Business Models Study on the Business Model of Innovation and making Revenue from a “freemium” modelSubmitted By:Anirban Ghosh2011PGP545
It is 2000 and news broadcasters all across the world are beaming images of Metallica frontman LarsUlrich filing a case against Napster, the poster boy of the IT boom of the last century. Metallica, a bandcomprising of billionaire musicians filing a case a case of “property theft” against a peer-to-peer sharingnetwork for “unlawfully” posting one of its songs on its network. This first case of an artist suing peer-to-peer (P2P) networks set the precedent for a long and continues battle which continues to be played outin courts today. Cut to 2008 and we are witness to another major website piratebay.org being forced tochange its domain name to piratebay.se. Ranked in the list of the “Top 100” most visited websites acrossthe world, this network developed by 4 Swedish personnel was found guilty of “facilitating illegaldownloading” and was “the most visible member of a burgeoning international anti-copyright or pro-piracy movement". Clearly opinion is still divided upon where the jurisdiction ends and technology cantake over.The world and the internet have come a long way since Shawn Fanning set up Napster from his dormroom at Northeastern University. Between then and now the world has come a long way, we had a hostof KaZaa, Morpheus, Gnutella, LimeWire etc. which allowed transfer of a variety of media via torrentand other sharing mechanisms, but where generally under the radar of authorities because they did notovertly focus on any particular type of media like music or movies.iTunes conceptThe truly phenomenal entry into the music sharing segment was of i-tunes, the music sharing servicedeveloped by Apple Inc. introduced in January, 2001. iTunes is a media player computer program usedfor playing, downloading, saving, and organizing digital music and video files on desktop or laptoppersonal computers. iTunes is based on the iTunes store concept and the single song purchase. The useracquires full rights to enjoy music by paying a fee for each number. In this model, the user becomesowner of the music. The acquired songs can freely be moved to an iPod or other mobile devices. Thedevelopment of iTunes crunched the CD as a medium for music. In response, artists often produce only4 – or 8-tracks instead of a complete album.iTunes as a service has generated billions of dollars for Apple Inc. The latest trade estimates state thatiTunes will generate atleast 13 billion dollars in revenues by 20131. So in other words ever since itsinception, iTunes attacked the basic fundamental of the bricks-and-mortar retail music industry andbrought in a revolution very few had envisaged. The iTunes business model is based on the concept ofan à-la-carte MP3 store, where individual songs can be purchased all at the same price. Apple signs dealswith all major record labels and in effect acts as an intermediary between the label and the consumer.For every 99 cents song sold on iTunes, Apple receives a 35 percent cut. iTunes currently boasts a libraryof 20 million songs which have been downloaded 16 billion times and still counting, clearly there is verylittle that can dislodge iTunes from the top of the mountain, but only until now.
Enter disruptive technology in the form of SpotifySpotify was developed in 2006 by Daniel Ek, A former CTO of “Stardoll”, and Martin Lorentzon, co-founder of “TradeDoubler”. They incorporated a company called Spotify AB in Sweden.Their official website states “All the music, All the time” which more than needed explains all thatSpotify is about.As of May 2012, the service is available in Australia, Austria, Belgium, Denmark, Faroe Islands, Finland,France, Germany, the Netherlands, New Zealand, Norway, Spain, Sweden, Switzerland, the UnitedKingdom, and the United States. As of May 2012, Spotify had a total user base of 20 million users, out ofwhich almost 3 million opt for the Paid service.So what does this service do, Spotify aggregates content from right holders, distributes it toconsumers through the technical platform and monetizes both through a free, ad funded service,and a subscription service.Before going about discussing the business model of Spotify, it will be good to have a look at theindustry it operates in, the global music industry.The global music industryA dynamic market, the global music industry is characterized by many players and fierce competition.Today the music industry has almost become a business model playground with scores of companieshighlighting the limitations of the brick-and-mortar recording companies.The music industry ecosystem consists of the following key players:Key players- consisting of distribution channels and manufacturersKey activities- consisting of ‘detecting talent’ and ‘marketing and promotion’Key resources- consisting of ‘copyrighted content’ and ‘portfolio’Services to offer- hits and wannabe hitsCustomer relationshipsCustomer segment- Mass marketChannels- consisting of retailers, TV, radio and digital channelsCost structure- involves marketing and promotion, subsidizing unsuccessful artists and royalty paymentsRevenue Streams- consists of sales of CD’s, merchandizing, tours and concerts
To understand the various business models, we will use the following framework of the music industry:The problem with the traditional business model was:
How Spotify has changed the ‘status quo’According to strategist Camilla van den Boom “Spotify operates a so-called “multi-sided platform”business model.” In a multi-sided platform, one player (in this case, the advertising party) finances theother player (in this case, the one accessing the music). Spotify serves these two customer groups thatcannot exist without each other: the music seeker and the advertiser. Both these segments exist in asymbiotic coexistence and cannot exist without each other.Spotify as a service provides a benefit for both of them. The user (”seeking music/fan”) is looking formusic and the experience of music. He is satisfied as long he is able to get the type of music he wants,irrespective of whether he is paying for it or not. The advertiser is looking for an audience to advertisefor their products. Spotify manages both segments by providing free access to music in a legal way. Forthose who do not want advertising, there is always the premium (paid) model. The user can listen tounlimited music for a nominal monthly fee. For those who do not want to pay, all they have to do is putup with the advertisements. Through Spotify, the user buys off the rights to listen to the music.These sentiments are perfectly echoed in the words of Camilla Boom who states “Spotify is adistribution channel for music rightholders (record companies and artist aggregators). They use Spotifyas a channel to reach their customers.” Thus, Spotify has a mixed advertising or in its own word a“freemium” business model.Specifically, there are three pricing tiers:1. Free: You can download and listen to Spotify for free. However, there are ads (audio and display) andlimitations on listening duration2. Unlimited: At US$4.99/month, you can enjoy unlimited listening time without any ads3. Premium: At US$9.99/month, you can enjoy unlimited listening time without any ads and you areable to take songs mobile on other devicesRepresented pictorially, it can be visualized as:
