Spotify: Stepping to the Right Beat

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Incorporating blockchain for Spotify’s payments positions it as an industry leader fighting for artists’ livelihoods.

Spotify’s First Move

The music production market has historically been an oligopoly dominated by four key players: EMI, Warner Music Group, Universal Music Group (Vivendi), and

Sony collectively command 70 per cent of the market. Because of this power, artists are at the mercy of their record labels. For example, it often takes months before artists receive payment for their work, making it difficult for them to sustain themselves financially.

Artist compensation is, in essence, a black box. Moreover, artists have also complained about a lack of creative control and exploitative contracts. As a result, music icons like Prince have heavily argued for young artists to avoid record labels, comparing them to “indentured servitude.” Yet, artists have traditionally relied on these labels to provide marketing and large-scale distribution.

Spotify was launched in 2008 and was a pioneer in the music streaming movement that disrupted the industry. Growing rapidly during its first decade of business, Spotify currently reaches over 100 million users, of which 40 million are paid, and provides access to more than 30 million songs. This disruptive distribution platform has benefited artists immensely, as they are now able to reach 100 million potential listeners instantly, rather than relying on record labels to market and distribute their catalogue.

Freely Expressing Music

Despite its rapid growth, Spotify has faced serious challenges en route to becoming the leader in music streaming. In recent years, there has been an influx of competitors including Apple Music, Tidal, Google Play, and YouTube Red. Many of these new entrants only offer their services to paid users, allowing them to pay artists significantly more than Spotify can. For example, Spotify pays artists anywhere from four to 20 times less than Tidal does, increasing the financial burden on artists. In fact, artists would need their songs to be streamed more than 1.1 million times on Spotify just to earn the U.S. monthly minimum wage. This has caused artists like Taylor Swift to publicly criticize Spotify, and subsequently remove her music from the platform in 2014. Instead, Taylor Swift signed an exclusive deal with Apple Music, similar to how Rihanna and Kanye West have released exclusive content on Tidal. As a result, these competitors have been able to create a competitive advantage by securing content exclusivity with major artists, driving consumers to their platforms.

The root cause of this discrepancy in royalty payments is Spotify’s freemium model. Artists earn five times less for a stream from a free subscriber compared to one by a paid subscriber. For this reason, Spotify has faced pressure from numerous artists to abandon the freemium model. Additionally, investors have questioned the viability of the freemium model from a financial perspective.

Spotify mainly generates revenue from subscriptions paid monthly, and must pay royalties for each stream played.

Thus, it is financially straining when its 60 million free subscribers outnumber the paid ones. This is especially evident when analyzing speculators’ prospective financial statements for Spotify, which show that of the $2.2 billion of revenue Spotify earned last year, the company paid out $1.8 billion in royalties. Despite its rapid growth over the last decade, Spotify has been unable to turn a profit, with people speculating that they most recently lost $194 million last fiscal year.

Yet, the ability to stream for free has been one of the main reasons behind Spotify’s success. Its 100 million subscribers significantly outnumber Apple Music’s 17 million subscribers and Tidal’s 4.2 million, where paywalls limit user trials. Thus, while there is currently debate over Spotify’s freemium model, the company should preserve it to keep its user base size. Instead, Spotify should look to use the blockchain to appeal to artists without hurting user growth.

Reaching The Audiophiles

In the short-term, Spotify can leverage the blockchain to disintermediate the middlemen in its complex ecosystem. The intermediaries can be illustrated by following the two streams of cash that Spotify pays out. The first stream goes through the middleman to the artist and their supporting team which includes the production team, engineers and managers. The middleman is the traditional record label who, in turn, provides anti-piracy, distribution, marketing, and tour support services. In return, the label receives a significant portion of the payout from Spotify.

The second stream goes through another intermediary to the songwriters and composers. The intermediary here is Performing Rights Organizations (PROs), which collect revenues from vendors who want to use copyrighted works publicly such as restaurants and bars.

For example, for the Whitney Houston song “I Will Always Love You,” one stream goes to Sony, the record label, while the other ultimately goes to Dolly Parton, the songwriter. Whitney Houston, the artist, waits to be paid at the end of the line after the record label. Even on Spotify, artists do not know when they will be compensated for their work, since the payment goes through the record label as an intermediary. Although Spotify should disintermediate the record label in the long-run, this would currently be difficult to implement in the short term. First, the distribution rights the record labels hold would prevent artists from replacing the record labels with another service. In addition, record labels play a big role in the artist’s other offerings, such as tours, which would present a logistical issue if removed.

Currently, Spotify pays $120 million annually for third-party vendors to handle the transactions between it and the two middlemen previously discussed. One of these vendors is Adyen, a billion-dollar company which identifies the recipient of the payment and distributes said payment. However, even these third-parties do not have enough resources to accurately comb through 30 million songs and find the correct information. As a result, not only is the $120 million that Spotify currently pays not going towards a service that is fully capable of handling Spotify’s streaming data volume, but it is also eating into

Spotify’s profits. By introducing blockchain technology to handle these payments, these transaction fees could be replaced by the cheaper variable costs associated with the smart contracts.

Spotify can use smart contracts through blockchain to remove the third-parties currently in charge of handling payments. By doing so, Spotify can improve its bottom line with a solution that scales with their growth as a company, freeing up cash to pursue long-term growth.

