The Business Model of Spotify

Authors:

Roel Wieringa

Jaap Gordijn

Copyright © December 2021 by The Value Engineers

All rights reserved. No part of this publication may be reproduced, distributed, or transmitted in any form or
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Contents
Introduction .................................................................................................................................................. 4
Value proposition .......................................................................................................................................... 4
Value network ............................................................................................................................................... 6
Revenue model ............................................................................................................................................. 8
Delivery model ............................................................................................................................................ 13
Discussion.................................................................................................................................................... 14
Spotify as a music distribution channel for record labels ....................................................................... 14
Raising the subscription fee .................................................................................................................... 14
Spotify as an ad matching platform ........................................................................................................ 15
Becoming an independent music channel .............................................................................................. 16
Becoming a podcasting channel ............................................................................................................. 16
Service provider or matching platform? ................................................................................................. 17
Introduction

Spotify is an audio streaming company founded in Sweden in 2006 by Daniel Ek and Martin Lorentzon.
Its mission is

“to unlock the potential of human creativity by giving a million creative artists the opportunity to live off
their art and billions of fans the opportunity to enjoy and be inspired by these creators.”

Today, its music library contains 70M tracks and it grows with 60 000 tracks per day. On top of that, the
Spotify library contains 2.2M podcasts. Spotify has 345M monthly active users, of which 155M are
paying users, with a subscription. The number of monthly active users grew 27% year-over-year.

But despite this, the company is losing money. Its net loss in 2020 was € 581M, up from €186 in 2019.
Since its founding, it has never made a profit.

This may be resolved if the number of monthly active users continues to grow as it has done so far, and
if with the number of users, revenue grows faster than expenses. But this is not the case for Spotify.
Spotify’s cost of revenue includes royalties paid to the intellectual property owners of music tracks and
this increases with the number of active users. These expenses eat into gross profit. Operational
expenses on the delivery network then create a net loss.

In this White Paper, we analyze Spotify’s business model in detail to understand this phenomenon and
see what Spotify can do about it. We will answer four questions.

1. What is Spotify’s value proposition?

2. What is the value network by which it delivers this proposition?
3. What is the revenue model of this network?
4. What delivery technology does it use?

Jointly, the answers to these questions identify the value that Spotify creates, how this is delivered to its
ecosystem and how it captures value from this activity. As usual, we will see that the viability of the
business model is determined by properties of its business ecosystem.

This report has been assembled based on public information. If you find mistakes or have other
comments, please contact us as info@thevalueengineers.nl.

Value proposition

Spotify offers on-demand audio streaming on desktops and smartphones. As of today, it offers about
70M music tracks and About 2.2M podcasts. Users can access this audio library in two ways.

 By means of a free service financed by ads. This may offer tracks at a slightly reduced quality, but
users can build their own library, share content, view lyrics and use Spotify radio.
  By means of a premium service financed by subscription. Subscribers can use the same services
as non-paying users but are not served advertisements. In addition to the free services of ad-
based access, they can download audio tracks to listen to them offline and skip tracks in
playlists. There are extended subscriptions for groups of up to six people and reduced-fee
subscriptions for students and for low-income countries.

This creates the following unique selling points for different stakeholders.

 For IP holders such as record companies and independent artists, it has put an end to piracy.
 Compared to other audio streaming services, Spotify has a unique catalog containing the back
library of all big record labels.
 For advertisers, it offers a new avenue of getting brand awareness and conversion.
 For new artists, it offers a way to gain exposure and receive royalties in a large audience.
 For users, it allows the discovery of new songs by Spotify’s recommendation mechanism.
Value network

The following value network shows that Spotify provides distribution services to music labels and artists
by streaming it to an audience of listeners. It uses these streams to sell ads to advertisers. It shows part
of the audio streaming value network. Another diagram could be made for podcasting, not shown here.

