How Accurate are Music Subscription Service Subscriber Numbers?

All of you who subscribe to the New York Times, fly Quantas, use any of a number of mobile carriers or who are in the 6th month of your third Spotify 30 day (or 90) free trial may be interested in this post.

According to Billboard in a story titled “Spotify Officially Hits 50 Million Paid Subscribers“, the “official” announcement came from a tweet:

I found this intriguing–how did we go from “Spotify Officially Hits 50 Million Paid Subscribers” in the headline to a tweet that doesn’t really say the same thing?  Maybe like this?

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First, what makes a tweet “official”?  Much less “official” totals of “paid subscribers”?  Finding out may be like asking what makes ketchup “fancy”.

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Newspaper subscriptions have long been verified by a company specializing in verifying circulation.  Television has the Nielsen ratings, music has Soundscan, and so on.  None of these systems are perfect, but they make it harder to outright misrepresent success in a business where frequently the only people who really know how well they are doing are the people who would like you to believe they are doing well.  This is nothing new, it’s as old as moral hazard.

The quest for truth leads one to independent verification services.

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A clown car for 6 million streams

Reuters reported the same story with a more subdued headline: “Spotify Says It Reached 50 Million Subscribers“.  A little more factual, a little less Kool Aid.

This is important because I have yet to find anyplace that Spotify actually says the 50 million subscribers were “paid”.  The press leaped to that conclusion, but Spotify did not say that.

And neither does Apple, a company which is already public and has to be careful what they say about the money they are making or not making.  Yet somehow nobody transforms Eddie Cue’s statement that Apple has “well past 20 million subscribers” into an “official” statement implying a verified number of “paid” subs.

Actually–it may well be that there is a significant revenue difference between “paid subscribers” and “subscribers”.  As the Music Industry Blog wrote last year:

[T]here is a more important story here: Spotify’s accelerated growth in Q2 2016 was driven by widespread use of its $0.99 for 3 months promotional offer. Which itself comes on the back of similar offers having supercharged Spotify’s subscriber growth for the last 18 months or so. In short, 9.99 needs to stop being 9.99 in order to appeal to consumers.

As Spotify has been “dominant” in the music subscription business for a while now (and yes, I mean that in an antitrust sense of “dominant”), it seems that it’s high time for someone to independently audit the veracity of the number of their subscribers.

Or would the Securities and Exchange Commission like to rely on a tweet?

 

 

Big Tech’s Latest Infringement Loophole: Mass Filings of NOIs to Avoid Paying Statutory Royalties (Part 1)

If the music-tech industry has one major failing from which all of their messaging and legal problems flow, it is their fascination with loopholes that predictably harm creators.  Whether it’s YouTube’s nefarious reliance on a tortured interpretation of the DMCA safe harbors that bears no relation to the law, Pandora and SiriusXM’s bone headed refusal to pay statutory royalties on pre-72 sound recordings (not to mention Pandora’s purchase of a radio station in a failed attempt to pay songwriters lower royalties), Spotify’s absurdly unnecessary collision with Taylor Swift over windowing, the MIC Coalition’s ridiculous manipulation of the Department of Justice on 100% licensing, or Amazon’s bizarre fascination with compulsory licenses for which songwriters have no audit right, these companies rival each other in the undignified pursuit of loopholes.

And in particular, loopholes that hurt songwriters who can’t afford the litigation and lobbying machine that is always the not-so-veiled threat brought by all these companies.  The latest debacle is no different–mass filings of NOIs to avoid paying mechanical royalties because of a loophole that is detritus left over from the 1909 Copyright Act that is being manipulated to benefit the rich Silicon Valley companies at the expense of songwriters.

Yes, that’s right.  They’d rather pay enormous sums in filing fees that vastly exceed any royalties payable just to get out of paying royalties at all.  You have a better chance of recovering an old utility deposit from a state unclaimed property office than you have of getting mechanicals once you fall victim to this latest move.

I have been reliably informed that Google, Amazon and Music Reports among others are filing “millions” of “address unknown” NOIs with the Copyright Office based on a database that these companies are purchasing for tens of thousands of dollars from the Library of Congress (remember that the Copyright Office is under the jurisdiction of the Library of Congress).  And by the way–once they file this NOI, they don’t pay royalties until the copyright owner can be identified in the records of the Copyright Office.  Regardless of how easily the copyright owner could be found in other readily accessible databases.

