What if Google Buys Spotify? The Case For and Against Stock-for-Royalties

While everyone else is focused on a potential initial public offering by Spotify–which is the only exit strategy that anyone seems to think Spotify has in mind–Re/Code reports that Google’s YouTube subsidiary is very interested in buying Spotify.  (That would be the same YouTube that doesn’t seem to be able to turn a profit after nearly 10 years but can come up with the money to buy Spotify.)

Omid Kordestani, who has just temporarily replaced Nikesh Arora as chief business officer of Google, is joining the board of Spotify, according to people with knowledge of the situation.

In addition, sources said, one of the search giant’s former execs, Shishir Mehrotra, will become a special adviser to CEO Daniel Ek and the company’s management.

The move is a fascinating one, especially since sources inside Google said that new YouTube head Susan Wojcicki has expressed interest in acquiring the popular online music service if it were for sale. It is not currently and there are no such discussions going on between the pair about such a transaction.

Which depends on what the definition of “is” is…that story was posted on July 21, 2014 at 10:18 am Pacific Time–what happened after that day and hour is anyone’s guess.  So you have to ask yourself how would the major labels feel if they were suddenly dealing with Google instead of Spotify?

While one could see that the time may not yet be ripe for litigating over the value of the Spotify stock grants widely reported to have been made to the major labels and Merlin, the idea of dealing with Spotify on the issue has more appeal than dealing with the highly, highly litigious Google who will sue over whether the sun rises in the East faster than you can say “Jamie Gorelick”.  If anyone thought that doing business with YouTube was like being sewn in a bag with wild dogs, just wait until Google uses its monopoly rents to gets its hands on Spotify.

The 19 Recordings Litigation

If you’ve ever been cheesed about Pandora executives lining their pockets with millions from IPOs, then you’ll understand why labels demand shares of stock when they license their sound recordings to tech companies.  And if you’ve ever been cheesed about low royalties for artists and songwriters from tech companies with or without stock, then you’ll also understand why 19 Recordings (an affiliate of the company that developed American Idol) wants to sue Sony Music for granting Spotify what 19 alleges are below market royalty rates in return for stock.

Some of this is still confidential (which is what passes for “unleaked” these days) but was reported by the Hollywood Reporter last week:

Richard Busch (perhaps best known for representing Marvin Gaye’s family in the “Blurred Lines” lawsuit) is representing 19 have been fighting in recent weeks to get Sony to come forward with the streaming agreements because they wanted to see whether streams were being discussed “transmissions.” According to the lawsuit, they were. Sony allegedly tried to “mislead 19’s auditors with highly redacted portions of the [streaming] agreements to allegedly support their mischaracterization of the services’ exploitations.”

But the lawsuit now means even more because it’s the first case to test whether the record industry establishment and tech industry vanguard are in cahoots at the expense of the creatives.

There will be a lot of ink spilled on this story, but it’s that “in cahoots” part that I want to focus on in this post.  Mr. Busch will be in an excellent position to “look under the hood” in that dialog and see what Spotify’s role was in the deal.

Because it does take two to tango.

What’s In It For Labels

The most common refrain you hear from labels when trying to license recordings for online services is “we’re not going to create another MTV.”  So let’s set aside the 10 examples of creating another MTV (including Pandora and YouTube) and just focus on Spotify.

It is pretty widely reported that major labels and Merlin got stock in Spotify.  I would argue that it is entirely fair that they got the stock because there is an intrinsic value for a company like Spotify in having large catalogs available to users, particularly if the company is going to feature the ad supported business model with its shite royalty.

And let’s stop kidding ourselves–Spotify is only about the ad supported model.  The subscription part of its business was merely a sop to the labels to close their deals.  As Daniel Ek and Google have both made clear, they will never give up advertising driven services.  Why?  Maybe it might have something to do with admitting Web 2.0 is a disaster for “content” creators?  So Mr. Ek and his board member Google are of the same mind on this issue.

So I think a compelling argument can be made for licensors getting shares of stock in Spotify.  My problem with the way this has worked out is that the compelling argument wasn’t made strongly enough. Not only should the major labels and Merlin have gotten stock, all the artists involved should have gotten equity or an equity-like kicker or cash bonus in return for granting the license at competitive royalty rate much less taking a below market rate in order for Spotify to get off the ground.  (Given securities laws, its a bit simplistic to ask for all artists to get stock–ever try to get a broker to take unregistered private company stock?  But cash works just fine, thanks.)