Getting Smart About Contracts

Blockchain is a data foundation that constructs a digital ledger of transactions which are then distributed amongst a network of computers in real time. The value in blockchain is its ability for network participants to reach consensus without a middleman or centralized authority.

This can be illustrated through a simplified case example in the financial services industry. Historically, all pending transactions were posted to a clearing house’s centralized ledger, where they entered an approval process lasting multiple days. In return for its work, the clearing houses were rewarded with significant fees. However, by leveraging blockchain technology and its decentralized ledger, these clearing houses become obsolete, significantly lowering transaction times and cost for all parties involved. Furthermore, transactions across a blockchain have the potential to do much more than simply transfer currency. They can also entail distribution of property rights, personal information, financial assets, and rights to physical assets, leading to heightened interest by financial institutions.

With the framework of the blockchain set out, innovation over time has enabled new applications to be created on top of the platform. Of these applications, Smart Contracts by the Ethereum Network has the greatest potential. A smart contract is one written in code to execute a certain task. These contracts are secure since they are coded directly onto the blockchain and cannot be tampered with. For the music industry, the information in current contracts between artists and record labels could be transferred to smart contracts. This would include details on when artists receive payment, and from whom. Although this would require an investment of time, this information is readily available from the record label and the artist, both of whom would be eager to provide said information if it ensured fair compensation. Blockchain technology would allow Spotify to disintermediate the third parties that it currently relies on. Additionally, Adyen currently handles payments in multiple currencies across a wide swath of geographies. Blockchain technology would enable a standardized cryptocurrency that can then be converted into any form of payment. Lastly, this would empower artists by allowing them to directly monitor their compensation in real-time.

Spotify

Stepping To The Right Beat

Currently, one revenue stream flows to the major record label, which is then distributed to artists, producers, band members, etc. This situation leaves the major record labels in a position of power, jeopardizing the artist’s livelihood as record labels are free to distribute revenues within whatever timeline they see fit. By utilizing smart contracts that have these pieces of information built in, revenue is instead allocated on a stream by stream basis to each member of the distribution chain, thus shifting the power away from the record label and empowering the artist. This would create a unique competitive advantage for Spotify over Apple Music and Tidal, opening the door for content exclusives. Ultimately, Spotify could increase the value it offers artists without threatening its freemium model.

Spotify posted more than $2 billion in sales in 2015. Only 10 per cent of this came from free subscriber advertising, while the remainder came from paid subscriptions. 83 per cent of this revenue is then spent on what Spotify calls the “Cost of Revenue” which includes royalties, distribution costs and processing fees. As a percentage of revenue, royalty payments constitute 79 per cent whereas other distribution costs are six per cent. The implementation of blockchain would reduce this six per cent distribution cost, or $120 million, while increasing the timeliness of distributions.

The estimated fixed cost investment for Spotify is approximately $10 million. This was based on the amount a bank recently spent when they implemented blockchain technology to handle their $12 billion in yearly payments with an average payment size of $6,300. The variable costs on a per-stream basis would be $0.0009, resulting in $36 million. These costs include the execution and maintenance required for events such as new song and album releases. The cost of execution was calculated by determining the amount of Gas required to run a smart contract, where Gas is the internal pricing for running a transaction or contract in Ethereum. These costs were derived from the average Gas consumption of a similar blockchain running smart contracts. As a result, the overall savings is estimated to be approximately $74 million per year.

A Better Tune

Spotify’s first step to achieving profitability should be to implement the internal blockchain in order to disintermediate its third parties. This not only achieves cost savings, but also empowers artists by taking control of compensation away from record labels. In the long-term, Spotify should boldly disintermediate the record labels altogether. It was previously mentioned that Spotify pays one of the lowest rates to artists in the industry.

However, the root cause is arguably not because of Spotify, but because of the record labels. Last year, Spotify paid $1.8 billion in royalties, more than 10 per cent of the record industry’s worldwide revenue. Yet, an Ernst & Young study showed that labels keep 73 per cent of these royalties, with artists receiving only 10 per cent. Thus, Spotify would be able to transfer an immense amount of value to artists by disintermediating the labels.

Labels received an estimated $1.3 billion from Spotify last year. Should Spotify be able to remove this middleman, the company can pay its artists an incremental $0.066 per song stream, almost ten times what Tidal currently pays. Even if it splits this 50/50 with artists, it would be able to become the industry leader in artist compensation, by far. The 50 per cent retained by Spotify would increase operating profit by $660 million, allowing the company to become profitable.

Spotify’s payments to artists have historically gone through several intermediaries and service providers, such as record labels and payment processing services. An implementation of blockchain technology has the potential to increase transparency and allow for more direct payments rather than going through middlemen. This alternative is attractive to both artists and Spotify.

On one hand, artists benefit from the increased timeliness and transparency of their revenues. On the other, Spotify stands to increase their operating profit with a less significant burden on the payment transaction side.

By doing so, Spotify would become an artist’s first choice for content distribution. Combining these capabilities with Spotify’s base of 100 million subscribers worldwide, Spotify would not only be positioned as the leader in music streaming, but also emerge as a leader in the music industry of tomorrow.


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