Mystified?  I will explain.  Rest assured, you’re not the only one who is surprised.  And remember that bit about the utility deposit, we’ll come back to that one.

As you read this post, remember one thing–it didn’t have to be this way.  This is all happening for the same reason.  Google, Amazon, Spotify, and likely soon Pandora (for its yet-to-be-launched on demand service) are all far more likely to take the legalistic and aggressive route rather than reach out to the songwriting community to work cooperatively to find a solution.

One music tech executive told me, we decide what’s fair and then we jam it down your throat.

That doesn’t work.

Mechanical Licensing and the Compulsory License

For one reason or another, the U.S. Government has a tradition of being very interested in regulating songwriters.  The Copyright Act of 1909 established the baseline rules that compel songwriters to license their songs and sets the terms on which those songs are licensed including the royalty rate.

Even if you are not troubled by this degree of attention that is probably the original wage and price control, it would be nice if the USG is going to pay enough attention to songwriters that they set the price at which they can license their work, that the same USG not forget to raise that rate for 60-odd years.

That’s right–the government set the mechanical rate in 1909 at 2 cents and refused to raise it until 1978 (as part of the 1976 Copyright Act revision).  Adjusted for inflation, that 2 cent rate would now be about 80 cents.  Instead, it’s been 9.1 cents for the last 10 years.

The current compulsory license law was crafted in 1909 and slightly amended in 1976, and amended again a couple times to include the concept of “digital phonorecord deliveries” which essentially makes that compulsory applicable to streaming.

The 1976 Act also got rid of the copyright registrations that formed the basis of copyright under the 1909 Act with the exception of requiring a registration to sue for statutory damages and attorneys fees in a copyright infringement lawsuit.  (Not quite that straight a line, but that’s where we ended up.)

But here’s the twist–the compulsory license rules are a notice based system.  A music user who intends to use a song that is subject to the compulsory license must send a notice to the copyright owner.  These notices are called a “notice of intention” or “NOI”.  If you’re going to require an NOI, then how do you deal with copyright owners who cannot be found?

There was an easy answer to this that derives from the registration requirements–look them up in the Copyright Office.  If the copyright owner can’t be identified in the records of the Copyright Office, then the music user can send a notice to the Copyright Office which the Copyright Office then publishes.  Just like when your state publishes a list of unclaimed utility deposits, closed bank account balances, etc.

Now we all know that nobody uses the records of the Copyright Office to find a copyright owner, or if they use those records they don’t use them exclusively.  Most people will look first at the PRO databases, cue sheets, publisher websites, other materials like that.  When all else fails, then they look at the Copyright Office.  This is partly due to the lag time between filing a copyright registration and receiving a conformed copy of that registration (which is when it is “official”).

There is also another public record maintained by the Copyright Office called the “recordation section”.  This is where people file documents relating to works of copyright, such as a notice of assignment or a mortgage of copyright (which is kind of like a UCC-1 financing statement).  The recordation section requires paper filings and typically only ingests a handful of titles from a large acquisition.  That results in a filing of “‘Yesterday’ and 10,000 other songs” or something along those lines.

In other words, the recordation section is not all that reliable either–and neither is dispositive because there hasn’t been a registration requirement for decades.  Is it a good practice to register?  Yes.  Is it required to have valid copyright?  No.

And it’s particularly not required for non-US songwriters.  In fact, there’s a good argument that a registration requirement in order to enjoy your rights (such as the statutory mechanical royalty, however poorly handled by the government) is actually barred by the Berne Convention’s prohibition on formalities.

Yet, the U.S. Copyright Act allows a valid compulsory license to issue for a copyright owner who may be listed in the PRO databases, may be a foreign copyright owner, or be under license (even direct license) for other songs with the same music user–if that copyright owner of a particular song cannot be identified from the public records of the Copyright Office–as determined by the music user.

Now why is this a moral hazard that should not be resolved by the music user?

Because the Copyright Act also provides that the music user filing that “address unknown” NOI is not required to pay royalties until that copyright owner is identifiable in the public records of the Copyright Office.

And who decides if the NOI is properly filed for the right song title?  That’s right–the music user.  Who is incented to play games with the song metadata?  That’s right–the music user.

