spend
listening to music, they can access it from any platform, and advertising is well integrated and
targeted. In comparison, Deezer, which makes its free offer available only via computer, has 38%
paying users, whereas WiMP simply doesn’t have a free offer, and does relatively well in its market.
The 75% to 80% of users who do not pay to access the 20 million songs available on Spotify
generated, through ad revenue, less than 10% of its annual income in 2013. In comparison, in the
entire music industry, the share of revenue related to users of the free offer of music streaming
services tended to be higher and handily exceeded 10% of revenue (figure 7). The proportion of
paying Spotify subscribers is therefore much lower when compared with that of other music
streaming services. Figure 7: Revenue share related to the types of use (paying and free) of
streaming services

throughout the music industry (Brustein, 2014)

The company remains optimistic about its ability to generate more revenue and better compensate
music rights holders. According to Daniel Ek, Spotify has already proven its ability to create value

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

for users, and it knows that the more time people spend using its service, the more inclined they are
to become paying subscribers. As the company reaches more users, the proportion of them who will
pay to access the service will grow, revenue will climb and the amounts paid to music rights holders
will increase proportionally (Dredge, 2014). To increase the share of paying subscribers, for a few
years Spotify has been trying to bundle subscriptions to its service with other complementary
services. The company has signed some 30 bundling agreements, the most important of which was
in the U.S. with phone service provider Sprint. Sprint will offer family plan subscribers a reduced-rate
subscription to Spotify and actively promote it, which should lead to a significant increase in the
number of paid subscribers to Spotify in the U.S. and in turn increase revenue.

6.6 Solving the profitability impasse

While increasing the number of Spotify users could lead to an increase in royalties paid to rights
holders, achieving profitability will not be quite so simple. Spotify pays rights holders a fixed
percentage of its gross income, or 70%, rather than a fixed rate, as similar services do. As a result, an
increase in the number of its subscribers, which results in a rise in gross income, increases its costs at
the same rate (figure 8).

Figure 8: Growth in Spotify’s revenue and costs from 2009 to 2012 (Brustein, 2014)

For a company running a deficit, with losses accumulating year after year, the increase in gross
income needs to be significant for it to be able to cover its costs and eliminate its accumulated
deficit with its 30% margin. Spotify therefore faces quite a paradox: on the one hand, its service is
causing a sensation among consumers, and it has seen a meteoric rise since it was founded. It easily
outpaces the other legal online music services, such as Deezer, Pandora and Rdio, on many markets.
And in spite of some reticence, rights holders are making their music available on the platform,
figuring that it is better to have titles on Spotify than on illegal downloading platforms, but hoping
that this use of their music will end up paying more one day. This allows Spotify to offer one of the
most complete music catalogues on the market. So Spotify has achieved a certain success. On the
other hand, the company has not yet turned a profit, and despite the fact that it accepts running an
annual deficit to pay rights holders, what they earn is not enough. Even sharing 70% of

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

its revenue with them and racking up losses, Spotify is not contributing to the viability of those who
create, produce and promote music. It is drawing consumers away from illegal downloading
platforms, of course, but the revenue it manages to generate is practically symbolic once in the
hands of music creators, producers and promoters. Paying rights holders more would mean
increasing the contribution for consumers, at the risk of losing them to free, illegal platforms. So like
the entire music industry, Spotify is struggling with the issue of the very value placed on music and
the difficulty of monetizing it. How will this impasse be broken? How can they keep giving consumers
what they consider value – free music, instantaneity, accessibility, diversity and flexibility – while
monetizing that value to better compensate rights holders and achieve what any company aims for:
profitability? The outcome of this struggle to create value, which music consumers and rights
holders play a part in along with Spotify’s legal and illegal competitors, is far from simple. To
reconcile the interests of consumers with those of rights holders, to reconcile the values of a
generation of Internet users with the value of music, while aiming for profitability and differentiating
itself from the competition, Spotify will need a great deal of creativity and strategy. 2015-09-11

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

Exhibit 1 Comparison of the Main Music Streaming Services

Service Launch Reach in

2015 Number of

subscribers in 2015

Number of paying

subscribers to Premium

service in 2015 and as a

percentage

Cost/month for Premium service

Free offer Percentage of revenue

allocated to music rights

holders

Titles in the catalogue

(in millions)

Profitable

2006

(Sweden)

58 countries 75 million 20 million

27%

$9.99 Yes, on computer,

without limitation, with

ads

70% of revenue

30 No

June 2015 110 countries

11 million trial subscribers

Unavailable $9.99 Yes, with limitations, without ads

Unavailable 35 Unavailable

2010

(U.S.)

85 countries Unavailable Unavailable $9.99 Yes, but only for radio

streaming

Unavailable 32 Unavailable
2007

(France)

180 countries

16 million 6 million

38%

$9.99 Yes, on computer only,

with ads

Unavailable 35 Yes, in France

2000

(U.S.)

3 countries

(U.S., Australia and New Zealand)

250 million 3 million

1.2%

$4.99 Yes, on computer and

mobile devices, with

ads

48% of revenue

1 No

2014

(U.S.)

1 country

(U.S.)

