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Up, Up and Away: The Spotify Balloon is a Cautionary Tale

February 6, 2017 2 comments

Already we see leaks to the tech press that Spotify is pushing off its IPO to next year while it pursues a “path to profitability”.  Now that’s a new one–the company has previously told investors a growth story like many other startups.  But unlike most other startups, Spotify now has a $1,000,000,000 convertible loan from private equity companies staring it in the face–along with what will no doubt turn out to be credit card interest rates when the total cost of the money is calculated (interest plus discounts on Spotify’s anticipated public stock).

Why is Spotify leaking this IPO information now?  Was any serious person refreshing their news feed in anticipation of a Spotify IPO announcement?  My bet is that it is mostly, if not entirely, to get out ahead of an anticipated breakdown in their negotiations with major labels and to try to put some chum in the water about the beastly record companies, greedy artists and nasty songwriters.  You know–the people who make Spotify’s only product.

In the meantime–one question about Spotify’s growth strategy is how will they be able to afford their interest payments on that billion-dollar debt–5% plus another 2.5% every six months that Spotify doesn’t IPO (capped at 10%).  The clock is ticking toward the one-year anniversary of that loan with its first interest reset.

Of course we can’t know the exact terms as the debt is private and the devil is in the details–but we can guess that it is at least possible that the interest not be paid currently but will roll into a balloon payment at the ultimate maturity date of the loan.  A balloon means no loan payments for now, but a relatively big nut to be paid pre-IPO (which will itself be carried as an obligation that will be at least something of a drag on Spotify’s pre-money valuation even if the interest is capitalized).

That balloon–if there is one–will itself likely also be subject to the 20% discount on share price that is another feature of the loan.  That means that Spotify’s bondholders might be able to elect to convert the accrued interest into shares as well as the loan principal.  A balloon would save Spotify from having to make payments on the bonds in the short run but shove more shares out the door in the long run IPO scenario.  (A convertible loan is a special type of security that allows the bond holder to buy shares of a class of a company’s stock in lieu of repayment, in Spotify’s case, probably common stock.)

And let’s be clear–these private equity companies weren’t born yesterday.  In order for over a billion dollars of Spotify stock to have value to them, the bondholders have to convert some (and eventually all) of the bonds to shares and sell those shares to somebody in the retail market.  An IPO gives them more potential suckers…sorry…buyers.  Buyers who are protected by the Securities and Exchange Commission.  (Inside joke.)

A billion dollars of Spotify stock hitting the public market all at once will tend to drive down the share price.  Getting that much stock sold requires some forethought and probably means selling in tranches.  This is why the bondholders will probably want a post IPO follow-on stock offering or two or three that will allow them to get out the door with their cash and a nice premium (sometimes called “demand registration rights” if the follow on is initiated by bondholders or “piggy back” rights for  bondholders to participate in a registration initiated by Spotify or another investor with demand registration rights).  Remember–“IPO” is “initial public offering,” not the only public offering.  (See, for example, Pandora.)  It’s also why they got a short “lock up” period that restricts how much stock they can sell in the IPO and after the IPO–which inevitably will be before the employees, and possibly the labels, get to sell their shares.

Markets know this overhang of shares is out there because they weren’t born yesterday, either.  That billion dollar overhang will tend to depress the present value of shares of Spotify stock based on technical analysis alone as the stock will tend to price-in the future dilutive effects of the total number of converts hitting the market.  This is just math–at best, high school algebra.

Trust me–the bondholders are going to make bank on this deal, or they’re going to take over the company and then make bank.

This should all be a cautionary tale about taking stock for a one-time pop in revenue in exchange for an absurdly low royalty rate with an unsustainable future return.  A royalty rate that then becomes the benchmark for everyone who doesn’t get the stock.  This is why I for one would rather have the damn money and let them keep the damn stock.

How about that “path to profitability”?   Bless their hearts.  I love how these guys always stumble on profitability as if it’s some new idea not previously seen by man or beast.

Spotify is now getting a bit long in the tooth to be ignoring how to convince investors that the company will eventually make money, or why the world’s dominant streaming services is not profitable given otherwise decent numbers according to Motley Fool:

Despite the influx of competition last year from big names like Apple and Tidal, Spotify managed to accelerate its revenue growth in 2015. Revenue grew 80% to reach 1.95 billion euros for the year. That’s up from 45% growth in 2014, when it recorded 1.08 billion euros in revenue.

So why can’t Spotify make money?  Because the company’s overpaid executives made the costly decision to bet on growth and stand up operations in dozens of countries to achieve market dominance but losses as far as the eye can see?  Or because they pay out so much of their revenue to the beastly artists and songwriters?  You know–the beastly artists and songwriters whose labels drive traffic to Spotify at no charge and make Spotify’s only product?

Either way, it looks like we’re in for another year of Spotify in our lives.  And Apple keeps quietly adding paying customers to Apple Music in anticipation of shutting down iTunes.