So what comes next should be of no surprise given the bad advice that these giant companies receive about their artist and writer relations.

Continued in Part 2.

 

 

Spotify IPO Watch: Blame ≠ Profit

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By its own calculation, Spotify dominates the global streaming music market.  According to a 2014 speech by Will Page, Spotify’s director of economics, as reported by Billboard:

….Page noted Spotify has launched in 32 of the 37 countries where streaming is the primary digital source of revenue. Page also pointed out that Spotify is half of the $1.5 billion global subscription streaming market. In the U.S. market, Spotify made up approximately 90 percent of last year’s growth in subscription revenue, according to Page.

While competition from Apple is certainly heating up, Spotify still is the dominant company in the space.  According to the Wall Street Journal, Spotify’s revenues nearly doubled to $2 billion last year and is expected to do well again this year.

Like Pandora and every other IPO-focused music service except for perhaps Tidal, Spotify blames its inability to make a profit on royalty payments rather than on its self-inflicted battle with Apple and spending levels based on a growth strategy.

Spotify also took on a billion dollar convertible loan at what will turn out to be credit card interest rates to fund that grown strategy.   Not to fund royalties, but to fund growth and competition with Apple.

Spotify’s main arguments about why no IPO is summed up in a Wall Street Journal article that misses a few key points, but the lead paragraph is revealing:

As Spotify AB gears up for a potential initial public offering next year, the music-streaming service is missing one key component in its pitch to investors: rights to play the music in years to come, according to people familiar with the matter.

First–as predicted, no Spotify IPO this year or for the foreseeable future.  And also as predicted, the blame for no IPO is not due to mismanagement by Spotify’s executive team, it’s due to The Evil Record Companies.  Due to solid reporting by Hanna Karp at WSJ,  Spotify’s “leak when you’re weak” strategy didn’t really give them what they wanted.

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Leak When You’re Weak

Spotify has a long history of leaks, and in particular leaks that backfired.  This WSJ story is no exception.  The actual story is not one of “scrappy little startup beset by The Evil Record Companies” which is the narrative that Big Tech has been selling since 1999 and is getting a little dog eared.  This is particularly true of Spotify with a valuation greater than any record company’s.  However misguided that valuation, that is the one they have.

Rather, the story is that inexperienced management has tried to play in the tall weeds with the big dogs on Wall Street and are embarrassing themselves from the financial corner they are painted into by the shortcomings of their own business strategy.

Nobody but Spotify got Spotify into the corner they’re in.  And that’s the story that the WSJ is telling.

How did they get there?  Lavish spending, rapid expansion, high executive salaries and a general failure to capitalize on the many markets in which Spotify operates before entering new and uncertain markets is not a good look for a “start up” with a higher market capitalization than that of any one record company they do business with.

And then there’s the songwriters–not mentioned once by the WSJ.  Spotify is outright stealing from songwriters by using unlicensed songs for which they don’t pay royalties.  So where ever Spotify comes up with this “we pay 70% of revenues in royalties” begs the question–if that’s true, then why are there two class action lawsuits brought against Spotify by songwriters for nonpayment?

Why did Spotify have to make a quick settlement with the National Music Publishers Association (former owner of Spotify’s licensing service provider)?  Why are there rumors that many independent publishers rejected that settlement and are planning their own class action?

That part of the story didn’t get included in the WSJ’s reporting, but you know who notices that kind of story?  Bondholders.

And bondholders have a clause in the typical bond that in extreme cases allows them to take over the company in cases of insolvency and a reasonable expectation that the bonds can’t be paid due to the uncured mismanagement of the debtor–an event which, at best, may result in a call for accelerated repayment of the loan or a reset of the bond’s interest rate–higher, and with even more warrant coverage.

Market Conditions

While the publicly traded tech sector leaders and the broader indices have recovered somewhat from earlier lows driven by downward pressure on oil prices and the Brexit crash, the U.S. IPO market is still in the doldrums and is likely to stay there for the rest of 2016 and probably at least the first quarter or two of 2017.

In order for a high risk investment like Spotify to get a full commitment underwriting syndicate interested in floating the company’s stock on a public exchange at a valuation that smells like victory in the morning, it’s going to need to do better than it’s doing now or has done in the last few years.  This is the point at which underwriters ask why a company with a $2 billion top line cannot seem to make a profit.  Will those underwriters be willing to accept The Evil Record Company story more than The Incompetent Management story?  Or The Incompetent Management Can’t Manage Their Vendors story?

