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HEC110 Volume 13 Issue 3 September 2015

Legal and Profitable? Spotify: The Challenges of an Online Music Service Case 1, 2 prepared by Joëlle BISSONNETTE3 and Professor Eric BRUNELLE4

Foreword Founded in Sweden in 2006, against the backdrop of a music industry plagued by illegal music downloads and plummeting record sales, Spotify is an on-demand music streaming service. It offers online music consumers legal access to a repertoire of over 30 million pieces of music, which varies by country. Its mission is to let people listen to the music they want, when they want and where they want. To accomplish this, the company offers a legal alternative that is superior to piracy, via a simple, clear and rapid platform, making listening to and sharing music easier than ever. But the company still faces major challenges. It has to respect intellectual property law, which requires adequately compensating the rights holders to the music it disseminates, while trying to become profitable and differentiate itself from the competition. How will Spotify position itself to meet the needs of online music consumers better than other online music services, while respecting the law and turning a profit?

1. Background: A Music Industry Between Crisis and Opportunity 1.1 Music and technology: a longstanding relationship Since its beginnings, the music industry has undergone many technological transformations that forced it to rethink how it does business. The introduction of cassettes in the 1960s made it possible to create copies for private use and led to a crisis with fine-groove records. When compact discs (CDs) hit the market, dethroning the cassette, almost 20 years of growth in sales of recorded music followed; it was a golden age for the music industry, reaching a peak toward the end of the 1990s.

1

Translation from the French by Rhonda Mullins of case #9 40 2015 015, “Légal et rentable? Spotify : les défis d’un service de musique en ligne.”

2

This case was prepared on the basis of public documents, i.e., articles, records and interviews in the media and sectoral studies of the digital music market. It is also a direct observation of Spotify’s Internet activities up until September 2015.

3

Joëlle Bissonnette is a doctoral student and research professional at HEC Montréal.

4

Eric Brunelle is an associate professor in the Department of Management, and Director and Editor-in-Chief of Gestion, at HEC Montréal.

© HEC Montréal 2015 All rights reserved for all countries. Any translation or alteration in any form whatsoever is prohibited. The International Journal of Case Studies in Management is published on-line (http://www.hec.ca/en/case_centre/ijcsm/), ISSN 1911-2599. This case is intended to be used as the framework for an educational discussion and does not imply any judgement on the administrative situation presented. Deposited under number 9 40 2015 015T with the HEC Montréal Case Centre, 3000, chemin de la Côte-Sainte-Catherine, Montréal (Québec) Canada H3T 2A7.

Legal and Profitable? Spotify: The Challenges of an Online Music Service

During the same era, the emergence of high-speed Internet connections and the mp3 file format – which has become the official file format for digital music – led to transformations that still have the industry trying to find its way, upsetting the foundations on which its performance is based. The mp3 file format can compress files to almost 12 times the size of the original, with no real audible loss of quality. With households adopting Internet technology, particularly high-speed Internet connections, these files could circulate efficiently. Digitized, compressed and stored by individuals, music started to be exchanged for free and with no restrictions on the Internet, without the authorization of the rights holders in these musical works and without providing them the compensation that is theirs by right. 1.2 Illegal downloading: from Napster to peer-to-peer In 1998, the first free sites for downloading mp3 audio files appeared, including Napster in 1999, which made it possible to easily share file directories between Internet users. In under three years, 60 million users illegally exchanged over 1.5 billion titles (SODEC, 2002, p. 22). However, Napster’s limitation lay in its centralization. Since the data it contained was not replicated anywhere, the operation of the network depended on the central server. If it failed, community members had no way of establishing a connection with other members. So in 2001, when the courts found for the music industry majors, 1 who saw the sharing system as a threat to their control over music distribution, Napster was forced to get rid of its central server, provoking the collapse of its Internet community. In the meantime, Internet users came up with alternative solutions. To avoid repeating the Napster experience, Internet users created sharing systems using multiple servers, ensuring that they remained independent of one another. In the event of an attack on one server, the community could remain connected via the remaining servers. The idea was refined and developed, from the principle that having more servers ensures a robust network, leading to the complete decentralization of sharing systems: peer-to-peer. 2 With this decentralized method of sharing, illegal downloading took off, was refined and diversified, to the point that it became completely uncontrollable. 1.3 Plummeting CD sales At the same time as illegal sharing networks were being developed, CD sales in all markets went into freefall. For example, in the U.S., the largest music market in the world, CD sales dropped from 730 million units in 2000 to 206.4 million in 2013, a decline of almost 72%, according to 1

“Majors” refers to international record companies that assume, in whole or in part, the technical and financial responsibility for producing, manufacturing, promoting and distributing recorded music (Ménard, 1998, p. 36). Until very recently, there were four majors, who together accounted for three quarters of music industry sales worldwide, even over 80% in Europe and the U.S.: Universal Music Group, Warner Music Group, Sony-BMG and EMI Group (Curien and Moreau, 2006, p. 23). In November 2011, Universal Music Group and EMI Group merged, further increasing the level of concentration. However, this oligopoly now has a major competitive fringe made up of thousands of small independent producers.

