Sony Sues Rdio Executives for Fraud, A Cautionary Tale for Entrepreneurs

I’m on the alert for signals and other signs and portends that the Bubble Riders are about to bring down the U.S. economy yet again.  My theory is that Dot Bomb II: All Dogs Go to BK is casting right now, and will go into principal photography later this year.  Three signs are Spotify’s bonds (where a year maturity can be a “century bond“), Deezer’s busted IPO and of course the Rdio bankruptcy.

When bubbles burst, the harsh reality of the rules of bankruptcy suddenly become part of the vocabulary instead of aggregating bricks-and-clicks niches or facilitating user-centric content. And before you think that Rdio’s disaster is Pandora’s blessing, realize we also may be seeing a bubble bursting signal with the lawsuit that Sony Music filed against Rdio executives Anthony Bay, Elliot Peters and Jim Rondinelli.

The cautionary tale begins right there–note that this lawsuit is against these men individually.  If the case withstands the various means of dismissing it before it gets started which time will tell, this is about personal conduct, not the corporate actions of Rdio which has filed for bankruptcy.  Another reason that Sony may be suing these men individually is to pursue their action outside of the bankruptcy court that has jurisdiction over Rdio, a legitimate, but potentially intricate maneuver.

Of course you should realize that we haven’t heard the other side of the story yet, so keep that in mind.  There will be defenses and another side to the facts.  But what you should also keep in mind is that given the current state of the business, if a streaming service owes you money, you will have virtually no way to find that out.  Streaming services are very snide about affording artists and especially songwriters the right to conduct a royalty compliance examination (or “audit” for short, although it has nothing to do with CPAs, GAAP or financial audits).  Often the only time an artist or songwriter knows they are owed money is when the service goes bankrupt and the creator finds their name on the unsecured creditors list.

According to the Sony lawsuit (read it here) the defendants seem to have been some or all of the negotiating team for Rdio that came to Sony and asked for help.  Pay close attention to the timeline and remember that if your company is insolvent and either shuts down or actually files for bankruptcy, what you did in the run up to your bankruptcy will get scrutinized in bankruptcy.  Or as I prefer to call bankruptcy, volunteering to have a federal judge oversee every breath you take and ever have taken (key concepts are highlighted):

Unbeknownst to SME [Sony Music Entertainment], however, at the same time that Rdio was negotiating the amendment to its Content Agreement with SME, it was simultaneously negotiating its deal with Pandora—under which Rdio would file for bankruptcy [also known as a “prepack” or “prepackaged bankruptcy” usually requiring the advance approval of the creditors, including SME in this case]; Pandora would  buy Rdio’s assets out of bankruptcy; defendant Bay (as part-owner, executive officer, and  director of Rdio’s secured creditor) [potentially conflicting duties in a bankruptcy setting] would expect to be first in line to receive proceeds of the Pandora  deal; and SME (as an unsecured creditor) would receive pennies on the dollar for the amounts owed to it under the amended Content Agreement.

To summarize Sony’s allegations:  You guys came crying to us about renegotiating your deal, we were nice and gave you a break.  Even while you were crying to us, you were conspiring with Pandora to screw us because you knew that we would be in a weak position compared to the secured creditors like you.

That highlights another part of the cautionary tale–while officers and directors of a company have a fiduciary duty to stockholders under “normal” circumstances, when the company is essentially or actually insolvent, that fiduciary duty shifts to the creditors including the unsecured creditors.  Why?  (For a trip down memory lane on this subject, see the New York Times coverage of a judge’s ruling that denied Bertelsmann the ability to bid on Napster assets due to the “divided loyalty” of Napster’s CEO, a former Bertelsmann executive.)

Because the law puts the onus on the officers and directors to protect the creditors when it is likely that the officers and directors are the only ones who know that the company is going under.  Is this surprising?  On the schoolyard, you are supposed to protect the weaker kid before they get beat up, especially before they get beat up by your crazy brother.

