by Chris Castle

Music licensing for online music services is a pay me now or pay me later kind of thing.  From an investor’s point of view, the paying is going to be done with your money and if you pay later, you’ll probably–almost certainly–pay a lot more.  This illustrates the rule of thumb–if you don’t have a license, don’t use the song or recording.

To better understand music licensing, let’s take the example of a single song and recording.  That’s right–the song and the recording are separate property rights, or copyrights in this case.  The song and recording may be owned by the same person or by different people.  A bit of nomenclature: Songs are created by songwriters and are frequently owned or administered by music publishers.  The symbol for a song is often a “©”.  Recordings are created by artists and are frequently owned or distributed by record companies or “labels”.  The symbol for sound recordings is often a “℗”.  Labels ≠ publishers and © ≠ ℗.

In the easy case, let’s take a single song written and recorded by one person who acts as her own publisher and label.  In this case, your portfolio company can get one license from one person for all the rights (except the right to publicly perform that song, which almost invariably comes from either ASCAP, BMI or SESAC under a blanket license.  Those entities are are called performing rights organizations).

If the same artist records “Yesterday” written by John Lennon and Paul McCartney, then the company will license the artist’s recording directly.  Your portfolio company will also need to get a license (probably a “mechanical license”) from Lennon and McCartney’s music publisher Northern Songs, Ltd.

A mechanical license can either be “direct” or “compulsory.”  If the license is direct, then your portfolio company will contract directly with Northern Songs for the use.  If the license is compulsory, then your portfolio company may be able to take advantage of the government-mandated mechanical license depending on the intended use.

The government-mandated mechanical license covers certain types of functionality only.  This license, sometimes called a “compulsory license”, is found in Section 115 of the Copyright Act (17 USC 115) and the corresponding regulations in the Code of Federal Regulations (especially 37 CFR § 201.18, § 201.19 and §385.10-§385.17).  (The Copyright Office has an excellent plain English summary in its Circular 73.)  Taken together, Section 115 and the regulations are a kind of uniform mechanical license that applies to all “mechanical reproductions” of songs, including streams.  (Not dissimilar conceptually from the way the Uniform Partnership Act covers partnerships.)

The thing to remember about compulsory licenses is that if your portfolio company qualifies for one, it’s entirely likely that all of its competitors do, too.  If your company’s services are truly innovative, then you’re probably in the direct licensing bucket as the compulsory license is for more standard types of functionality.

In order to take advantage of the compulsory license, the Copyright Act requires that your company comply with certain formalities.  Assuming that the song is subject to a compulsory license (many but not all are), the threshold formality is that your company send a notice informing the owner that your company intends to rely on the compulsory license.  That notice is sent either to (1) the copyright owner of the song, or (2) the U.S. Copyright Office if the copyright owner cannot be found.  The notice has to be sent before or within 30 days of making, and before distrib­uting, any reproductions of the song.  The reference to “making” is more of an analog concept, but the the import of “before distributing” is pretty clear.

In addition to sending the notice, your portfolio company’s other threshold obligation is to account and pay royalties to the copyright owner or authorized agent of the owner on or before the 20th day of each month for every copy “made and distributed“.  Notice that phrase “made and distributed”–not sold.  That means that unless you have an agreement to the contrary with the copyright owner, the compulsory license requires a payment for every reproduction of the song whether or not your portfolio company was paid.  This is one reason to get a free license for the iTunes “download of the week” for example.

The compulsory license establishes a royalty rate and a method of calculation of that rate. The Copyright Office publishes a list of those rates.   The method of calculation is especially relevant for revenue share rates.  Remember–if you don’t have a direct license and you don’t qualify for the compulsory license, the royalty rate is entirely at the discretion of the copyright owner.

If your portfolio company tells you that they are “escrowing” royalties without a license, the alarm bell that should immediately go off is how can they know what the rate is if they don’t have a license.  And if they don’t know what the rate is, how can they “escrow” a royalty?  (Setting aside the fact that no such “escrow” is permitted for unlicensed songs.)  And if they don’t know who is entitled to the money, how can that copyright owner have ever agreed to the escrow.

The closest that the Copyright Act comes to establishing an “escrow” concept is for users who want a compulsory license but can’t find the copyright owner’s name or contact in the Copyright Office records.  (Most users look beyond the Copyright Office records.)  For unfindable copyright owners, the user files the notice with the Copyright Office licensing division, but accrues the royalties in anticipation of the copyright owner being found or coming forward.  (This raises a question of what happens to any accrued royalties if the user goes out of business for whatever reason.)

The important thing to remember about filing these notices and complying with the license is that doing so can stop an infringement claim, assuming no other problems.  While there is a filing fee for each song that averages about $25 per song, that’s pretty cheap insurance to avoid a copyright infringement lawsuit or the other statutory rate–statutory damages.

If your portfolio company plans to use a large number of songs, say in the millions, you can see that filing fee adds up.  The first question for investors is whether the company really does need to use that many songs.  If there is reliable consumer research that supports the idea that a successful consumer offering requires tens of millions of songs, I haven’t seen it.  If you don’t have a good reason to get into licensing tens of millions of songs in order to launch then you probably should take a more leisurely and prudent pace. Because you’ll either pay now or pay later.

As I will address in a future post, there is a way to get direct licenses and avoid the entire process of statutory licensing.