Mr. Busch is now in an interesting position as he may be able to discover exactly what “in cahoots” really means.

There’s some other aspects to this that may start to come out in the 19 litigation given Mr. Ek’s recent protestations of love for the ad supported side of his business.  If the reality–perhaps discovered in emails–turns out to be that Spotify never intended to boost the subscription side of their business, told the labels that they did intend to do so knowing that the labels would rely on this material promise, and negotiated a contract that addressed this issue from many different angles and issued stock to those who were induced to license on this basis–well, that’s kind of an interesting possibility.

“The better to stream you with, my dear!”

What’s In It For Spotify?

Streaming services like Spotify and YouTube all pay horrendously low royalties and apparently trade stock-for-royalties in their major label and Merlin licenses.  But here’s the trick–once Spotify establishes the subsidized royalty rate, that rate then becomes the top rate they will pay to any other sound recording owner licensing to Spotify.  In fact, they have crammed down even worse royalty rates on independent artists (and presumably independent labels that are not Merlin members) who don’t get the stock.

So if Spotify can trade some of its private shares for an across the board crappy royalty rate, what’s stopping them from doing it?  Particularly if they never intended to transition to a subscription service?  Aside from ethics and stuff like that.

Staying a predominantly ad supported service would be very Googlely after all–and if Google is planning on buying Spotify with all the goodies that would entail for Mr. Ek….Seems like we’ve seen this movie before, I think it was called Rightsflow (the licensing company that couldn’t seem to find the copyright owner for Gangnam Stylevery Googlely).

Would Spotify’s board member encourage more conversion to subscription?  Here’s what YouTube told Music Ally on the subject:

“It’s in Google’s DNA to be in the ad-supported business. Subscription is an add-on. It’s an adjacent business that we’re building.”

Subscription is an add-on?  Is that the approach we would want from an acquirer of Spotify?

What’s In It for Artists?

Record deals typically have language that prevents artists from participating in catalog-wide advances or fees except in extremely rare cases.  Given the recent uproar about “breakage”, the 19 litigation seems to come at an opportune time for artists–if the proceeds from the sale of the Spotify stock is treated as unallocated payments or breakage, then it seems like some of those monies will be passed through to artists based on extremely carefully worded breakage policies.  (Mr. Busch will also be in a position to encourage a court to make sure that policy is enforced.)

Remember, the value of private stock is essentially set by the issuer’s board of directors (with reference to valuations set by the lead investor in private equity rounds).  That’s why Spotify’s valuation is jacked up so high beyond any possible reality.  The investors want it that way to hype their exit. We’ve seen that before–it is called the Dot Bomb Explosion.  (Or more accurately, Implosion.)

In order to sell the shares either privately or in an IPO there’s usually some restrictions from the issuer as well as statutory holding periods.  For example, if the label shares (probably preferred stock) are able to be sold in an IPO, that usually means that (after converting preferred to common stock) the stock held by a label can be registered along with the IPO common stock shares.  After the company’s registered stock is available on a public stock exchange, the holder of the label stock can sell the shares to the public after “lock ups” come off.   Lock ups are a period of time that is usually set by the company in which holders are prohibited from selling their stock (to prevent a rush of selling).  There may be other restrictions.

So valuing those shares and also getting the cash from that valuation to distribute as breakage is not quite so easy.  Then there’s the question of how to distribute the cash value among artists and one thing we know for sure is that no record deal addresses this issue head on (although presumably superstar lawyers have got this figured out by now).  I’m looking forward to seeing how Mr. Busch solves these problems–although I fully expect the resolution will be a confidential settlement.

Tango for Two

Don’t let your eye get taken off of the ball here.  You can say that Sony (and probably all the others) negotiated a lower minimum guarantee and royalty in return for stock.  Or you can say that the stock was a way to capture an intangible value that would have been distributed to artists under Sony’s breakage policy.  That may or may not have been fair to the artists depending on what the breakage policy was.  If you’re like me, you’d want the stock and the market-price royalty, too.

But what we do know is that Spotify profited from the stock-for-royalties subsidized rate to jam it down everyone else’s throat without giving them equity or the cash equivalent.  That benefit flows strictly to Spotify and likely had nothing to do with the labels that got equity.

And that sounds like a Spotify class action to me.