The difference in these streaming service bankruptcies is going to be numerosity–the number of unsecured creditors will include every songwriter, artist, publisher and record company who is owed money.  Another reason why experienced digital service royalty auditors like Keith Bernstein of Royalty Review Council advises creators lucky enough to have an audit right to audit annually.  Don’t wait around for the service to go bust.

And here it comes in the next paragraph of Sony’s complaint:

Defendants knew that, had SME learned about Rdio’s negotiations with  Pandora at any time during the negotiations to amend the Content Agreement, SME would have  demanded immediate payment of the $5.5 million that Rdio owed to SME, and would have refused to grant Rdio further access to the recordings owned by SME. That in turn would have  diminished Rdio’s business and jeopardized the secret proposed sale to Pandora….Unbeknownst to SME at the time, Rdio had one day earlier signed a Letter of Intent with Pandora concerning the intended bankruptcy filing, which would prevent Rdio’s performance of its obligations to SME under the Renewal Amendment. Rdio never intended to fulfill the commitments it made in the Renewal Amendment.

I would point out that it takes two to tango (or maybe four or five in this case) and I’m surprised that Pandora isn’t in this lawsuit as well.  It would have made sense for Pandora to ask for some evidence that Rdio had the approval of all of its creditors (or at least all of the major creditors) before committing to buy Rdio’s assets.  Gutting the company of its ability to earn revenues (like buying its major assets and hiring its relevant employees) has its own set of problems.  Time will tell.

The timeline in this case is crucial:

On July 8, 2015, Pandora presented Rdio with a preliminary Letter of Intent to proceed with a sale of Rdio’s assets in bankruptcy. This was followed by further negotiations that culminated in a signed Letter of Intent between Rdio and Pandora on September 29, 2015, one day prior to Anthony Bay’s signing of the Renewal Amendment with SME. In other words, Rdio and Pandora had agreed in writing to proceed with a bankruptcy sale before Bay executed the Renewal Amendment [with SME]….

A material provision of the Renewal Amendment was Rdio’s obligation to pay SME $2 million on October 1, 2015—the day after the Renewal Amendment was executed.  This presented a dilemma for Rdio: the Pandora deal would be jeopardized either upon Rdio’s taking $2 million in cash out of its business, or upon Rdio failing to make the payment to  SME and putting its ongoing access to SME’s content at risk. To escape this bind, Defendants made false statements designed to induce SME to extend the due date for the payment rather than terminate the Renewal Amendment. Defendants Bay and Rondinelli fraudulently misrepresented to SME that Rdio was raising capital that would enable it to make this payment, when in fact Rdio was finalizing its deal with Pandora, under which Rdio would pay SME neither the $2 million, nor the monthly fees it owed for the rights to SME’s content that Rdio continued to exploit, nor the millions of dollars in other payments required under the Renewal Amendment.

And here is the Old Testament ending you knew was coming, sure as Cain and Abel:

As detailed below, Rdio ultimately succeeded in hiding the Pandora deal from SME until November 16, 2015, the date on which Rdio and Pandora signed an Asset Purchase Agreement and Rdio filed for Chapter 11 relief. As a result of this fraud, SME lost millions of dollars owed to it by Rdio.  Each of the Defendants was an officer or director of Rdio, and each of them knew of and participated in the fraud on SME. Defendants Bay and Peters were both personally involved in Rdio’s simultaneous negotiations with Pandora and SME, and knew that Rdio’s representations to SME were false. In addition, Defendants Bay and Rondinelli personally made fraudulent misrepresentations to SME in furtherance of the fraudulent scheme.  Defendants’ fraudulent actions substantially harmed SME, and enriched the individual Defendants by making the Pandora deal possible.

These are very serious charges, and Sony has a lot to prove.  But the cautionary tale is this: When you get into these situations, streamers have to be very careful about the sequence in which you do things and be very clear with all concerned about who benefits.  The timing of pre-bankruptcy events that affect the value of the bankruptcy estate will definitely get questioned.