Absent the “greater fool” frothiness in the markets which I don’t see coming back from 1999 any time soon, a lack of “irrational exuberance” may means goodbye IPO for Spotify and hello Chapter 11.

And Then There’s the Debt

Said another way, the earliest that Spotify could IPO in the U.S. is likely to be more than one year from March 29, 2016, the date that Spotify announced its $1 billion convertible note with Texas Pacific Group, hedge fund Dragoneer and Goldman Sachs clients.

If Spotify holds a public offering in the next year [that is, before March 29, 2016], TPG and Dragoneer will be able to convert the debt into equity at a 20% discount to the share price of the public offering, according to two people briefed on the deal. After a year, that discount increases by 2.5 percentage points every six months, the people said.

Spotify also agreed to pay annual interest on the debt that starts at 5% and increases by 1 percentage point every six months until the company goes public, or until it hits 10%, the people said. This interest—also called a “coupon” and in this case paid in the form of additional debt, rather than cash—is commonly used in private-equity deals but rarely seen in venture funding.

So the equity warrants start to decrease 18 months out, i.e., starting around September 2017, but the interest rate will increase from 5% to 6% around the end of September 2016–next month, that is.

Running Spotify will get very much more expensive in about 30 days from today.  That has nothing to do with royalty payments or licenses.

Do you think that Spotify executives will be asked to take salary cuts?  Cancel magazine subscriptions?  Fly coach? Move from Manhattan to Syracuse?  No more Uber black cars?

And will that make the bondholders happy?

When is a Down Round Not Called A Down Round?

When it is convertible debt, apparently.  Companies often use debt to avoid closing a round of financing at a valuation that is lower than the last round of financing.  Why?  Because there are usually antidilution penalties that are triggered to protect the “pre-money” shareholders from being diluted by the subsequent down round that they may or may not invest in, too.

Even so, Spotify’s debt may have already diluted the pre-debt valuation of the company. Again, according to the Wall Street Journal:

While Spotify’s valuation doesn’t technically change with the debt round, one of its mutual-fund investors has marked down its stake. Fidelity Investments held its Spotify shares at [absurdly high stock price of] $1,643 a share in January, down 27% from last August, according to regulatory filings. [That’s a markdown from an implied share price of an even more exuberant share price of $2,250.] Another mutual fund, Vanguard International Growth, paid $2,229 a share for a stake in Spotify and still held it at that price as of December.  [Attention Vanguard shareholders!]

The Deal is Bad and They Are Untrustworthy

If the songwriter experience with Spotify is any guide, you can’t trust these people to run what is essentially a glorified record club unless they are under the watchful eye of a magistrate judge.

On top of that, they routinely seem to leak terms in an effort to get themselves a better deal with the people who actually own the rights they need to license.

If people want to do exclusives with Apple, they’re going to do them even if the dominant multinational in the space–that means Spotify–doesn’t like Apple getting those deals.  Maybe if Spotify got caught up on all their songwriter payments they’d be more worthy of sympathy.  In fact, maybe the songwriters (who are often the artists, too) might even take their side occasionally.

These deals should have been closed long ago, and that’s a reflection on poor management at Spotify that can manage to borrow $1 billion, but can’t close a box when it comes to licensing their one product.

Show Me the Proof

There are two great canards at Spotify (and all subscription services that offer a free tier, to be fair):  Exclusives hurt their business and if consumers get something for free long enough, they’ll want to pay for it instead.

There is no public consumer research that I’m aware of that supports either of these conclusions.

I’d love to hear about that research, I’m all ears.  Maybe its just another excuse for not being able to turn a profit on $2 billion of top line revenue.

Conclusion:  No Spotify IPO, not now, maybe never

As I’ve written before on Spotify IPO Watch, a combination of factors have gotten Spotify where it is now.  Market conditions, bad management, arrogance, stiffing songwriters and getting too big, too fast.

Until all those things change to one degree or another, it’s likely that the Spotify IPO myth will remain just that.

Are Legacy Revenue Share Deals More Trouble Than They Are Worth?

