Category: Digital Services: Spotify

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.