Will Spotify Get IRFA’d? New Boss Spotify Wants to Pay Artists Even Less

February 21, 2013 3 comments

Greg Sandoval is one of the great reporters on tech and music.  While I don’t always agree with him, I think he’s fair and one thing I know for sure–he is old school when it comes to getting facts and sources right.  So when Sandoval says Spotify is going back to the well to drive down artist royalties even further, you better believe that I believe him.

According to his story at the Verge:

About 70 percent of Spotify’s revenues pays music-licensing fees while another 20 percent covers customer acquisition, these sources said. That leaves 10 percent to pay all of the company’s other costs, including its much praised technology platform. Insiders have told The Verge that this cost structure zeroes out Spotify’s profits.

So brace yourself–Spotify is about to do a Pandora-style argument about how artists should take even less because Spotify’s “profits” are consumed by royalties.  (And yes, I do know that Spotify doesn’t pay most artists directly, but I also know that the reason that Adele held back her records from Spotify wasn’t because Beggars or its US distributor Sony weren’t making enough money.)

Since You Brought It Up

Since Spotify has put its profits at issue, then let’s discuss those profits.  The good thing about Pandora is that it’s a public company.  So when Pandora asks artists and songwriters to take less, the creators can look up the CEO’s salary (around $750,000) and can see that Tim Westergren is cashing out of Pandora stock to the tune of about $1 million a month.  Just to be clear, I don’t mind at all if Westergren makes bank on the company’s stock.  That’s they way it’s supposed to be in a free market, entrepreneurs should be rewarded.  That $750,000 salary though…again, none of my business if the stockholders approve it, but it is my business if Pandora pays too much in executive comp and wants to take it out of royalties.

Spotify is a private company, and so we don’t really know what they pay their executives–but something tells me they’re not wanting for much.  Why?  Because Daniel Ek (Spotify founder and CEO) has a net worth of $310 million (or had) and showed up on the Sunday (London) Times 2012 Rich List as the 10th richest person in the music industry.

So since Spotify seems to be putting its profits at issue, perhaps they also need to be transparent about exactly why they make so little money.  Do they have to disclose their executive compensation?  Certainly not.  But artists don’t have to agree to participate in the charade…sorry…license their music, either.  And after all, Spotify are the ones who brought up profitability.

Maybe Their Management Team Is Incompetent

Given all the goodies that Spotify is rumored to have gotten from the labels and publishers, why is it that they are not doing better?   Particularly given their spectacular valuation–while it dropped from $4 billion to $3 billion after the Facebook and Zynga IPO debacles, it’s still $3 billion.  For a company whose sole product is distributing other people’s music.

And let’s not forget–this is an Internet company.  Feeling a little bubbly down in the tummy, maybe?  It’s still probably overvalued at $3 billion–as Peter Kafka put it in All Things D:

Investors already know what a digital subscription business looks like at scale.

That would be Netflix, which has some 27 million subscribers at around $8 a month….Netflix has a market cap of $4.3 billion.

Spotify says it has 4 million paying subscribers at around $10 a month. Bear in mind that if you value Spotify at $4 billion today, you’re really saying it will be worth three times that — $12 billion — in a few years, when it would presumably go public.

The two companies aren’t exactly analogous — Spotify, for instance, also has a nascent advertising business — but they sure look similar from a distance. They’re both international, they’re both dependent on rights deals for their content and they both face the perpetual threat of competition from the likes of Amazon, Apple, etc.

So even at $3 billion, Spotify backers will need to work hard to explain why their digital subscription business is worth so much more than Netflix when it comes time to IPO.

Notice–no crocodile tears from Netflix about mommy saving them from their royalty obligations.

Or Maybe It’s About Brand Sponsored Piracy

There’s another way to look at both Pandora and Spotify’s profitability problems–even discounting the grotesque executive salaries.  Both are dependent on advertising, and both offer advertisers a shot at music fans.  Just like the illegal bit torrent sites that major brands buy advertising from.

Imagine if that illegal inventory wasn’t available?  I think there’s at least a plausible argument based on supply and demand that those advertisers would be buying advertising from legitimate services like Pandora and Spotify in even greater quantities.  Perhaps at higher prices, which is what one would expect.

Is Google shedding any tears over Pandora and Spotify suffering from the ads that Google serves to pirate sites?  Not really.  Lower royalties help Google in its quest to commoditize all culture.  If Google can drive down royalty rates by selling advertising to pirate sites and driving traffic to those sites from search–while skimming ad revenues away from legitimate sites–all the better for them, right?

 

The Most Important Man in Music Has Never Made a Record

What I think should happen here is that Spotify should put its books out into the public.  After all, as Forbes told us, “Spotify’s Daniel Ek [is] The Most Important Man In Music”.  How did we ever get along without him?

Maybe Mr. Ek would like to open his books and show us all what we’re doing wrong?  And why we need to help him make a profit so he can say on the rich list.

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