110,000 to 200,000

110,000 to 200,000

100%

$9.99 No 65% of revenue

20 Unavailable

2004

(Taiwan)

7 countries in Asia
10 million 2 million

20%

$9.90 Yes, online only with

limitations, with ads

10 Unavailable

2010

(Norway)

5 countries in Northern

Europe

580,000 580,000

100%

- Including 17,000 Hi-Fi

3%

$4.99 (Basic) $9.99 (Premium)

$19.99 (Hi-Fi)

No Unavailable 25 Unavailable
November 2014

35 countries

(Europe and North

America)

Unavailable Unavailable $19.99

(high-quality streaming)

No Unavailable 25

+ 75,000 videos

Unavailable

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

Exhibit 2 Spotify’s Commercial Partnerships

In addition to partnering with advertisers, who place their ads on the music service in a number of
audio and visual formats, Spotify sometimes enters into closer, more developed relationships with
brands. In these cases, both the partner brand and the service benefit from each other’s audiences.
Most significantly, by being associated with music, which is an important expression of identity, the
brand takes on some of that identity. It increases its value, takes on a new personality, one users are
more likely to identify with.

1. Lucozade For example, in March 2011, Spotify partnered with Lucozade, the leading energy drink
in the U.K. A promotional campaign ran online on social networks, primarily targeting 16 to 24 year
olds, who account for a significant share of Spotify users. The public was informed that when they
bought a bottle of Lucozade from March 1 to May 31, they could win one of a thousand Premium
subscriptions to Spotify as well as other prizes related to music or Lucozade. Every bottle sold during
that period contained a promotional code, giving consumers access to exclusive content from Spotify
on the Lucozade website, such as playlists created by popular artists who took part in the campaign.
For example, artist Tinchy Stryder shared songs that inspired him, and consumers were encouraged
to vote for their favourite song. They could also play online DJ and remix songs. When consumers
took part in these activities, they became eligible to win one of the prizes. This partnership provided
Spotify with new users and allowed Lucozade to boost its image with existing consumers and attract
new ones, no doubt won over by the music they could access by taking part in the contest. Both
companies have reported being satisfied with this partnership. Adam Williams, Spotify U.K.’s
director of sales, said that there was a great deal of synergy between the brands. Andy Mahoney,
Lucozade brand manager, said that the partnership came at the right time for both brands.

2. Reebok, Volvo and Ford In April 2012, Spotify announced that it would take partnerships further
with brands that wanted to leverage Spotify technology to offer their customers music services.
Since then, it has signed an agreement with Reebok, which offers playlists for runners. It also
entered into partnerships with Volvo and Ford to integrate Spotify services in both brands’ vehicles,
with touch and voice controls to choose music, change tracks and create playlists, while remaining
focused on driving. These latest agreements will add value to the two brands’ vehicles and
significantly grow the number of Spotify users, particularly thanks to Volvo, which would like to offer
the service to customers for free.

3. Coca-Cola A partnership was also created between Spotify and Coca-Cola, resulting in the Coca-
Cola Placelists application. The application, which also works with Facebook Places, encourages
teens to associate songs from the vast Spotify repertoire with places and events: a neighbourhood
café or park, a tourist destination on the other side of the planet or a World Cup soccer game. The
application’s other users agree or disagree with a song being on the list for the place or event. New

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

playlists are thus created collaboratively via Spotify, lending the sites and events a tone or ambiance
and offering songs context. For Coca-Cola, Spotify is becoming a way to keep up a conversation with
young people, tapping into their universal passion for music, and a way to associate Coca-Cola with
the music experience, as Joe Belliotti, director of entertainment marketing at Coca-Cola, explains:
“We want to combine the physical experience of drinking a Coke with the virtual experience of
listening to, discovering and sharing music. Our ambition is to have a Placelist associated with
everywhere Coca-Cola is enjoyed.” Spotify technology was the perfect way to achieve this goal,
because it uses music as a connector and offers a platform for discovering and sharing new music.
For Spotify, this is another way to attract new customers, leveraging collective value creation with
users and remaining in line with its desire to democratize music. These strategic partnerships with
Lucozade, Reebok, Volvo, Ford and Coca-Cola, to name only those, help extend Spotify’s reach
beyond the markets the company normally targets and introduce the service to ever-increasing
numbers of people.

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taught by MICHAEL SHERIDAN, SUNY - New Paltz from May 2018 to Nov 2018.

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Foreword

1. Background: A Music Industry Between Crisis and Opportunity

1.1 Music and technology: a longstanding relationship

1.2 Illegal downloading: from Napster to peer-to-peer

1.3 Plummeting CD sales

1.4 The digital music market

1.4.1 Music file sales platforms and music streaming services

2. Spotify’s Origins

2.1 Drawing inspiration from pirating

2.2 Improving on pirating

3. Legal Constraints

4. Spotify’s Strategies

4.1 The “freemium” model

4.2 Social media integration

4.3 Creating value jointly with consumers

4.4 Brand partnerships

5. A Meteoric Rise

5.1 A strong influence: from ownership to access

6. The Problem of Monetizing Music

6.1 Spotify’s net revenue

6.2 Capital investments and cumulative losses

6.3 Spotify’s revenue and cost structure

6.4 Streaming versus downloading: the rights holders’ cut

6.5 Increasing revenues to offer better compensation for music, but how?

6.6 Solving the profitability impasse

Exhibit