During his quarterly earnings conference phoner on October 22, 2015, Pandora CEO Brian McAndrews cast some shade on archrival Spotify:

“But I think some other models like Spotify and others, there are some that have perpetual free alternatives, and that is going to attract some of the younger audience. Whether that’s sustainable or not is a very different question.”

Aye, there's the rub. Juggling increasing customer expectations of free stuff, against the need to make a profit, has always been at the heart of the digital music industry.

In the age of digital technology, many industries have transformed to more effectively reach consumers. During most of the 20th century, people listened to music on the radio, usually in their homes and automobiles. With the rise of the internet and mobile computing, the radio and music industry landscape has evolved with it.

As a means of listening to music, radio broadcasts started to lose customers to mp3s and Napster in the early 2000s. Presently, internet radio has taken the forefront of transmitting music to individuals. The internet radio industry is dominated by number of major players including Pandora (P) and Spotify. Pandora and Spotify operate as music streaming services controlling 31 percent and 6 percent of internet music streaming respectively.

Pandora and Spotify both discriminate services between free and premium subscriptions. Pandora boasted $652.8 million of revenue in the first 9 months of 2014 from premium subscriptions and embedded advertisements. However robust revenue streams may be, a majority of revenue must be paid in royalties to artists and recording companies respectively.

Through the rapid growth and expansion of the internet music industry, controversy has risen from artist’s perceived lack of compensation. Recently, platinum recording artist Taylor Swift pulled her music from Spotify’s platform to raise awareness of artist’s lack of compensation and how music sales have been affected by internet streaming.

Radio Royalties

The music industry generates a portion of income from royalties each time a song is played. Royalties are payments made to the legal owner of a copyrighted piece of work. In the music industry, artists collect royalties when their music is performed publicly. A public performance constitutes music played over the radio or through internet services. Performance rights organizations (PROs) exist to collect songwriting royalties from music users and distribute them to the legal owners.

Three of the major organizations that currently exist to collect royalties from radio performances include BMI, ASCAP and SESAC. Broadcast Music Inc. (BMI) classifies a radio performance as a broadcast of a song that lasts 60 seconds or more. Each performance is categorized as either commercial, classical or college radio. Commercial radio performances encompass music typically played on FM Broadcasts with potential for bonuses based on current popularity. Classical radio is associated with symphonies, opera performances or classical concerts and gross 32 cents per minute. Performances played on stations associated with colleges or universities are classified as college radio and inherently source less money in royalties.

Digital Royalties

As the rapid expansion of technology continues, the formation of new industries does as well. Music streaming services continue to grow, as exemplified by industry leaders Pandora, iHeartRadio, iTunes Radio and Spotify. The International Federation of the Phonographic Industry (IFPI) estimates that in 2013, digital music services grew 4.3 percent to $5.9 billion in revenue.

The increased revenue can be attributed to a larger number of users utilizing subscription services and sales from downloads. Similar to the PROs utilized in radio broadcasts, SoundExchange operates to collect performance royalties for recording artists and labels whenever music is played through a digital platform. As a representative of the entire music industry in the digital space, SoundExchange operates in a free market with negotiating power over royalty payments.

Pandora

As an industry leader in digital music services, Pandora boasts 250 million users with 1 million songs in the Pandora collection. Users have the option to use Pandora for free with limited advertisements or pay a premium for no advertisements. Utilizing SoundExchange’s services, Pandora pays royalties for the streaming of sound recordings. Royalties are calculated using a performance rate and are subject to change each year. Under the Pureplay Settlement, Pandora pays SoundExchange less money in royalties than under their previous agreement.

The royalties Pandora pays are discriminated between subscriptions and non-subscriptions users. The pay per performance rates are higher for listeners that subscribe to Pandora One premium service. In 2014, performance rates were $.0014 for non-subscription users and $.0025 for subscribers. Besides performance royalties, Pandora is subject to pay for musical works embodied in the sound recording being streamed. With licenses between ASCAP, BMI and SESAC, Pandora covers royalties for copyright owners of musical works, typically songwriters.

As expected, royalties are the largest expense subject to Pandora and companies operating in the digital music space. It is estimated that as of 2014, 46.5 percent of Pandora’s revenue was paid in royalties, a stark decrease from 2013.

Spotify Controversy

Since its inception in 2008, Spotify insists that royalties have been its largest expense, accounting for 70% of revenue and about $1 billion over a 5 year span. Per stream payments are estimated to be $.006 and $.0084 with royalty payments for premium subscribers being naturally higher. However with large overhead costs, the Swedish company is still estimated to gross $1.2 billion from its 10 million paying subscribers alone. As a result, Spotify has been recently valued at $8.3 billion.

These exorbitant numbers do not come without controversy. Recently, Taylor Swift withdrew her albums and songs from the Spotify library stating that artists should be compensated fairly for digital streaming. Other artists have also witnessed stark decreases in album sales in large part due to streaming services such as Pandora and Spotify. The royalties artists receive from digital streams are not equal to those realized from album sales.

The Bottom Line

As technology has evolved, the landscape of the music industry has changed from radio broadcasts, to mp3s, and now to music streaming services. Companies operating in the digital music space have witnessed large year-over-year growth due to paid subscriptions and on screen advertisements. Even though artists such as Drake and Lil Wayne each gross an annual rate of $3 million from Pandora alone, some artists say the system isn't fair. As Pandora and Spotify continue their rapid expansion and revenue growth, we may see more artists follow Taylor Swift’s lead in bucking the current royalty model.

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