Reducing marginal costs by pushing listeners to direct signings, AI music and sponsored content

Spotify still lose money

Spotify are still a loss-making company. That’s because music is expensive - you have to pay licensing fees (or royalties) to the three big record labels who control the rights to most of the music you listen to - and you have to pay these for every single customer that joins. So, how could spotify fix this problem?

There’s three ways Spotify could make the music more profitable:

  1. Sign musicians directly to their own record label, and cut out the middlemen
  2. Commission ‘stock’ music - like ‘Relaxing Piano’ - and avoid royalties entirely
  3. Promote sponsored content, i.e. advertising

I believe that Spotify will use Discover Weekly and Spotify Playlists to push users towards the most profitable music. More perniciously, I think this could slowly degrade the quality and variety of music we consume, as we’re increasingly funnelled towards beige, mass-manufactured music.

Full disclaimer - I used to work at Jukedeck, a company building software that can generate music using artificial intelligence. I’ve written about what we were doing there before.

Spotify has a problem with high marginal costs

Spotify have really high marginal costs. That’s unlike a typical tech company. A Stratechery article gives a brilliant overview of this.

marginal costs

Essentially, as you grow your user base you expect your costs to scale much more slowly. Every new user that joins Facebook costs them basically nothing (i.e. zero marginal costs), but the revenue they generate from that new user (from advertising) is considerable.

Spotify doesn’t work like this. It pays out a flat percentage of its revenue to labels. Its costs of revenue (or marginal costs) increase with users - the more Spotify grows, the more it pays. This revenue is paid out mostly to Universal, Sony and Warner who control about 85% of the market. The labels are then responsible for paying their artists.

As of 2013, this is roughly how the share was calculated (source). royalties

Spotify’s problem is best demonstrated with a stark comparison to Netflix. Spotify’s subscriber growth has rocketed since 2011, and yet their average revenue per subscriber is declining. Netflix, who generate a lot of their own content, and aren’t held at knife-point by just three major rights-holders, are better able to translate that user growth into revenue growth (source). subscribers

Ultimately, what this all means is that Spotify still makes a loss overall, and so it needs to reduce either its operational costs or its marginal costs in order to breakeven. I want to focus on the latter.

Three ways Spotify can make their music more profitable

Aside from negotiating better deals with record labels, I think there are three main ways to make the music more profitable.

1) Launch Spotify Records, and cut out the record labels

Spotify pays the record labels a lot of money. According to the New York Times:

Spotify typically pays a record label around 52 percent of the revenue generated by each stream, or play, of a given song. The label, in turn, pays the artist a royalty of anywhere from 15 percent to, in some cases, 50 percent of its cut. By agreeing to a direct licensing deal with Spotify, artists and their representatives are able to keep the whole payout.

As NYT say, striking direct licensing deals with independent musicians will avoid paying the record label’s share. The artists will be incentivised to do this as they’ll end up with a larger share. Overall net cost will still be lower for Spotify given labels get such a big cut now.

Spotify could get additional benefits from this too:

  • Certainty that catalogues can’t be removed by labels, by locking artists into streaming content on Spotify forever
  • Revenue from all the other streaming services (Apple, Amazon, etc), if Spotify don’t allow artists to retain the music rights in their entirety
  • Exclusivity on the best upcoming music, if they scoop some big names (for example, Taylor Swift is coming to the end of her contract with her current label)

Spotify’s data means it’s well positioned to spot trends and identify up and coming artists to bring onto their books too.

But how will the labels react to this? This would definitely wind them up, but it’s hard to know what they’ll do. Spotify has largely driven their revenue recovery from the dark days of piracy (Overview from the Economist here, and a full read here in this book) and their product is the best on the market meaning they’ve got over 35% market share.

The labels could back another horse. Apple Music’s got an increasing market share and pay higher royalty rates, but they have a natural limit with Apple Devices only having 50% market share, which probably makes this unattractive. Spotify is just the biggest player by a mile.

The labels could remove the tracks from Spotify, as they’ve tried in the past. Taylor Swift didn’t put her album 1989 on Spotify, but backtracked later following overwhelming demand from fans.

Either way, direct signing is definitely on the up.Even in the last few weeks (as I’ve been writing this) there’ve been a few more examples of direct signing in action.

2) Invest in stock music, with zero marginal cost

In 2017 Music Business Worldwide highlighted a scandal where Spotify had over 50 ‘fake’ artists on its platform. The value of ‘fake’ artists to Spotify is immense. They’ll pay one-off cost and be able to stream that to users indefinitely, for no additional cost. As I was saying before, Spotify currently pay a revenue share of 70% to the labels. If the tracks are owned by Spotify this no longer applies.

This way, Spotify are optimising for zero marginal cost. They start to look like a normal tech business whereby revenue scales much quicker than cost. Music Business Worldwide also picked up on the idea that AI music doesn’t need royalties.

Even better, in a future world, they don’t need to pay real people which is expensive. They can use AI like Jukedeck. Full disclaimer - I used to work at Jukedeck. To add weight to this theory, Francois Pachet - an expert on AI music who spearheaded Sony’s AI music development - was hired by Spotify in 2017. The benefit of AI is it’ll be much cheaper than human-composed music. A human-composed track could cost anywhere between £500 and £2k; AI could be pennies if Spotify owned the AI.

The most devastating part of this solution is how excruciatingly bland most of this music is.

3) Sponsored songs and other advertising

Spotify started trialling sponsored songs last year. This makes sense, everyone’s in the advertising game now (Amazon is on track to make $10bn this year from advertising), and it’s also a way to lock-in favourable royalty rates. It’s not clear exactly how this will work yet - but it’ll likely be a pay per play or a reduced royalty rate.

This TechCrunch article picks up on a few other ways they are using advertising: sponsored playlists, banner ads, video ads.

The most worrying part of this is that Spotify could hold the power to make a song a Top 40 hit. If it funnels enough screen and eartime to a particular song, by slipping into enough relevant playlists, it could pick up enough streams to make it into the charts (where it’ll take on a life its own). It has a secondary benefit; if Spotify own what becomes successful, they increase their leverage with the labels. This all feels like the anti-democratisation of taste-making (i.e. a reversal of the trend).

Spotify can use its playlists to push users towards more profitable music

Given how royalties are calculated (see further up this blog) Spotify are heavily incentivised to push users towards the lowest cost music. Whether it’s direct signings, AI-generated background music or sponsored content, it’s almost certain that they’ll use discovery weekly and playlists to funnel users towards the most profitable music.

“… up to 20% of streams are via one of Spotify’s own playlists. AWAL, an independent label run by Kobalt, a music-services company, says that getting on a Spotify playlist boosts a music act’s streams by 50% to 100%”

The economist

Is there truly such as thing as freedom of choice?

Could this mean the slow death of music?

Of the three routes to profitable music I described, only the first fills me with much optimism on the future quality of music.

I think that the utility of record labels is increasingly diminishing (not 100%, but still diminishing) and so I’m excited that there’s a way for artists to get direct access to fans, and make more money in the process. I think that this could actually lead to more exciting, experimental music if there’s no longer a record executive vetoing releases and worrying about ‘mass appeal’.

I don’t expect popular music to die, or anything too foreboding, but I do worry that the best music will get harder to discover. As playlists get stuffed with sponsored content and AI-generated filler there’s a risk it’ll crowd out the independents. I hope that artists and discerning fans lobby Spotify to make sure this never happens, and that there’s a clear differentiation between muzak and music on the platform.

Either way, the future of music is going to be interesting to watch. From both a commercial and an artistic perspective.