By Chris Castle

As an important publisher panel observed at MIDEM this year, revenue share deals make it virtually impossible for publishers to tell songwriters what their royalty rate is.  That’s especially true of streaming royalties payable under direct licenses for either sound recordings or songs or the compulsory licenses available for songs.

There are some good reasons why streaming rates developed without a penny rate–or at least some reasons that are the product of sequential thought–but there are also good reasons for creators to be distrustful of the revenue share calculation.  This is particularly true of compulsory licenses for songs where songwriters and publishers don’t even have the right to examine the services books to check if the service complied with the terms of the compulsory license (known as an “audit” or “royalty compliance examination”).

If you thought record deals were complicated, you will probably have to find a new vocabulary to describe streaming royalties.  (Calling Dr. Freud.)  But even under direct licenses for songs or sound recording licenses where there usually is an audit right, the information that needs to be audited is so closely held, so over-consolidated and the calculations so complex that there may as well be no audit right.

The result is that smart people with resources at big publishing houses cannot determine the penny rate coming out of Spotify and others with the information that is on their accounting statements.  That is hard to explain to songwriters (or artists for that matter, as they have similar problems).

Why is the calculation so complex?  The artist revenue share calculation looks something like this in its generic configuration:

[Monthly Service Advertising Revenue or Monthly Subscription Revenue] x [Your Total Monthly Streams on the Service/All Monthly Streams on the Service] x [Revenue Share] = Royalty per stream

Both monthly revenue and monthly usage change each month–because they are monthly.  In order to get a nominal royalty rate, you have many calculations on both sides of the equation.  Because these calculations are made monthly, it is not possible to state in pennies the royalty rate for any one song or recording at any one time.  There’s actually an additional eye-crossing wrinkle on subscription deals of setting a negotiated minimum per subscriber which can vary by country, but we will leave that complexity aside for this post–YouTube’s “Exhibit D” lists 3 pages of one line entries for per subscriber minima around the world.

In a simple example, if both advertising revenue and subscription revenue were $100, your one recording was played 10 times in a month, all recordings were played 100 times in a month and the revenue share was 50% for the sound recording then you would get:

$100 x [10/100] x .50 = $0.50 for that month.  How you get to the multiplicand in the revenue pot is not so simple and has gotten more complex over the years.  In fact, the contract language for these calculations make the Single Bullet Theory seem more plausible.

Revenue share formulas produce a different product when the factors change–which for the most part changes every month.  The formula we’re using is for the sound recording side, but publishers have a version of this calculation for their songwriter’s royalties, too.  The statutory rates are a version of this formula (see the nearly unintelligible 37 CFR §385.12).

Most of this information is under the exclusive control of the service, and largely stays that way, even if you are one of the lucky few who has an audit right.  Bear in mind that the “Monthly Service Advertising Revenue” in our formula is a function of advertising rates charged by the service, and “Monthly Subscription Revenue” is a function of net subscription rates charged by the service.  These calculations take into account day passes, free trial periods, and other exceptions to the royalty obligation.  There is essentially no way to confirm the revenue pot when the royalty rates appear on the publisher or label statements.

The problem is that the entire concept of revenue share deals is out of step with how artists and songwriters are used to getting paid, even for other statutory mechanical rates such as that for downloads.  If a publisher or label can’t come up with a nice crisp answer for what the songwriter or artist royalty is based on, the assumption often is that the creator is being lied to.  And who’s to say that’s an unreasonable conclusion to jump to?  The question is–who is lying?  Here’s a tip–it’s probably not the publisher or label because they’re essentially in the same boat as the artist.

How Did We Ever Get Here?

Let me take you back to 1999.  Fish were jumpin’, the cotton was high, and limited partners showed up for capital calls.  Startups were starting up their engines–some to drive into a brick wall at scale, others to an IPO (and then into a brick wall at even greater scale).

On the Internet, you didn’t just do business with a company, they were your “partner.”  You didn’t just negotiate a commercial relationship with a behemoth Fortune 50 company that could crush you like a bug–in the utopian value system your little company “partnered” with AOL for example.  Or Intel.  Or later, Google.

What that meant for music licensing was that startups wanted rights owners to take the ride with them so if they made money, the rights owner made money.  Rights owners shared their revenue, you know, like a partner.  Except you only shared some of their revenue.  You weren’t really a partner and had no control over how they ran their business even if the only business they’d had previously run was a lemonade stand.

