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Why Every Music Start-Up Will Fail (and Apple Will Win)

The streaming music business is getting more crowded and competitive. Get ready, start-ups: A shake-up is coming soon.
iPhone application of Swedish music streaming service Spotify
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Stereomood CEO Eleanora Viviani doesn’t mince words on how she plans to make money off her start-up: "We want to get acquired."

Unless she invents a new business model--and a way to conquer music licensing fees--she's dependent on a corporate giant that does it all. If a deal comes through, Stereomood--a free music streaming service that curates playlists by moods and has a $1.5 million valuation--would become part of a larger, more visible app but be lost to history. 

"It's not easy to monetize and have a strong business model if you just have music streaming," says Viviani, who resides in Italy. "Acquisition is the solution for a small company like ours."

A Perilous Business

Dozens of would-be Pandoras and Spotifys have launched in recent years, with varying degrees of success. Some spawn from corporate giants such as Google Music All Access and Apple’s forthcoming Pandora killer that's expected to be revealed at its Worldwide Developers Conference Monday. Others like Stereomood, Rdio, and Grooveshark have millions of monthly users, but struggle to turn a profit.

More established streaming companies like Spotify, which received a $100 million round of funding and is valued at $3 billion, say they’re focused on growth, but refuse to share numbers. Pandora, which went public in 2011 and counted 70.8 million users as of last May, has yet to reduce its royalty burden and has never had a profitable year in more than a decade as a company.

"The music industry is inherently a 'sword in the stone' story," says Grooveshark CEO Sam Tarantino. "No one has really been able to succeed in streaming yet, and the prize for winning is very 'sexy.' Who doesn't want to work with rock stars and pop stars?"

But while passion drives his business, that hasn't sustained it. As he told Mashable in April, the majority of 2011 and 2012 was spent laying off employees or watching them go, and fighting legal battles with all four major record labels.

David Pakman, a venture capitalist and former CEO of eMusic, says he isn't surprised: "There is no start-up that is profitable and doing music streaming today." 

Despite enviable user numbers, neither Spotify nor Pandora have turned a profit because of the cost of music royalties. Pandora generates revenue through a mix of paid subscriptions and ads, but licensing fees eat up a huge chunk of that revenue. In 2011, the company paid $149 million in content acquisition costs out of $274 million in total revenue--that's 54 percent of its revenue. Spotify reportedly posted a loss of $57 million in 2011, largely because of high licensing fees.

"When you are totally dependent on the music rights and on the licensing, that's where all your money goes," says Vincent Reinders, CEO of 22tracks, a music discovery service based in the Netherlands. "I think it's really hard to be a viable distribution platform. You can see them struggling all the time." 

Why Apple Will Win

While numbers like these might keep an entrepreneur up at night, corporate giants like Apple and Google have less to worry about.

By virtue of being an established brand, both have a better chance of negotiating good deals with the major record labels. Apple reportedly negotiated its deals directly with three major record labels (instead of acquiring a "pureplay" license negotiated by the third party Copyright Royalty Board). Billboard suggests the move could help the company save $39 billion on the $156 billion it earned last year. But in going the direct route, Apple cut a deal to share 10 percent of its ad revenue with Warner Music Group. Pandora pays out just 4 percent, but unlike Apple, cannot precisely target users based on all their entertainment tastes, in addition to their sex, area code, and other listening habits.  Google was able to launch All Access so quickly because it agreed to pay advances to some of the major copyright owners. A small, fledgling start-up couldn't possibly pull this off. 

According to Ted Cohen, a digital entertainment executive who's worked for Napster and EMI, tech giants also have the advantage of using music as a loss leader, something a single-purpose start-up can't do. Apple has a whole ecosystem of products to fall back on, while Amazon, who is reportedly eyeing the music space as well, can sell music subscriptions so long as customers keep shopping on its site. 

Beyond that, none of these companies have to deal with operational costs since all their offices, staff, and equipment are in place. "Apple has never been concerned about the economics of licensed content," says Pakman. "They just want you to use their device for consuming all media. They've got fantastic profit margins on that."

A Feature, Not a Business

Apple doesn't have much to lose the way a single-purpose start-up does. And that's why so many of these companies will either be acquired or lost to history. 

Spotify proved it could do what Pandora was doing by adding a radio feature last year. It also introduced a Discovery tab in May, proving it could recommend songs just as well as Twitter Music, 22Tracks, and the French service Whyd. 

Today's listeners want to make playlists, share songs, and stream stations. They also want to be local, which is why Clear Channel's iHeartRadio service, with its news, weather updates, and hourly traffic reports is winning. A single-purpose start-up can't do all of that, though it can make a useful accessory. 

The Road Ahead  

Up until now, small music services were competing with the likes of Spotify and other start-ups. But now that it’s Google and Apple, it's hard to tell how they'll fare in the long run.

"I think that there are way too many ships on the ocean, and you will see in the coming years, a couple of companies really winning and the rest of them will go away or be somehow acquired by other companies," says Reinders.

"These companies have a big structure, they have the market," adds Viviani. "We are a small company; we are Italian. If we are not acquired, I do not know what the future will be." 

Last updated: Jun 10, 2013

JILL KRASNY | Staff Writer

Jill Krasny is a staff writer for Inc. magazine, where she covers the intersection of entertainment and startups. Prior to Inc., she was a writer for MTV and Esquire and an editor at TheStreet. She is a graduate of the University of Southern California with a degree in communication. She lives in New York City.




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