The diagram shows three of the largest labels, which between them generate 69% of recorded music
revenue. There are many more smaller ones, many of which have organized in the Music and
Entertainment Rights Licensing Independent Network (Merlin). In 2020, these four accounted for 78% of
the music streams on Spotify (Spotify SEC 2020 Report, page 16).

Artists include composers, writers and performing musicians. Many artists are under contract with a
record company, often called a record label, which provides at least its brand to help the artists
distribute their music but provides additional services such as production, recording, publishing and
distribution. Record labels source online distribution to Spotify.

Independent artists have a direct contract with Spotify. They can get help with online distribution from
companies such as TuneCore.

Spotify partnered with many companies to create access to listeners. It can stream music from popular
series and movies from Netflix. Users can register and login through Facebook. The Spotify app is
integrated with the messaging app Discord, so that Discord users can share music. Spotify created a
streaming hub for families with Disney. It created playlists for the SXSW conference. It is the exclusive
partner for Sony PlayStation Music. It launched an entertainment bundle for students with Hulu.
Microsoft Xbox game Pass members are eligible for a four-month free trial of Spotify’s subscription
service.
Spotify sells ad impressions to advertisers, not only on Spotify itself but also on its audience network,
which is a network of advertising partners that stream advertisements created for Spotify.

Spotify has a 31% share of music streaming subscribes worldwide, compared with 16% for Apple Music,
13% for Amazon Music, and 13% for Tencent Music. The other streaming competitors, include Google’s
YouTube Music, have single-digit market shares. Competitors not shown in the diagram are internet
radio, satellite radio, and terrestrial radio.
Revenue model

Today, Spotify controls around one-third of the music-streaming market. Its user growth resembles the
optimistic exponential graphs that investors love. Today, there are 345M monthly active users, 155M of
which take out a subscription.

Source: Varun Rustomji, Spotify’s podcasting strategy, Medium Jun 2, 2020.

How is this monetized? Spotify has two revenue models, a subscription model and an advertising model.
In 2020, 91% of its gross revenue of €7.9B came from subscriptions. This is a classical subscription
revenue model, shown next.
A user must take out a subscription and then can listen to any track when giving a proof of subscription.
Every time a user listens to a track, Spotify pays royalties to the IP owners of the track. These could be
record companies or independent artists, including produces, authors, composers and performing
artists. There are four subscription schemes: Individual subscriptions are €9.99/month, a subscription
for two persons is €12.99/month, for a group of six (a family) it is €14.99/month and for students it is
€4.99/month.

In the advertising model, users listen to tracks in return for data, which Spotify uses to target
advertisements to users and sell impressions, clicks or conversions to advertisers, who pay Spotify for
this. Spotify pays royalties to IP owners. Campaigns cost at least US$250 and Spotify determines the cost
per ad served.

Spotifty thus matches advertisements to users, but this is very different from the advertising models
used by social networks. In social networks, publishers and readers of content are both users. Publishers
do not get paid for their content, as IP holders in the music industry are. Without royalty payments,
Spotify would have no users to match to advertisements, and so the core value activity of a social
network is not matching, as it is for social networks, but royalty payment.

In both revenue models, the core function of Spotify is royalty payment, not matching. Each month,
each artist is responsible for a fraction of streams. Spotify takes that fraction of the month’s revenue
and pays 70% of this to the IP holder. If the IP holder is a record company, they pay a fraction of that out
to the artist, depending on the contract they have with that artist.

Source: https://www.stereogum.com/1587932/spotify-explains-royalty-payments/news/

Estimates of how much artists receive vary from US$0.00029 per stream to 0.0084 per stream. Artists
complain about the low rates they are paid. According to one estimate, to make US$ 1 160 per month,
an artist must sell 143 self-pressed CDs or stream tracks over 4M times on Spotify.

Yet, the 30% revenue that remains for Spotify is not sufficient to cover its expenses. According to its
2020 SEC report, gross revenue in 2020 was €7.9B and the cost of revenue was €5.9B, so gross profit
was €2.0B. Cost of revenue rises proportionally with revenue.