2

In peer -to-peer networks, members play the role of both client and server. As files are downloaded by a user, they become available for download to other users. The particularity of files that circulate on peer-to-peer platforms, .torrent files, is that they are broken down into small pieces. Once users receive a piece of a file they are downloading, they immediately and automatically start sharing this piece with other users. Each new download of a file increases its availability so that other members of the community download it, thereby creating a vicious circle of downloading. Sharing is done directly between users, who have access to all files downloaded by each of the other members of the peer-to-peer community. Controlling the files available on these systems is therefore impossible, given the fragmentation of servers that make them available. The only limits to sharing are the size of the community and the number of files all members have.

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

Nielsen SoundScan data (Statistic Brain, 2014). According to the same data, in Quebec, where the decline in CD sales hit later and was less pronounced, from 2004 to 2013, sales dropped by half, going from 13 million units sold in 2004 to 6.1 million in 2013. Across Canada, CD sales went from 36.6 million to 11.7 million during the same period, or a drop of 68% in nine years (Fortier, 2014). While the drop in CD sales cannot be directly linked to illegal downloads because too many variables were at play, 1 the fact remains that one of the foundations of music industry revenue was challenged, at the very time the Internet and digitization came on the scene. As a result, the music industry needed to look at the fit between how they meet consumer needs ‒ in other words, creating value for them with recorded music ‒ and how they generate revenue for themselves. 1.4 The digital music market In response, new ways of creating value for consumers are emerging, such as the sale of digital tracks and albums and continuous or on-demand streaming of music. They are inspired by new music consumption habits that are developing online and the opportunities of digitization. These initiatives led to a 1000% increase in the market value of digital music between 2004 and 2010 worldwide (IFPI, 2011), and this market continues to grow year after year (figure 1). Figure 1: Increase in global revenues in digital music from 2008 to 2013 (IFPI, 2014)

In 2013, revenue from digital music accounted for 39% of all global music revenue (5% more than in 2012 and 10% more than in 2010) and even represented the majority of this revenue in three out of the ten largest music markets. In comparison, in 2013, revenues from CD sales accounted for 51.4% of music revenue, almost 5% less than in 2012 (IFPI, 2014). This growth trend in digital music revenue is still far from compensating for the drop in revenue from CD sales of the past 10 to 15 years (figure 2).

1

On the question of variables at play in the drop in CD sales, readers can refer to Curien and Moreau (2006, pp. 63-67).

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

Figure 2: Drop in revenue from CD sales compared with revenue growth from digital music, worldwide from 1997 to 2012 from 2013 IFPI data (King, 2013)

1.4.1 Music file sales platforms and music streaming services Among the legal initiatives behind the rise in sales of digital music, there are platforms for the sale of digital albums and tracks, such as iTunes and Amazon MP3, as well as music streaming services, which include Spotify, Deezer, Rdio and Apple Music, to name just a few. According to IFPI data, in 2013, 67% of worldwide revenue from digital music was generated by downloading music files, from platforms that sell albums and tracks, compared with 27% for music streaming services. Music downloads therefore remain the main source of global revenue for digital music. However, streaming services are gaining in popularity on all markets. Their revenue rose 51% between 2012 and 2013 (figure 3), growth that shows no signs of slowing. These services offer online music consumers access to a vast online music library, anywhere, any time and on any platform. Because of the growing popularity these services are enjoying and the approach to consuming music they offer, they are seriously undermining the illegal offer, which some observers see as hope for the music industry. Figure 3: Online music streaming services (IFPI, 2014)

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

In some markets, music streaming services even outperform the downloading of tracks and albums, such as in Sweden, France and Italy. The clearest example of this is Sweden, where 94% of digital music revenue comes from these services, mainly from Spotify (IFPI, 2014). Of these services, Spotify is garnering attention for its positioning with online music consumers, differentiating itself in a number of markets from other streaming services and even from music downloading services, and for the way it has worked with music rights holders to make its music library legally available. The magnitude of the challenges the service has to tackle in terms of profitability and compensation for rights holders make it even more interesting.

