On 3 April 2018, Spotify went public on Wall Street in New York. However, the path to this IPO was anything but straightforward and was unavoidable, as Spotify’s economic survival without the IPO would have been more than questionable. For cost reasons, it was not a classic IPO, but a simple listing with no subscription period and no issue price. This blog post explains why Spotify had to go public and recounts the company’s colourful history up to that point.
THe Music Streaming Economy – Part 9: Spotify’s Long Journey to the Stock Market
The music majors had made a bet that Spotify would either be bought by a major investor or go public in the foreseeable future. In both cases, the investment would have paid off. On 3 April 2018, the time had come. Spotify’s shares were traded on the New York Stock Exchange (NYSE) and the IPO was communicated by the company in a skilful marketing manner as another milestone in the Swedish streaming service’s success story. However, this was not a traditional Initial Public Offering (IPO), which is prepared with a prospectus from issuing banks and corresponding marketing hype, but a Direct Public Offering (DPO), in which neither a subscription period nor an issue price is set in advance. The shares are therefore traded on the first day without any preparation and the first quotation is also the issue price.[1]
Why did Spotify choose to go public through the back door, rather than through the main Wall Street entrance? It has to do with the significant cost of an IPO, which is usually prepared by investment banks and their stockbrokers, who also bear the underwriting risk by subscribing to some of the shares themselves in case not all of the shares can be sold at the IPO. By bypassing the intermediaries, Spotify was able to save costs and sell its shares directly to investors. However, the risk for investors is that they have no indication of the value of the shares, and for Spotify there is no capital coming into the company’s bank account.[2] There is also the risk that not all shares can be sold on the first day of trading, which would drive down the share price.
However, the decision to avoid a prestigious initial public offering (IPO) also had to do with the unfavourable financing structure that virtually forced Spotify to go public. The IPO was therefore more of a leap forward than the culmination of a success story. The company’s growth could not be financed from cash flow but was based on venture capital investments that had increased the company’s value.
In 2009, Spotify raised US $22 million and US $50 million in two financing rounds and landed a marketing coup in 2010 with a US $15 million deal in which Napster co-founder Sean Parker was also involved.[3] Parker not only launched the first P2P file-sharing network, but was also the founding president of Facebook, which made him a billionaire. For his investment in Spotify, he received a 5 per cent stake in the company and a seat on the board. Although his investment was comparatively small, Sean Parker played a leading role in the licensing negotiations with the majors for the US launch, which took place in July 2011 after tough negotiations. He also brought with him Facebook’s expertise, which was reflected in the repositioning of Spotify as a platform and the immediate signing of a cooperation agreement with the social media giant. In June 2017, Parker left Spotify to make way for more potential investors for the IPO.[4]
Launching in the US was crucial to Spotify’s economic survival. The US was and still is the largest music market in the world, and a successful entry is a guarantee for further growth. Investors agreed. A consortium led by Facebook investor DST Global and Kleiner Perkins Caufield & Byers provided an additional US $100 million in venture capital for market development in exchange for a 10 per cent stake in the Swedish company, which was now valued at US $1 billion. However, the investment deal was not finalised until Spotify had signed the licensing deals with the US music majors.[5] But the price of the US licensing deal, and the associated US $100 million investment, was that Spotify had to massively scale back its free service in the US. Originally, the majors wanted to shut it down altogether, but Spotify successfully fought back. The compromise was that users could only use the ad-funded free service for ten hours and could only repeat a track five times in total.[6] This should put more pressure on active users to switch from the free to the lucrative premium model.