Although the growth in the number of users resembles an exponential graph, revenue grows only
linearly and gross profit grows hardly at all. What is happening?

First of all, why is gross revenue not growing exponentially when the number of users seems to be
growing exponentially?

One reason may be that user growth is closer to linear than exponential. After an exponential start,
growth does seem to be linear. Another reason is that users are attracted with various discounts such as
the duo, family and student rates. Extended free trials and low-cost introductory deals in high-income
countries and low-cost subscriptions in low-income countries all drive user growth without
corresponding gross revenue growth. Spotify warns in its SEC 2020 report that revenue may stop
growing at all (SEC 2020, page 11).

An analysis by Anuj Shah shows that in 2018, the total subscriber acquisition cost was US$16.2, while
the total lifetime value of a subscriber was less than twice this amount, US$31.1. This is not a very
healthy ratio.

Next, why is cost of revenue so high? It contains royalty payments for tracks streamed. This increases
when the number of subscribers increases, and therefore it increases when revenue increases. This
makes Spotify’s revenue model very different from that of social networks, whose cost of revenue
nearly remains constant when the number of users increases. When a social network adds a user, the
marginal cost of delivering its service to this user is nearly zero.

The news gets worse when operational expenses are included — costs made not to stream an individual
track but to keep the business running. In 2020, Spotify spent €1B on marketing and sales, €0.8B on R&D
and €0.4B on general & administrative tasks. Deducting these operational expenses from gross profit
gives an operating loss of €293M.

Gross profit, operating expenses and operating loss

2,5
Billion Euros

1,5

0,5

-0,5
2016 2017 2018 2019 2020
Year

Gross profit R&D Sales & marketing G&A operating loss

The high cost of marketing & sales is motivated by the need to keep the user base growing and keep the
competition, Apple Music and Amazon Prime Music, at bay. Where social networks spend little
marketing money on acquiring users, Spotify spends considerable money on this. In addition, like social
networks, Spotify spends marketing money on acquiring advertisers.
After deducting taxes and finance expenses from the operating loss, Spotify’s net loss in 2020 was
€581M.
Delivery model

To support the value proposition, Spotify’s delivery model must support high-quality audio streaming on
all desktop and smartphone devices. It must analyze user behavior and recommend personalized
playlists to users.

To support the value network, it must connect with IP owners to upload music tracks and podcasts. This
includes interfaces to the big record labels as well as to individual artists that help them create music. It
must also monitor streaming to check if it conforms to the license agreements Spotify has with IP
owners. And Spotify must connect to advertisers so they can create and target advertisements, and link
to an audience network of partners who can host advertisements outside Spotify.

To support the revenue model, Spotify should verify who is using Spotify, measure which tracks are
streamed to them, when an ad is displayed and what happens to the ad.

The architecture of Spotify’s delivery network is not public, but Spotify’s technology stack shows that
they use cloud services from Google and Amazon to store and retrieve data. Fastly is providing an edge
cloud platform for content delivery closer to the users.

There are a lot of events to track in the delivery network and Spotify uses Google’s pub/sub to do this.
David Mytton gives a reasoned estimate that Spotify may be paying nearly US$300K for using Google
pub/sub. Spotify Research and Engineering jointly are responsible for €800M expense in Spotify’s cash
flow statement.
Discussion

What kind of company is Spotify? In its mission statement, Spotify says that it is a company that helps
artists make a living and enables listeners to enjoy their creations.

However, artists complain about the very small royalty percentage they receive, and some have
assembled in an anti-Spotify club. And the big record labels seem to have a different view of Spotify.
According to them, Spotify may be a way for users to discover and enjoy music, but this depends on its
primary function for record companies to distribute music and collect royalties from it. For them, Spotify
is a way to prevent piracy.