On the licensor’s side, you have to always ask yourself, what happens if they go bankrupt tomorrow?  Is my minimum guarantee going to get caught up in the bankruptcy, either as a preference or am I never going to see the money?  There are ways to get comfortable with this, but it requires some extra precautions.

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.

 

 

What’s Next for Pandora?

Tim Westergren has returned to Pandora as the company’s CEO.  He’s got a golden opportunity to change how Pandora is viewed–we all want Pandora to succeed, but there’s little support for the path the company has been on for years now.  The 42% decline in Pandora’s stock price over the last 12 months hasn’t been helped by the company’s rocky relationship with the vendors of their main product: music.

pandora stock price

With some analysts giving Pandora a fair value stock price of $7, here’s a little unsolicited advice.

Overhead:  Pandora’s overhead is out of control.  They will blame it on royalties, but a closer look shows that the company has a problem with its operating costs that they would like you to ignore (hence the $7 fair value price target).

Pandora 2015 YOY

Integrity:  Westergren arrives at Pandora in a much different point in the zeitgeist than when he founded the company in terms of artist relations.  He made a huge misstep by associating himself with a string of attempts to lower Pandora’s royalty payment to artists and songwriters all of which have either outright failed or created more hostility than they ever would be worth.  In an atmosphere where artists are increasingly suspecting digital music services of cooking the books or operating without licenses, Pandora needs to be doing it better than the next guy.  Westergren doesn’t want to get stuck with Pandora’s “Enron moment”.

Legislation: Pandora backed the failed Internet Radio Fairness Act that was designed to lower artist royalties and created a huge backlash from the artist community.  Some refer to its spectacular failure as “lobbying malpractice.”  One time can be chalked up to bad advice. Don’t make it twice.

Litigation Against Compensating Artists: Pandora became the poster child for refusing to pay royalties on recordings made prior to February 15, 1972 which has come to be known as the “Pandora loophole”.  This would mean that if you were to record “Sophisticated Lady” or “Hello Dolly” tomorrow, Pandora would pay you but not the estates of Duke Ellington or Louis Armstrong.  In a move reminiscent of Spotify’s settlement with the NMPA, Pandora settled with just the major labels and is continuing to litigate against the class lead by The Turtles.  Westergren should settle Pandora’s case and treat all artists fairly.  Again, bad advice can get forgiven if the company does the right thing.  Avoid having loopholes named after your company on a go forward basis.

Litigation Against Compensating Songwriters:  Pandora has lead the way in using the rate courts against songwriters at great expense to ASCAP and BMI.  While Pandora is reportedly trying to make direct agreements with publishers, the company is using the rate courts to drag songwriters through the muck.  Westergren should stop trying to litigate royalty rates and ask yourself if you really saved that much money compared to your own legal fees and brand damage.

Lobbying With MIC Coalition:  Pandora is a member of the MIC Coalition, an alliance of companies against songwriters and artists—companies with a combined market capitalization of over $2 trillion.  (I stopped counting at $2 trillion dollars as I get confused by that many zeros to the left of the decimal place like I get confused by zeros to the right of the decimal place on Pandora’s royalty payments.)  There’s no good reason for Pandora to be in the MIC Coalition–whose first official act was to file an antitrust complaint against SESAC.  That’s right–because Google, Clear Channel (iHeart) and all the rest need protection from songwriters.  (The MIC Coalition even had a fake panel at SXSW moderated by their lobbyist who failed to identify her connection to the “McCoalition”.)

MIC Coalition

Tim Westergren built the better mousetrap, but it’s managed to catch a rat.   By pursuing a path of high integrity and fair dealing with creators, Pandora might have a chance to make it.  It would be a shame to see it go under.  Westergren’s brief should be to do everything he can to get the creative community back on board instead of looking like a stock-rich bubble boy having breakfast at Buck’s.