The revenue share deal was born.  To some people, it seemed like a good idea at the time.  And it might have been if there were relatively few participants in that revenue share.  But revenue share deals don’t scale very well.

Enter Professor Coase and His Pesky Theorem 

Here’s the basic flaw with revenue share deals:  Calculating the share of revenue for the entire catalog of licensed music on a global basis requires a large number of calculations.  For companies like Spotify, Apple or YouTube, calculating the share of revenue for millions of songs and recordings requires billions of calculations.

Free services like Spotify or YouTube involve billions of essentially unauditable calculations, all of which are based on a share of advertising revenue.  Advertising revenue which is itself essentially unauditable due to the nearly pathological level of secrecy that prevents any royalty participant from ever knowing what’s in the pie they are sharing.

That secrecy runs both upstream, downstream and across streams.  And as we all know, keeping secrets from your partner is the first step on the road to ruining a relationship.

But before you get too deep into nuances, let’s start with a basic problem with the entire revenue share approach.  In order to get to a per unit royalty, you have to multiply one dynamic number (the revenue) by another dynamic number (the usage).  Meaning that the thing being multiplied and the thing by which it is multiplied change from month to month.  The only constant in the formula is the actual percentage of the pie payable to the rights owner (50% in our example).

Remember–this all started with the digital service proposing that artists, songwriters, labels and publishers should take a share of what the service makes.  If you have a significant catalog, however, you do what you do with everyone who wants to license your catalog–you require the payment of a minimum guarantee as a prepayment of anticipated royalties (also called an “advance”).

So in our simple example, if the service is pitching that they will invest heavily in growth and make the catalog owner $50 over a two year contract, the catalog owner is justified in responding that however much confidence they have in the service, they’d like that $50 today and not a burger on Tuesday.  The service can apply the $50 minimum guarantee against the catalog’s earnings during the term of the contract, but if the minimum guarantee doesn’t earn out, the catalog owner keeps the change.  This shifts the credit or default risk from the catalog owner partner to the digital service partner (who actually controls the fate of the business).

But–given the complexity of the revenue share calculations, at least three questions arise:

Question: How will creators ever know if they are getting straight count from the service due to the complexity of the calculations?

Answer: The vast majority will never know.

Question:  How will anyone know if the advance ever recoups with any degree of certainty if they cannot verify the revenue pot they are to share?

Answer: The royalty receiver has to rely on statements based on effectively unverifiable information.

Question:  And most importantly, if streaming really is our future as industry leaders keep telling us, then which publisher wants to sign up for a lifetime of explaining the inexplicable to songwriters and artists who question their royalty statements?

Let’s Get Rid of Revenue Share Deals

There’s really no reason to keep this charade going any longer.  If the revenue share deal was converted to a penny rate, life would get so much easier and calculations would get so much simpler.  There would be arguments as always about what that penny rate ought to be.  Hostility levels might not go away entirely, but would probably lessen.

Transaction costs should go down substantially as there would be far fewer moving parts.  Realize that it’s entirely possible that the transaction costs of reporting royalties in revenue share deals (including  productivity loss and the cost of servicing songwriters and artists) likely exceeds the royalties paid.  My bet is that the costs vastly exceed the benefits.

And the people who really count the most in this business–the songwriters and artists–should have a lot more transparency.  Transparency that is essentially impossible with compulsory licenses.

Because when you take into account the total transaction costs, including all the correcting and noticing and calculating and explaining on the publisher and label side, and all the correcting and processing and calculating and messaging that has to be done on the service side, surely–surely–there has to be a simpler way.

 

What is Texas Pacific Group Up To with Pandora and Spotify? Something? Anything?

by Chris Castle

As I’ve noted a couple times, convertible debt financing is all the rage with digital music service these days.  Deezer turned to it after a busted IPO in France, and now both Pandora and Spotify went there.  What’s attractive about debt?  Different reasons depending on the company’s situation.

Convertible debt is a special form of (usually) secured or collateralized loan that looks like any other loan except that it is convertible into the shares of the company.  The amount of time between the funding of the notes and the call on the debt gives the company some running room.  Given that the shares of the company may be worth less (or worthless) at the time the note converts, there’s usually some equity kickers in there along with a pretty bullet proof “event of default” clause.