2. Spotify’s Origins The men behind Spotify are Daniel Ek and Martin Lorentzon, two Swedish entrepreneurs and music lovers who have had successful careers in the Internet and information and communication technologies. In 2006, at turning points in their respective careers, Ek and Lorentzon decided to team up to find a technological solution for the music industry. They were concerned that the industry was in crisis, at a time when people were listening to more music than they ever had and when there was a greater diversity of artists than ever before. In fact, at the time, the Swedish music industry, like the industry everywhere else, was in the midst of a decade of constantly plummeting revenues. At the same time, the country had long been a hotbed of pirating. It is in Sweden that Kazaa was developed, a peer-to-peer downloading software, and, more importantly, The Pirate Bay, one of the largest platforms for illegally sharing music files. In the European elections of 2009, the Swedish pirate party (Piratpartiet) even won 7.1% of the vote, earning it a place in the European Parliament. Ek and Lorentzon wanted to offer something better than pirating: “Our idea was to create something that would generate revenue for the music industry and that would work on any terminal, that would be like water” (quoted in Beuth, 2011). Rather than dismissing piracy, they drew inspiration from it. Daniel Ek describes his brief flirtation with the illegal downloading site Napster at the end of the 1990s as being the experience that most changed him as a music consumer. That was where he discovered his two favourite bands, The Beatles and Led Zeppelin. Because of this experience, he also became part of the generation of 18 to 30 year olds who don’t believe in paying for music, and who think that it should circulate freely on the Internet. In fact, in a November 2011 article about Spotify that appeared in Wired, Steven Levy explains the influence Napster had on this generation. He says: “Unleashed in a dorm room in 1999 and killed in a courtroom in 2001, it taught a generation that music should be obtained with mouseclicks, not money.” Having experienced it, Ek understands how Napster, The Pirate Bay and the other illegal downloading platforms shaped the expectations of this generation when it comes to access to music, its uses and how it is consumed. So rather than offering online music consumers the chance to buy and own the music they listen to, he came up with the idea of offering them access to a vast library of music, that would have all the characteristics of illegal downloading sites. He took as a given that the best way to listen to music was to give the public unlimited access to an exhaustive catalogue of songs, stored on servers and available online. This was similar to what Napster had been offering, except the now-defunct service had used downloading rather than streaming, was

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

slow and often experienced glitches, and users could be traced and prosecuted. So there was room for improvement. 2.1 Drawing inspiration from pirating Before improving on the pirating experience, Ek tried to keep what worked best on the top illegal downloading platforms. So he built his service using the same technology as The Pirate Bay – peerto-peer architecture – which enables a very fast rate of transfer of music files. Spotify functions as an application downloaded to the user’s hard drive rather than as an online service, and it draws on the hard drives of all users. This increases the speed of the service and relieves the pressure on the central servers by spreading demand over different connections.1 2.2 Improving on pirating But Spotify does more than just draw inspiration from the best aspects of pirating platforms. Ek wanted his service to do better than the most popular of these platforms, to be more efficient, convenient and accessible. Illegal downloading platform interfaces are often not clear or inviting, and users cannot always create their own accounts, adapt the platform to their preferences or use it on any device. Plus the music offer is not always as diverse or complete as users would like. So opening an account, downloading a program and being able to listen to any of the 30 million tracks on Spotify is what differentiates the company from illegal alternatives. This is in addition to Daniel Ek’s obsession to create an endlessly faster and higher performance platform, striving to keep diminishing the time between click and sound. He combines a number of technologies to accomplish this: a local cache memory, peer-to-peer sharing, as noted above, and traditional streaming. When consumers click on a song, it plays immediately, as if it were already on their hard drive. In order for listeners not to notice a delay between the click and the sound, songs have to be streamed within 200 milliseconds, or the time it takes for the human brain to perceive the slightest delay. When building Spotify, Daniel Ek told himself that if he could manage to deliver this speed to consumers, it would be as if they owned all the music in the world on their computer hard drive. With this superior technology infrastructure and its presence on multiple platforms, including mobile platforms, Spotify encourages consumers to abandon pirating and may eventually lead them to want to pay for the service. In fact, Ek believes that “An entire generation had rejected the idea of ownership […] If not files, maybe they would pay for convenience” (Greeley, 2011). But what distinguishes Spotify from pirating platforms is also, and most importantly, the ability for Internet users to get unrestricted access to music online, without breaking the law.

3. Legal Constraints Daniel Ek couldn’t have launched Spotify without entering into agreements with the rights holders to the works his service would provide access to. He wanted to demonstrate that it was possible to 1

This approach has allowed Spotify to build and grow, and, in April 2014, the company announced that its even higher performance servers could gradually replace peer-to-peer technology.

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Legal and Profitable? Spotify: The Challenges of an Online Music Service

work with the companies that represent rights holders. But after his company was launched, he met with resistance from record companies, which were not taking him seriously or buying into his model. But Daniel Ek was 23 years old at the time and was confident no challenge was too great. So while he thought it would take him less than three months to negotiate an agreement that would authorize him to use all European music, it was only in October 2008, more than two years after Spotify was founded, that it was finally launched in Norway, Sweden, France, the U.K. and Spain. Its launch in Finland, Denmark and the Netherlands followed soon after. It took almost three more years to finalize agreements with rights holders in the U.S., which was accomplished in July 2011, two years later than anticipated. And legal issues again meant that it took until November of the same year for the service to be offered in Austria, Belgium and Switzerland, and until March 2012 for it to be available in Germany. In Canada, Spotify only managed to reach an agreement with copyright lobby groups to launch its service in September 2014. These groups believed that the service devalued music and asked for a higher rate each time music was streamed. The rate negotiated is not as high as the lobby groups would have hoped, but is comparable to what was negotiated in other countries – for every 1000 streams, rights holders receive 10.2 cents – and Spotify committed to promoting Canadian talent on the Canadian version of its platform. A channel specializing in Canadian content was created to do just that.

4. Spotify’s Strategies Spotify is not the first or the only legal music platform on the Internet, nor is it the only service that offers access to an online r...