Below, we review the role of Spotify as distribution platform and then discuss the possible ways in which
Spotify could increase its revenue by playing other roles. It could increase gross revenue by raising the
subscription fee and by extending its advertising. It could reduce its royalty payments by licensing artists
directly and by extending other kinds of audio business, such as podcasts or other kinds of spoken word
streaming.

Spotify as a music distribution channel for record labels

The big record labels have a power position with respect to Spotify because they own the IP of a huge
library of music produced in the past decades that users want to hear. Users are attracted by this.
Without it, users would leave Spotify.

This is a bit similar to why some users are attracted to Netflix: old series such as Seinfeld. The attraction
is much bigger for the music back library though. Contrast this with the lack of desire of readers to
access old stories newspapers. Spotify generates revenue from the desire of adults to listen to the music
of their youth.

The value of Spotify for record labels is that it prevents piracy. If Spotify is not efficient enough in
collecting royalties and handing them over to the record labels, they could go to an alternative
streaming company. But if the record labels ask too much for the right to distribute music, Spotify has
no place else to go. In this respect Spotify’s position is similar to that of the IP rights clearance
organizations.

Spotify may view itself as a platform that matches the interests of artists and listeners, but for the
record labels it is a distribution and royalty collection channel. They acknowledge this as a risk of their
current revenue model. “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.” (SEC 2020 page 11).

Raising the subscription fee

Spotify’s monthly subscription fee ranges from 119 Rupees (€1.40) in India to 99DKK (€13.31) in
Denmark. In Qatar, a monthly subscription costs 0.1% of monthly income and in Nicaragua it is 3.9% of
the average monthly wage. Spotify believes that raising prices may push users back into online piracy. So
we can expect Spotify to be hesitant about raising subscription fees further.

The subscription-based revenue model may not be viable in the long run because it gives the user access
to content without paying for individual usage. Royalties are computed from the number of times a
track is streamed. This is bound to be more expensive than subscription fees for access. It would be
more logical if user would pay a base fee for access and a usage fee for the number of streams, similar
to telco subscriptions.

Moving to this revenue model may cause users to revert to piracy again. And it may motivate record
labels to move to the competition, taking users who don’t revert to piracy with them. Competitors
would probably continue their access-based revenue model, ignoring usage. Apple does not need to
make a profit with Apple Music, because Apple Music’s primary function is to motivate people to buy
Apple hardware, which is where Apple makes money. Amazon Prime Music does not need to make
money either, as Prime is a mechanism to attract people to Amazon Marketplace. Prime members buy
twice as much as other customers on Amazon Marketplace.

All in all, raising the subscription fee is not an attractive option for Spotify.

Spotify as an ad matching platform

A matching platform facilitates contact between buyer and seller and then lets them do their business.
Amazon marketplace matches buyers and sellers, Uber matches riders and drivers and neither platform
delivers the product or service that the user was looking for.

Spotify is different. Spotify does not match artists and listeners, or listeners and record labels, but is a
distribution channel for audio streams.

But Spotify does match advertisers and listeners. This is similar to Facebook. Facebook matches
advertisers with users. The difference is that users provide Facebook with content for free, but Spotify
pays record labels (a lot) for content. But Spotify may perhaps live from advertising fees, just as
Facebook does?

The number of ads shown or played to users is roughly proportional to the number of streams about
which Spotify must pay royalties. This is more sustainable than the subscription model, where users play
a flat fee for an unlimited number of streams. According to the SEC 2020 report (page 36), the ad-
supported service of Spotify grew 25% in 2018-2019 en 10% in 2019-2020. Spotify wants to grow this
part of the business.

But on the same page, Spotify says that their ad-supported service is a funnel that leads users to the
premium service for subscribers, where users are free from ads. It is currently a small part of the
business (9% of revenue), with a “significant” conversion to subscriptions (page 37). So we should not
expect too much of a growth of this part of revenue.
Becoming an independent music channel

Contracting independent artists would turn it into a record label, which is probably forbidden in the
contracts Spotify has with the big record labels. Spotify has chosen a licensing model where they do not
own the IP in a track, so that artists keep the IP in their work and Spotify does not become a label. The
70% payout to IP owners then goes directly to artists.