The Spotify executives also realised that simply distributing music to consumers was not enough for a business model. Pandora in the US and LastFM in Europe had paved the way for an interactive future with music recommendation systems and interactive playlists.[7] This required further investment in innovation, which the acquisition of Tunigo provided. Tunigo is a Swedish company founded in 2011 to help users find the right playlists, music news and information about new music releases.[8] The service had already been integrated into Spotify’s offering as an app, but now the team of around twenty Tunigo employees has mutated into the core of Spotify’s curated music recommendation system, in what Spotify’s biographers describe as a “curatorial turn”.[9]
Spotify’s second acquisition, of music recognition service Echo Nest in March 2014,[10] completed this turnaround, transforming Spotify into a curated music recommendation system based on algorithms and artificial intelligence.[11] As it later turned out, Spotify paid US $50 million for Echo Nest,[12] which seems like a good bargain from today’s perspective. For Spotify, however, this was a major investment in 2014 that could only be realised with the help of venture capitalists. The two company acquisitions were financed by Technology Crossover Ventures (TCV), which had made a name for itself as an investor in many Silicon Valley start-ups and provided Spotify with US $250 million in November 2013, increasing the company’s value to US $4 billion.[13]
With the fresh capital injection, Spotify was able to expand into other markets, announcing its launch in the Philippines, Brazil, Canada and Russia in early 2014.[14] Russia, which was already subject to economic sanctions imposed by the West for its illegal annexation of the Ukrainian peninsula of Crimea, proved to be particularly difficult territory. The sanctions had triggered an economic crisis in Russia, and the dictatorial regime in the Kremlin imposed repressive internet censorship on the country, which also caused problems for Spotify. The launch in Putin’s empire was cancelled in early February 2015.[15]
In June 2015, Spotify faced with Apple Music a new serious competitor in the US.[16] Spotify needed to further expand its algorithmic curation of music and required additional investment, also to develop new markets. This time the money came from long-time partner TeliaSonora, which pumped US $526 million into Spotify with a consortium led by Goldman Sachs, doubling Spotify’s enterprise value to US $8.5 billion (fig. 1).[17]
Figure 1: Financial Funding Rounds for Spotify Technology AB, 2008-2015
Source: After Music Business Worldwide, “Spotify fights back: $526m funding secured to battle Apple Music”, June 10, 2015, accessed: 2024-08-11.
The list highlights that Spotify needed fresh capital almost every year to continue its operations and international expansion. The investment volumes were getting bigger and riskier. Not only did Spotify need to increase its user base every year, but it also needed to upgrade its technology to compete in the highly competitive streaming market. The fresh capital was therefore used in 2015 to buy Seed Scientific, a data analysis company specialising in big data analysis, which counted Apple’s Beats Music among its major clients. With this acquisition, Spotify was not only able to deepen its expertise in data analysis, but also to take an important cooperation partner away from Apple.[18] The battle for the international music streaming market was on. To keep up with the giant Apple, Spotify needed even more financial resources and discovered the financing instrument of convertible bonds. Instead of receiving shares in the company, investors were promised the right to buy Spotify shares at a preferential price in the future. This made it clear that Spotify intended to go public in the foreseeable future.
Specifically, Spotify issued stock options in January 2016 at an interest rate of 4 per cent, raising US $500 million in venture capital. Buyers could exercise the option at a 17.5 per cent discount if Spotify went public within a year. If it did not, the discount would have increased by a further 2.5 percentage points every six months.[19] At the end of March 2016, Spotify struck a similar deal with investment funds TPG Capital, Dragooner and other clients of investment bank Goldman Sachs. At an interest rate of 5 per cent, the streaming service agreed to convert debt into company shares at a 20 per cent discount in the event of an IPO within a year. In this case, the financing costs would also increase by 2.5 per cent every six months if no IPO took place.[20] As Spotify did not go public at the end of 2017, the discounts had increased to 22.5 and 25 per cent respectively by spring 2018. In its report for the 2017 financial year, Spotify highlighted financing costs totalling EUR 974 million.[21] The loss before taxes thus exploded to EUR 1.23 billion in 2017, compared to EUR 82.9 million in the previous year, an increase of 1,388 per cent. In the same period, Spotify increased its revenue by 851 per cent from EUR 430 million to EUR 4.08 billion. The comparison shows that Spotify urgently needed to reduce its financing costs because the loss from operating activities in 2017 was massive at EUR 378 million.[22]
In addition to the unfavourable financing structure, Spotify’s ongoing operating losses were also a problem, as the company had to admit in its IPO prospectus: “We have incurred significant operating losses in the past, and we may not be able to generate sufficient revenue to be profitable, or to generate positive cash flow on a sustained basis. In addition, our revenue growth rate may decline.”[23] In 2017, the cost of revenue was almost 80 per cent of total revenue, meaning that Spotify was far from profitable. Spotify did renew its licensing agreements with Universal Music Group, Sony Music Entertainment, Warner Music Group and MERLIN in 2017, resulting in a slight reduction in rights fees. However, this came with a requirement to achieve certain user numbers and an assurance that certain new releases would not initially be offered in the free model.[24]
This demonstrates Spotify’s dependence on the music majors and their huge music catalogues, on which the streaming service still relies today. To free itself somewhat from this grip, Spotify entered into a partnership with Tencent Music Entertainment, a subsidiary of Chinese conglomerate Tencent Holdings, in late 2017. The deal consisted of a mutual exchange of 10 per cent of the company’s shares. This opened the fast-growing Chinese music streaming market to Spotify, while Tencent Music gained access to the European and US markets. The share swap also provided Spotify with much-needed capital, since Spotify was valued at between US $16 billion and US $20 billion at the end of 2017. A 10 per cent stake in Spotify therefore corresponded to a value of between US $1.6 and 2 billion. However, the value of Tencent Music, including the streaming and social media offerings Kuwo, KuGou and QQ Music, totalled only US $10 billion. As Spotify’s share in Tencent Music was lower in value, Tencent had to pay between US $600 million and 1 billion in cash to Spotify.[25] The share swap provided Spotify with important cash and gave the Swedish company a strong strategic partner in Tencent Holding.