Investors Deserve a Standard for Measuring Music Service Subscribers

“Today, Spotify CEO Daniel Ek officially announced that the streaming service has hit the 30 million paying subscribers.”

Digital Music News.

Spotify “officially” announced today that it has 30 million paying subscribers.  What does “officially” mean?

I wonder if that’s like its announcement that it pays 70% of its revenue to rights holders–except when it doesn’t as David Lowery’s class action and other challenges to Spotify’s arithmetic credibility have revealed.

How do we know that Spotify has 30 million subscribers?  Because Spotify’s CEO says so.  Moral hazard much?  Isn’t that the same guy who claims to be the savior of the music industry but is underpaying songwriters to the tune of millions of dollars?

The ability of advertising supported media to deliver a reliable audience is hardly news, so it is hardly news that someone figured out that these numbers need to have some independent third party auditing those statements.

The Alliance for Audited Media is just such an independent third party.  AAM describes itself:

The Alliance for Audited Media connects North America’s top advertisers, ad agencies, media companies and platform providers. Our clients stand for trusted media analysis across all brand platforms—print, web, mobile, email and more—to make smart decisions. AAM delivers insightful, audited cross-media metrics that matter. We are one of the world’s most experienced providers of technology certification audits to industry standards established by the Interactive Advertising Bureau, Media Rating Council and Mobile Marketing Association. As a third-party auditor, we deliver media assurance via our verification and information services and provide solutions that empower media professionals to transact with greater trust and confidence.

It would be helpful for investors to know exactly what a “subscriber” means to Spotify (and other DSPs for that matter).  If the user is “subscribing” to an ad supported service, such as Spotify’s dearly beloved “freemium” service with Ads by Google, what does that mean?  Does it mean that a user has paid their bill for 90 consecutive days, or does it mean that the user is on their fourth 90 day free trial?

Given complaints by experts like WPP’s CEO Sir Martin Sorrell that click fraud and false billing is rampant on YouTube, shouldn’t investors expect to have subscribers audited by an impartial source?  (Harvard Business School Professor Ben Edelman called it back in 2009 with his prescient “Toward a Bill of Rights for Online Advertisers“.)

In this particular context, “investor” takes on a broader meaning.  Spotify and its defenders routinely ask that artists and songwriters “trust” but “don’t verify” to help Spotify grow–that is, to “invest” in Spotify’s future by taking a low royalty today for a burger on Thursday.  Now that class action lawsuits from songwriters are motivating the company to cover its tracks, it’s starting to look like Spotify is asking for a burger today for a dollar on Thursday.

It’s time that all investors in music services got independent verification of exactly what these subscriber numbers actually mean.

Investor Alert: Multichannel Networks Have Exposure to Deceptive Advertising Prosecution

We’ve all seen “brand integration” videos on YouTube promoted or produced by multichannel networks such as Maker, Machnima and others.  I’ve been convinced that if these videos were on television, they would violate the “sponsorship identification” or payola rules that require disclosure of consideration paid or exchanged for placement.  (As an aside, David Lowery has raised this issue in the context of “steering agreements” by Clear Channel and Pandora.)

Even so, there’s a straight up false advertising claim that could apply in these cases and the Federal Trade Commission has now prosecuted a claim against Machinima, one of the biggest.  (Read the FTC endorsement guidelines for social media here.)  All MCNs and YouTube itself should take note.  (Good thing for YouTube that they have extraordinary political influence at the FTC, but that’s another story.)

The FTC first published the case on September 2, 2015:

A California-based online entertainment network has agreed to settle Federal Trade Commission charges that it engaged in deceptive advertising by paying “influencers” to post YouTube videos endorsing Microsoft’s Xbox One system and several games. The influencers paid by Machinima, Inc., failed to adequately disclose that they were being paid for their seemingly objective opinions, the FTC charged.

Under the proposed settlement, Machinima is prohibited from similar deceptive conduct in the future, and the company is required to ensure its influencers clearly disclose when they have been compensated in exchange for their endorsements.