Depending on how much money is involved and the negotiating position of the lender (usually near infinite leverage at this point), it’s possible for the lenders to effectively take over the company.  If you’re in the management team, that kind of thing can ruin your whole day.

When a company has already been to the well  in the public equity market like Pandora, sometimes going a third time is just not in the cards.  This is particularly true when the company’s share price is going the wrong direction, like Pandora.

Pandora 4-4-16

For Spotify, I’ve already speculated that the main reason Spotify would like converts is because it avoids establishing a valuation for the company.  This can either be a clever move or a desperation hail Mary.  Since both Pandora and Spotify are suddenly in the debt business in a big way (Pandora $300,000,000 and Spotify $1 billion) something common to both caught my eye and that is Texas Pacific Group (or “TPG”).

According to the Wall Street Journal and Bloomberg, TPG is a lender in Spotify’s $1 billion line of convertible debt.  As Spotify is not publicly traded (and I presume these are not publicly traded bonds), we don’t have all the details you’d get in a public offering.  But it looks to be a pretty rich deal for the lenders as you would expect.

According to the WSJ:

Private-equity firm TPG, hedge fund Dragoneer Investment Group and clients of Goldman Sachs Group Inc. [which probably means Sean Parker] participated in the deal, which has been signed and is expected to close at the end of this week, these people said.

But wait, there’s more:

In return for the financing, Spotify promised its new investors strict guarantees tied to an IPO. If Spotify holds a public offering in the next year, TPG and Dragoneer will be able to convert the debt into equity at a 20% discount to the share price of the public offering, according to two people briefed on the deal. After a year, that discount increases by 2.5 percentage points every six months, the people said.

Spotify also agreed to pay annual interest on the debt that starts at 5% and increases by 1 percentage point every six months until the company goes public, or until it hits 10%, the people said. This interest—also called a “coupon” and in this case paid in the form of additional debt, rather than cash—is commonly used in private-equity deals but rarely seen in venture funding.

In addition, TPG and Dragoneer are permitted to cash out their shares as soon as 90 days after an IPO, instead of the 180-day period “lockup” employees and other shareholders are forced to wait before selling shares, the people said.

TPG and Dragoneer will buy $750 million worth of the deal, with the remainder going to clients of Goldman Sachs Group Inc., which advised on the financing, according to people familiar with the deal.

Spotify indicated to new investors it plans to go public in the next two years, people familiar with the matter said.

It’s possible to get more expensive money, but that would involve credit cards.  One thing I feel confident in guaranteeing about TPG, they got their pound of flesh.  And for Spotify–this deal looks pretty desperate.

As an aside, the Bloomberg reporting continued the thoughtless canard:

[L]ike other streamers, Spotify makes losses because it has to pay high fees to the music labels. On about 1 billion euros ($1.1 billion) of revenue in 2014, Spotify suffered an operating loss of 165 million euros, with some 70 percent of costs going to pay labels.

Wrong–the reason that Spotify loses money is because it is trying to maintain a near vertical growth curve.  Remember “get big fast”?  The mantra of the Dot Bomb Collapse?  And then there’s that nasty bit of not actually paying songwriters or bothering to get a license.

But TPG also turned up at Pandora where they got a board seat.  According to a Pandora press release:

[Pandora] is expanding the size of Pandora’s board from nine seats to 10 seats with the addition of Anthony J. “Tony” Vinciquerra, a technology, media and telecom expert with over 30 years of industry experience. Vinciquerra will join the board as a Class III Director and will be included in Pandora’s proxy statement for election at the 2017 Annual Meeting of Stockholders.

Mr. Vinciquerra has a background working very successfully for that well-known milktoast, Rupert Murdoch.  I find it interesting that within a month of Mr. Vinciquerra joining the board Brian McAndrews is out and Pandora is reportedly selling the radio station it bought for the sole purpose of sticking it to songwriters.  Hard to say if Mr. Vinciquerra is kicking ass and taking names, but ousting the guy who championed dropping $450 million on Ticketfly, antagonizing creators to the point of rank hostility and did not understand the definition of payola might be a step in the right direction.

Whether he can do the same for Spotify is an open question.

pandora_500_billboard_cover

Who knows?  Peace could be breaking out all over.  And that would be nice for all of us.