The matching part of the service to artists and listeners is similar to the service that Amazon
Marketplace, Facebook and Uber provide to their users. Spotify additionally stores music created by
independent artists, similar to Amazon offering to store third-part sellers’ products in its warehouses. It
also delivers the music to listeners, similar to Amazon delivering products to buyers and to Facebook
delivering post and ads to readers. It differs from Uber, which lets drivers use their own car to deliver
the trip to the rider.

Taking a 30% cut of a transaction every time it takes place may be normal for these businesses, but it
may not be enough to let artists live off their art. For comparison, 87% of the sellers on Amazon sell less
than $100 000 per year on Amazon. Their profits will be a lot less. For most of them, selling on Amazon
is probably a side hustle or a modest sales channel. This suggests that streaming independent artists will
help artists to be heard but may not be enough for them to make a living off Spotify streams.
Nevertheless, it is a move in the right direction of mission accomplishment for Spotify.

The revenue-generating potential of licensing independent artists is whether Spotify can continue to
identify trends in its audience segments (SEC 2020 report, page 46).

Becoming an independent music channel probably improves revenue both for Spotify and for
independent artists, but it is not clear whether this will be enough for Spotify or independent artists to
live from.

Becoming a podcasting channel

A second way to circumvent the royalty burden of the record labels is to expand outside music in spoken
word, such as podcasts, negotiating royalty agreements with podcasters directly. Spotify is expanding
rapidly in this field (SEC 2020 page 40). They currently have 2.2M podcasts, to which about 25% of
monthly active users is listening (page 37). It is not reported much revenue is generated by this.

Becoming a channel for podcasts is similar to become a channel for independent musicians. Spotify
stores podcasts, matches podcasts to listeners, and delivers the podcasts. However, Spotify can acquire
the IP of podcasts, whereas for music tracks it can only acquire licenses to stream them.

A big difference is that podcasts, unlike music, age. There will be no adults listening to the podcasts of
their youth. Spotify amortizes each period of a podcast over the useful economic life or over its license
period, whichever is shorter, starting at the release date of the period (page 49). Unlike the back catalog
of music that the record labels sit on, the library of podcasts needs to be refreshed continuously.
Here too, the revenue-generating potential of contracting podcasters depends on whether Spotify can
continue to identify trends in its audience segments (SEC 2020 report, page 46). If Spotify manages to
continue to add attractive podcasts to its library, this is an attractive way forward.

Service provider or matching platform?

As a music streaming service provider, Spotify risks being exploited by the big record labels just as some
artists are. If this is all Spotify would do, it cannot survive, because the cost of revenue rises
proportionally with revenue, and the subscription model only asks a fee for access and not for usage.
Including usage in the fee could yield a viable revenue model for streaming music, but this may cause
users to revert to piracy and record labels to move to the competition.

Opening its infrastructure for artists as third-party music providers makes Spotify a matching platform
between listeners and artists. This is similar to Amazon marketplace, which turned into a marketplace by
opening its online retailing infrastructure to third-party sellers. The analogy may extend to the sellers,
artists in Spotify’s case, who pay a 30% transaction fee when their music is streamed. It may even
extend to advertising. Sellers must pay Amazon Marketplace a fee for a place on the first page of search
results. Artists may end up paying Spotify a fee for a first place of music search results. Nevertheless,
this is an attractive way forward for Spotify.

Podcasts and other forms of spoken words offer a promising avenue for revenue growth. But podcasts
age, not as fast as news but faster than movies. So the library of podcasts must be replenished
continuously. And the profitability of the podcast library depends, just as that of the music library, on
Spotify’s ability to detect trends among user groups earlier and better than its competitors. If these
conditions are satisfied, this is an attractive way forward for Spotify.