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Coffee brief: Spotify’s direct listing on the NYSE

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Foundations
It hasn’t been without it’s challenges
Pivotal strategy moments
Why no investment bank?
Summary of F-1 SEC filing
Final comments

Foundations…

Music and technology have had an interesting couple of decades. Moving from analogue sales to digital has been difficult. Both piracy and the economics of streaming haven’t made it any easier.

Rewind a decade or so and the challenge was posed, could someone deliver a product that (1) was convenient and at the right price point for consumers (2) paid royalties to artists (3) had the negotiating expertise for what was a minefield industry and largely anti-tech, and (4) innovative enough to stay ahead of behemoths such as Apple and Amazon?

In April 2006, the challenge was accepted.

Then, 23 year old, Swede, Daniel Ek (pictured above) teamed up with Martin Lorentzon.

They had an idea, rather than listeners buying and owning the music why didn’t they pay a monthly subscription fee for access to a catalogue that would allow them to stream and explore as much music as they wanted? And if they didn’t want to pay, infuse the listening stream with adverts.

Freemium, genius.

They launched Spotify1.

In their first round of funding, Ek and Lorentzon raised €15m of venture funding from Creandum and Northzone Ventures, choosing to focus exclusively on Sweden. Ek saying, “the US just wasn’t ready”.

One interesting side note: the reason Sweden may have been more “ready” was due to the interesting relationship between technology and music in the country. Sweden was a nation synonymous with peer-to-peer sharing. Remember that infamous website, The Pirate Bay? Sweden took a very liberal approach to music and music rights, they even had a political party called the Pirate Party – with more than 7% of all votes.

People thought Ek and Lorentzon were crazy to work with the music industry. The general thinking was to just do whatever you wanted with music and then ask for forgiveness later. They sought to work, legally, with the industry, from the start.

It hasn’t been without its challenges

The artists

Universal Music Group, Sony Music Entertainment, Warner Music Group and [independent label coalition] Merlin, make up the majority of music consumed, approximately 87% of streams.

Spotify is, in essence, a very smart middleman. Without the labels above providing the music, there would be no Spotify.

This isn’t the real challenge though; the challenge lies with the artists. Just a couple of months ago we saw Enrique Iglesias sue Universal2 for failing to properly assign a royalty rate for streaming in two contracts. Couple this with the fact that last year top artist Taylor Swift removed her entire catalogue, and we can see there are still some growing pains, and ultimately the artists aren’t yet satisfied with the platform. Somewhat of a panacea is that at least the labels are fighting in the same corner (for now). Over the twelve year history, and as part of the rights negotiations, the labels have got themselves a 20% shareholding of Spotify.

Pivotal strategy moments

In an effort to keep this post’s length to a minimum, we’re not going to jump into each of these pivotal strategy moments, perhaps in the future. But do spend a couple of minutes reflecting on the strategic genius of each, allowing them to navigate ahead of the likes of Rdio, Grooveshark, Apple, Pandora and others.

  1. Betting on a freemium model for music
  2. Mobile free tier
  3. Facebook integration
  4. Acquiring Editorial and ML expertise to integrate successfully

Spotify’s announcement to go public

Fast forward to the present day and Spotify has now raised a total of $2.7 billion through twenty rounds of funding.

This week, in February 2018, they have now opened their doors, and bared all through their F-1 filing to the SEC detailing its intention to list on the NYSE under ‘SPOT’.

You’ll note that they elected not to go the traditional route of going public…

Why are they filing without an investment bank?

The main reason is due to a convertible note the company agreed to in 2016 with TPG, Dragoneer, and clients of Goldman Sachs. The company raised $1 billion in exchange for these notes with aggressive terms where TPG and Dragoneer can convert the debt to equity at a 20% discount to whatever share price Spotify sets for an eventual IPO. For every six months the company doesn’t IPO, the discount goes up 2.5% potentially causing severe dilution in shareholder percentages.

Traditionally, an IPO is completed with the support of investment banks, but when the company sells shares to the market, only 20%-30% of the stock floated is provided by exiting shareholders. Usually the company issues treasury shares (new shares which dilutes existing shareholders) to raise money for the company – typically the intended purpose of going public.

When the company sells shares outside of an IPO, they complete a direct public offering (DPO), and in this type of offering, the full issue can be secondary shares (exiting shareholders) instead of treasury. All this means for Spotify is that the company will avoid diluting shareholders by only selling existing shares rather than new ones with the expectation that Dragoneer and TPG will convert their note and force the company to issue new stock for them.

Worth noting that the banks who help complete the DPO will only make half of what they would of had it been an IPO. It will also be interesting to see if Spotify sets the trend for other late stage startups who are on the verge of going public.

What have we learned from the F-1 filing?

Private market values it between $16bn and $23bn

Spotify didn’t specify any prices for the share sale but said current secondary activity would give the firm an estimated market value of between $16bn and almost $23bn. This puts it close to the valuation of Snap, the owner of the photo-sharing app Snapchat, at its IPO a year ago.