 

What Does Spotify’s Billion Dollars of Debt Mean for Labels and Artists?

The Wall Street Journal reports that Spotify has raised $1 billion in convertible debt with this telling analysis:

Music-streaming site Spotify AB has raised $1 billion in convertible debt from investors, a deal that extends the money-losing company’s runway but comes with some strict guarantees, people familiar with the matter said.

Private-equity firm TPG, hedge fund Dragoneer Investment Group and clients of Goldman Sachs Group Inc. participated in the deal, which has been signed and is expected to close at the end of this week, these people said.

Tech startups are increasingly turning to convertible debt—bonds that can be exchanged for stock—as investors push back on rich valuations amid a volatile stock market and economic uncertainty.

By raising debt instead of equity, Spotify adds to its war chest without the possibility of setting a lower price for its stock, which can sap momentum and hamper recruiting.

That last paragraph is very telling.  As I have warned about before, the main reason for any privately held company to take on convertible debt, particularly large amounts of convertible debt, is to avoid a “down round”, meaning a round of investment at a lower valuation than the previous round.  This means the new investors buying in the down round pay a lower price per share, and receive certain rights and preferences that are superior to the rights of the previous rounds’ investors.

The main reason for existing stockholders (like the major labels and Merlin in Spotify’s case) to avoid a down round is to protect the preferences that the prior investors have built into their stock ownership.  Those preferences can require the company to issue more shares to protect the percentage ownership of the insiders and key executives, for example, and that can lead to washout financings and recapitalizations to incentivize investors in the down round (who often are not, as one might say, “babies”).

Down rounds are also one indicator that a bubble is about to burst but that investors have not yet capitulated.  (Down rounds are a precursor to failed capital calls, which are the real sign of a bubble bursting.)  Down rounds were very common in the dot bomb bubble burst.

An example of down round protection would be lowering (or “resetting”) the strike price of a warrant if the company issues securities at a lower price in the future–the down round.  In any event, the company must sell more shares than in the previous rounds in order to generate the new investment, so down rounds will almost inevitably dilute existing stockholders even if they give up their preferences.

So why did Spotify raise convertible debt?  To avoid a down round, which means that there is a good possibility that the company was told either that their proposed valuation that they wanted to get in their next round of finance was too high or that their last valuation (over $8 billion) was too high.

Convertible debt is secured debt.  That means holders of convertible debt will be at the head of the line in a bankruptcy.  This is almost certainly going to create a new hierarchy overnight and should start every royalty recipient thinking differently about Spotify because it introduces the concept of preferences in bankruptcy.  And if you find yourself thinking that Spotify could never go bankrupt, welcome to bubble mania.

Get what you’re owed out of the company as fast as possible.  You are now looking at a senior secured creditor who will almost certainly take the lion’s share of any recovery from a bankrupt Spotify after washing out all the equity the labels gave up in return for discounted royalty rates (which would be Daniel Ek’s last laugh on the music business).  I’m using Spotify as an example, but it could be any of them–Pandora also has a large debt financing.

Audit Early and Often:  The first thing that should happen is that instead of auditing at the “bankers hours” pace that the industry usually operates at (every three to five years), everyone who is owed royalties by Spotify should conduct a royalty compliance examination every year.  The longer you wait, the greater the chance that you will become known as an unsecured creditor.  This is true of artists, songwriters, labels, publishers, PROs, the lot.  Unions that have any residuals based on streaming?  Get in there.

Contractors, Get Your Money:  If you’re an independent contractor for Spotify, get your money paid.  Don’t wait.  Ask any independent contractor for a dot com that’s gone under and they’ll tell you–kiss that delivery payment goodbye after the whip goes down.  This especially includes lawyers–you will be the first to go.

Employees, Don’t Count on Bonuses:  Employees should take some advice on how protected they are on bonuses or deferred compensation.  And of course, your common stock will likely get washed out completely in order to protect the holders of preferred stock.

Settlements and Preferences:  Get the money, get the money and be sure you get the money.  Consult with bankruptcy counsel to determine whether you are receiving a preference that can be undone in  a later bankruptcy filing.

Fiduciary Duties of Officers and Directors:  When a company becomes insolvent, there is a point along that path where the primary fiduciary duty of officers and directors shifts from the stockholders to the creditors.  Get smart about this.