“When people see a product touted online, they have a right to know whether they’re looking at an authentic opinion or a paid marketing pitch,” said Jessica Rich, Director of the Bureau of Consumer Protection. “That’s true whether the endorsement appears in a video or any other media.”

Seems pretty simple, right?

According to the FTC’s complaint, Machinima and its influencers were part of an Xbox One marketing campaign managed by Microsoft’s advertising agency, Starcom MediaVest Group. Machinima guaranteed Starcom that the influencer videos would be viewed at least 19 million times.

In the first phase of the marketing campaign, a small group of influencers were given access to pre-release versions of the Xbox One console and video games in order to produce and upload two endorsement videos each. According to the FTC, Machinima paid two of these endorsers $15,000 and $30,000 for producing You Tube videos that garnered 250,000 and 730,000 views, respectively. In a separate phase of the marketing program, Machinima promised to pay a larger group of influencers $1 for every 1,000 video views, up to a total of $25,000. Machinima did not require any of the influencers to disclose they were being paid for their endorsement.

While it’s good that the FTC brought this case, the dollars are truly small potatoes in the world of YouTube stars with elite channels boasting over 1 million subscribers.

YouTube star Nikki Phillippi told Frontline:

“[W]hat is happening with YouTube is there is this weird line where I won’t rep a product I do not like, but, that being said, I don’t work with brands that don’t understand the value of YouTube either. I would rather not make as much and do stuff by myself, for free, with stuff I have picked up from the drugstore, than work with a company who either doesn’t understand the value of it, or does understand the value of it, but they think that we don’t, and are like here is $100, and I realize that that sounds really strange to people […] but it’s really what is going on in the industry and a matter of trying to elevate and help the entertainment industry kind of segue and understand the value of digital marketing.”

The FTC announced the consent decree today (songwriters take note–it’s not just you).

Following a public comment period, the Federal Trade Commission has approved a final consent order with Machinima, Inc., requiring the company to disclose when it has compensated “influencers” to post YouTube videos or other online product endorsements as part of “influencer campaigns.”

According to the FTC’s complaint, announced in September 2015, the California-based online entertainment network engaged in deceptive advertising by paying influencers to post YouTube videos endorsing Microsoft’s Xbox One system and several games. The influencers paid by Machinima failed to adequately disclose that they were being paid for their seemingly objective opinions, the complaint alleges.

The final order settling the complaint prohibits Machinima from misrepresenting in any influencer campaign that the endorser is an independent user of the product or service being promoted. Among other things, it also requires Machinima to ensure that all of its influencers are aware of their responsibility to make required disclosures, requires Machinima to monitor its influencers’ representations and disclosures, and prohibits Machinima from compensating influencers who make misrepresentations or fail to make the required disclosures.

On PBS’s Frontline, YouTube star Tyler Oakley says:

“If you want to get involved, then you have to play by our rules. This is our platform. We have built this up in our own capacity, in our own way without you. So if you want to come on and if you want to get involved, you can’t just come in like a bully and kind of get your way. You may have to like, play by our rules a little bit. Which is FUN!”

Actually, we all have to play by the same rules.  MCNs take note: You could be next.

As Ben Popper in The Verge summed it up:

As consumers increasingly turn to ad blockers, brands and the media companies are blurring the boundaries of advertising and independent content. Add in teenagers with little business experience and millions of passionate followers on platforms like YouTube, Instagram, and Snapchat, and you have a recipe for unscrupulous advertising that the FTC is clearly working hard to bring under control.

Investors and Music Licensing

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.

Direct Statutory or
Compulsory
Blanket License
Song © Contract (interactive) Sec 115 Mechanical (permanent download, limited download, streaming, a few others)

Non interactive usually does not require a mechanical license

PRO (ASCAP, BMI, SESAC)
Sound Recording ℗ Contract (interactive) Sec 114(g) SoundExchange (noninteractive) N/A for interactive
SoundExchange for non interactive

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.