Operating with widening losses

The F-1 filing highlighted that Spotify had an accumulated deficit of approximately $3 billion following “significant operating losses” of $286.7 million in 2015, $425.8 million in 2016 and $461.2 million in 2017.3

But with that said, it has been achieving year-on-year revenue growth.

Spotify tallied just under $5 billion in total 2017 revenue, up from $3.6 billion in 2016 and $2.4 billion in 2015. Revenue from its ad-supported service rose 41% last year, to $507.5 million from $359.9 million in 2016. Spotify also said the cost of revenue for its ad-supported business fell from 109% of revenue in 2016 to 90% in 2017.

Year-on-year growth in royalties

Spotify paid almost $10 billion in royalties to artists, labels and publishers from its launch in October 2008 through Dec. 31, 2017, with expenses for rights-holders rising 27% in 2017 versus the previous year.

Spotify pays a revenue share of around 55% to labels (not including publishing money). For comparison, the now-bust Rdio, paid around 60% and Apple Music is paying 58% of revenue to labels – after users’ free trial periods have finished. The majors want Spotify to move its revenue share up towards that point.

Global leader, beating Apple

In the filing Spotify estimates that it’s twice as big as its closest rival, Apple Music – taking 42% of the overall market. Besides being the first mover in the streaming space, Spotify’s free tier is unique among competitors like Apple, Amazon, Google and Tidal. It’s a crucial acquisition strategy, with the ad-supported tier being the entry point for 60% of paid subscribers.

Net Neutrality could harm in the long run

In summary, Spotify makes mention of the fact that the FCC recently repealed its net neutrality rules in the United States. And in turn this could increase Spotify’s cost of doing business if broadband providers limit access to content, sign deals with content providers for faster or better access over their data networks or unfairly discriminate against content providers. It seems like a slim possibility, but they do have to list all risks for potential investors.

A third of users rely on playlists

As listed above, acquiring editorial and machine learning expertise has been crucial for Spotify’s strategy. This ‘Discover Weekly’ or Radio that comes on once a Playlist ends. Further, the browse functionality to allow you to find playlists like ‘Great British Sundays’ – opening you to more music and reminding of songs that you used to love. All of this contributes to the average 25 hours listening time per user per month.

Enviable churn rate

As all the startup entrepreneurs and VCs who are reading this will know, when it comes to a subscription business, such as Spotify, it’s all about the churn rate. This is the central figure upon which lifetime values as well as future cashflow projections are based. And Spotify has enviable stickiness. With only 5.1% of Premium Subscribers leaving the service. One interesting data point that jumped out at us was that people who cancelled their subscriptions tended to rejoin. About 40% of premium subscribers who churned rejoined within three months, and half rejoined within a year.

Final comments

So what are our thoughts on SPOT, as an investment, once it goes public?

Focusing on share price for a moment, the company says in its F-1 that low and high price for its ordinary shares in private transactions last year (excluding Tencent transactions) was $37.50 and $125 respectively. In 2018, it’s been $90 and $132.50. The filing also states the warning, “Consequently, the public price of our ordinary shares may be more volatile than in an underwritten initial public offering and could, upon listing on the NYSE, decline significantly.”

We think that it’d be a buy and hold for roundabout where the private transactions have valued. Smartphones and better wireless networks, combined with high economic growth all around the world, will enable more people to enter the market for music streaming. As the world’s number one streaming service, it will grow users and revenue even further. Spotify will diversify and deliver on its goal of becoming more than just a streaming service. It will become an important music platform, servicing artists, fans and record labels.

On a personal note, what Daniel has achieved with Spotify is nothing short of genius.

Spotify is truly one of the original startups. One that helped usher in the gold rush that we’re currently experiencing. Building a company and taking on such a large industry through technology and innovation is no easy task. And to do it with the style and humility that the founding team have done with Spotify is to be respected.

So even though the losses are widening and there remains quite a few challenges ahead, I do believe that they’ll continue to dominate the space for the next decade.

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Footnotes

  1. Daniel went on record stating how they came up with the name: “This takes us back to my flat that I had out in the suburbs of Stockholm. Martin and I were sitting in different rooms shouting ideas back and forth of company names. We were even using jargon generators and stuff. Out of the blue Martin shouted a name that I misheard as Spotify. I immediately googled the name and realised there were no Google hits for the word at all. A few minutes later we registered the domain names and off we went. We were a bit embarrassed to admit that’s how the name came up so our after construction was to say that Spotify stems from SPOT and IDENTIFY.”
  2. https://www.theindustryobserver.com.au/enrique-iglesias-suing-universal-music-group-streaming-royalties/
  3. The company cited “significant costs” to license content, including royalties to music labels, publishers and copyright owners, saying in its SEC filing, “We cannot assure you that we will generate sufficient revenue from the sale of our premium service and advertising for our ad-supported service to offset the cost of our content and these royalty expenses. If we cannot successfully earn revenue at a rate that exceeds the operational costs, including royalty expenses, associated with our service, we will not be able to achieve or sustain profitability or generate positive cash flow on a sustained basis.”

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