Nevertheless, Spotify’s IPO in April 2018 had become inevitable and necessary for survival, as the financing costs were exploding. The IPO turned out to be a jackpot for the music companies. In 2008, the majors and MERLIN had acquired a total of 18 per cent of the company for just EUR 8,804, which was worth around US $2.6 billion on the day of the share issue.[26] This was probably the highest return on investment (ROI) ever realised in the music industry. MERLIN sold its shares in Spotify for US $100 million on the very first day after the IPO. The Warner Music Group also sold its entire stake in Spotify for US $504 million shortly afterwards and Sony Music Entertainment sold half of its Spotify shares for US $768 million in 2018. Only Universal Music Group resisted the temptation to sell off its investment and still holds shares in Spotify today, which are worth around US $1.0 billion depending on the share price.[27]
The key to Spotify’s business model is therefore the music rights that the streaming service has to licence not only from the labels but also from the music publishers, and it is the yearly growing number of users that keeps the Spotify cash printing machine running. Let’s take a closer look at Spotify’s business model.
Endnotes
[1] For a detailed explanation of how a direct public offering or direct listing works, see Investopia, “Direct Public Offering (DPO): Definition, How It Works, Examples”, June 1, 2023, accessed: 2024-08-11.
[2] Ibid.
[3] Spotify Teardown, 2019, p 52.
[4] Music Business Worldwide, “Sean Parker exits Spotify board after seven years”, June 22, 2017, accessed: 2024-08-11.
[5] TechCrunch, “Breaking: Spotify Announces Impending US launch (really)”, July 6, 2011, accessed: 2024-08-11.
[6] Spotify Teardown, 2019, p 53.
[7] The topic of music recommendation is discussed in more detail in the part on “AI in the music industry”.
[8] Billboard, “Spotify Acquires Music Discovery Service Tunigo”, May 3, 2013, accessed: 2024-08-11.
[9] Spotify Teardown, 2019, p 61.
[10] Billboard, “Spotify Acquires the Echo Nest”, March 6, 2014, accessed: 2024-08-11.
[11] Spotify’s use of artificial intelligence with the help of Echo Nest is also discussed in detail in the section “AI in the music industry”.
[12] Music Business Worldwide, “Turns out Spotify acquired The Echo Nest for just €50m”, May 10, 2015, accessed: 2024-08-11.
[13] Spotify Teardown, 2019, p 62.
[14] Music Business Worldwide, “Spotify launches in Canada, reaches 58 countries”, September 30, 2014, accessed: 2024-08-11.
[15] The Independent, “Spotify cancels launch in Russia for the ‘foreseeable future'”, February 2, 2015, accessed: 2024-08-11.
[16] Billboard, “What Apple’s Streaming Service Will Need to Succeed”, June 8, 2015, accessed: 2024-08-11.
[17] Music Business Worldwide, “Spotify fights back: $526m funding secured to battle Apple Music”, June 10, 2015, accessed: 2024-08-11.
[18] TechCrunch, “Spotify Buys Beats’ Analytics Provider Seed Scientific”, June 24, 2015, accessed: 2024-08-11.
[19] TechCrunch, “Spotify Is Raising Another $500M In Convertible Notes With Discounts On IPO Shares”, January 27, 2016, accessed: 2024-08-11.
[20] TechCunch, “Spotify raises $1 billion in debt with devilish terms to fight Apple Music”, March 30, 2016, accessed: 2024-08-11.
[21] Spotify Technology S.A., 2018, Amendment No. 2 to form F-1 registration statement to the US Securities and Exchange Commission (SEC). New York City, p 10.
[22] Ibid.
[23] Ibid., p 17.
[24] Variety, “With 70 Million Subscribers and a Risky IPO Strategy, Is Spotify Too Big to Fail?”, January 23, 2018, accessed: 2024-08-11.
[25] Music Business Worldwide, “Spotify’s mini-merger with Tencent Music isn’t just about power – it’s about getting rich quick”, December 12, 2017, accessed: 2024-08-11.
[26] Music Business Worldwide, “Here’s exactly how many shares the major labels and Merlin bought in Spotify – and what those stakes are worth now”, May 14, 2018, accessed: 2024-08-11.
[27] Music Business Worldwide, “One reason why Spotify’s deals with the major labels are balanced on a knife-edge”, November 13, 2018, accessed: 2024-08-11.
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