Increased investments in refining product and broadening its platform resulted in a wider-than-expected loss at music streaming service Spotify last year. The London-based company reported an operating loss of 349 million euros ($389 million), up from 236 million euros, according to a Reuters report. "This is explained by substantial investments that have been made during the year, mostly in product development, international expansion and a general increase in personnel," a spokesperson for the company said in a statement. Those investments seem to have paid off for Spotify as it grew revenue by a billion euros to 2.93 billion ($3.27 billion). 

The music streaming service is a hot contender for an IPO in the coming year. According to reports, it may opt for a Direct Public Offering (DPO) in the markets, instead of an underwritten IPO, when it list on the New York Stock Exchange later this year or early next year. A Reuters report earlier this year quoted anonymous sources as saying that Spotify is valued at $13 billion and that it's debut is being advised by investment firms Goldman Sachs, Morgan Stanley and Allen & Co.    

There are several advantages for Spotify if it goes the direct listing route. First, the company could save considerable fees paid to investment banks for underwritten IPOs. Second, it will lessen Spotify's exposure to regulatory scrutiny and its founders would be able to retain more control after being publicly listed. The latter is especially important for Spotify as it experiments with business models in its quest for profitability. These advantages do not come without caveats. For example, public investors may value the company below its own expectations. Alphabet Inc. subsidiary Google (GOOG) used a Dutch auction method back in 2004 to offer shares to the public. The Mountain View company debuted at $85 per share when expectations were for a pricing of between $108 and $135. A DPO could also mean more volatility for Spotify's shares, if large institutional investors, who generally invest for the long term and act to stabilize a company's stock price, choose not to invest. 

Spotify has been clearing the decks for an IPO for some time now. Recently, it reached an agreement with music publishers to lower royalty rates, a critical part of its balance sheet. According to the terms of the deal, music publishers will receive lower royalty fees from Spotify in exchange for the music streaming service restricting big new album releases to its paid tier. Before now, all music launches were available simultaneously on free and paid tiers. (See also: Spotify). 

Here is a brief primer on Spotify's finances and risks. 

The Financial Picture 

Spotify is valued at $13 billion in private markets. The Swedish company raised $1.5 billion in debt financing during its last funding round from an array of investors, including Goldman Sachs and private equity giant TPG. Per the terms of that deal, the company is required to pay 5 percent annual interest on its debt. The interest will increase by 1 percentage point until the company goes public. That is when investors will be able to cash in their bonds for a 20 percent discount to the company’s proposed stock price. (See also: Startup Analysis: How Much Is Spotify Worth?)  

The most important thing to remember when evaluating Spotify’s finances is that its fortunes are intertwined with those of the broader music business. The industry has been in steep decline since the start of the millennium, when services like Napster and Apple Inc.’s (AAPL) iTunes disrupted the business model. Rampant piracy coupled with the unbundling of albums played havoc with the industry’s model. Unit sales and royalty rates have not been enough to offset the decline in sales.  

But things have taken a turn for the better of late. The industry reported its second successive year of profits last year, thanks largely to music streaming services. According to research from Goldman Sachs, streaming has become a much more sustainable revenue model for the music industry. Goldman forecasts streaming will help industry revenues double to $104 billion by 2030.     

While it helped revive the industry, Spotify did not partake in much of its success. The London-based startup reported impressive revenues of $2.2 billion in 2015, the last year for which its sales are known. However, it paid $1.8 billion of that figure out to music labels. After adding in costs for marketing and administration, the startup’s finances tallied to a net loss of $194 million in 2015. And its royalty costs aren’t going down anytime soon. According to reports, publishing rights can be “as much as 15 percent of a deal,” up from 10 percent a couple of years ago.  

The Competition 

When launched 11 years ago, Spotify was part of a crowded field, one that included the likes of Rdio and Rhapsody. But the arena has whittled down considerably since then. As other services closed shop, Spotify survived and thrived. But it faces a new set of formidable competitors. Apple launched Apple Music in 2015 and Inc. (AMZN) undercut Spotify’s $9.99 per month price for paid subscribers by offering a $5 subscription service through Amazon Music. 

Both services have made impressive gains in a short period of time. Apple’s service, which was launched in 2015, already boasts 27 million subscribers, as of June 2017. Amazon has refined its algorithms and integrated its service with Alexa, it’s smart assistant. (See also: Amazon And Pandora Offer $5 Music Streaming Service.

There are two ways in which Spotify’s new competitors can affect its business. 

First, they apply margin pressure on the company because of the strength of their brand. For example, Apple Music reported gross margins of 40 percent last year while Spotify had margins of 25 percent. This was partly because the company increased its marketing costs by offering deep discounts to attract more users to its service even as its royalty rates remained the same. The company’s gross margin per user declined to $3.45 in 2015 from $4.20 in 2013. 

Second, Apple and Amazon have deep pockets and offer a number of channels for music labels to mop up additional revenues from their content. For example, Amazon Music could drive merchandise sales for music labels on its e-commerce site through song promotions. Similarly, Apple has attracted superstars like Taylor Swift to its service. 

But Spotify is taking steps to counter competition. 

A surge in its user numbers may help the service in the long run. Spotify has 50 million paid subscribers, as of this writing. According to reports, it is responsible for 10 percent of revenues at prominent music labels. This gives it sufficient negotiating leverage to help drive down royalty rates. 

Spotify has also begun diversifying its business and reducing its reliance on music labels for content. It is expanding beyond its core offerings into video and podcasts. The service has 12 different video series under production currently. Media partners for its video stream include the likes of BBC, Vice, Turner, Viacom (VIAB​), and Walt Disney Co. (DIS). As mentioned earlier, it has also reached an agreement with music labels to restrict big releases to the paid tier category, instead of offering them for free (as it has done in the past). 

Risk Factors

Spotify’s recent growth has cost the company. Its sales and marketing costs ballooned by 42 percent between 2014 and 2015. As the service ventures into new products, costs will likely increase and eat into its overall profitability. New agreements with music services may have helped the company garner more business but contributions to its balance sheet will likely be offset by fresh fees. 

Market reception and content costs for its new ventures will play an important part in determining the service's success. Spotify has not disclosed costs associated with new products. However, given that the service is working with premium content providers for the new series, it is likely that they will be substantial. If the new series do not offer substantial returns, the costs will be sunk

Then there is the scale and breadth of the competition. When all said and done, Apple and Amazon have deep pockets and famously profitable businesses beyond music. This means that they can absorb losses from their streaming music lines and show profitability elsewhere. Spotify is completely reliant on music streaming, a business that is heavily dependent on royalty rates from music publishers. The case of Pandora Media Inc. (P), which is under pressure to sell, is an example of what can go wrong when music streaming businesses take too long to innovate.

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