Spotify with its new value system added a few dimensions to the existing industry framework, eg:Inclusion of bandwidth cost and salaries under Cost Structure, Key Activities for Spotify is platformmaintenance and development, similarly on offer is both music and advertising and other fewmodifications which are elucidated in the model below.The ways in which all these interact with each other are:
How Spotify’s freemium business model workThe creators at Spotify have clearly understood the human behavior and put the theory of “free drivespaid” into practice. They understand that the user wants to listen to (access) music. And the user is(under certain circumstances) also willing to pay for music. Therefore, Spotify has two services on themarket: Free and Premium. But then the fundamental question arises, why are users willing to pay formusic if it is available for free?The application of Spotify is easy to install and easy to use. It can be used to play (access) music on anydevices like ones PC, mobile and even a car. The music literally moves with the person who is accessingit. The application also provides the user with many opportunities and options how to build your playlistand music library. And the user can easily share it with his/her friends, via email or Facebook or anyother social networking platform. The Spotify user invests much time in building and sharing his or hermusic and these investments are the driver in the Spotify business model and Spotify make use of this ina good way. The user starts using Spotify in the free version, with advertising. While getting to know theapplication, a complete new world opens up. The level of customization and personalization is such thatuser can play with it the way they want. And after a while, the user starts getting bothered with theadvertising and shifts towards the paid subscription model. This concept ‘free drives paid’ is fullyunderstood by Spotify and built into their business model.Will Spotify kill iTunesToday iTunes still pretty at the top when it comes to online music platforms. On its introduction, it beatthe brick-and-mortar model on selection, convenience, and price. As an online marketplace it had afundamental advantage. Since it was online, it was omnipresent, in one’s home, there were no physicallimitations, no inventory, and could beat any existing service offering on price because of its lower fixedcosts.Now, a decade later we have Spotify. Based on the job of providing music to those who want, anytimeanywhere, Spotify completes this job in much the same way as iTunes does. Spotify is convenientlylocated, has a wonderful selection, is compatible with ones computer, smart phone, and tablet (whichare in turn compatible with the stereo and car), and is backward-compatible to play music from anyexisting iTunes library.So on the face of it does not seem Spotify has any fundamental advantage over the incumbent. Even ifSpotify competes in a similar fashion, that doesnt necessarily mean its better than iTunes. Indeed,Spotifys library of just 12 million tracks does not even come close to those on iTunes. And thoughSpotify is compatible with a handful of important devices, iTunes user base continues to increase day-by-day. But this is the nature of what Professor Clayton Christensen calls low-end disruption. He definesit as “at first, a disruptive product fails to deliver a superior offering to the incumbent technology in oneor more characteristics of the job-to-be-done. But consumers switch nonetheless because the disruptorhas a systemic advantage in at least one of these characteristics. We gave up minicomputerperformance for the cost advantage of PCs, we gave up plasma television contrast for the slimness ofthe LCD, and we gave up the personality of written letters for the speed of emails.”
In an analysis done by Maxwell Wessel at Harvard, he says that Spotify holds a systemic advantage overiTunes in one particular job characteristic of delivering music: relative pricing. While iTunes and Spotifyboth deliver music over the net, Spotifys position as a radio service lets it price far below the level ofiTunes. For $10 a month, one can gain access to unlimited music as long as they are listening through aSpotify music player. A person doesn’t even have to be connected to the net. Because Spotify paysrecord labels only a small royalty by audio stream, it has aligned its business model around this lowpricing, which in itself is a business model innovation.Though Spotify did not pioneer this disruptive innovation, it is the first time mainstream media isexposing the American public to it. And we know its disruption because it is a business model,fundamentally advantaged in one of the characteristics we value in completing the job-to-be-done.Whether it displaces iTunes or not remains to be seen but according to analysts Spotify is here to stayfor the long haul.Spotify co-branding with other companies: a strategy for sustained growthSpotify has partnered with a number of well-known brands in different industries, linking its name andlogo to the ones of those other companies. Let’s have a look at a few of them:Spotify and Virgin MobileVirgin Media is a telecommunication company and a mobile operator based in UK. It offers a threemonth Spotify Premium account to the customers that buy one of their Premier or VIP collectionpackages (Virgin Media, 2012). With the new offering launched in 2012, they have integrated Spotifyinto its TiVo box, which gives users the option of enjoying Spotify on the television. Also those whosubscribe to some selected packages on their phones, get access to a 3 month free premium account.This was an important collaboration for Spotify because through this their logo got visibility across awhole range of media. A snapshot of the website in shown in the Exhibits.Spotify and SEATSpotify entered a partnership with a Spanish car manufacturer called Seat. There was another companywhich was a part of this partnership Samsung. According to the deal, Seat came up with a model calledIbiza Spotify with a Samsung smart phone as a gift with Spotify preinstalled on it for 6 months withoutany charge. This was advertised in both TV and print media. The Spotify logo was also shown on the Seatwebsite, websites for car lovers and magazines.Spotify and VolkswagenThe partnership with Volkswagen, the world’s second largest car manufacturer consisted of a websitecreated by Volkswagen which would have the functionalities of a music player and users could log onand suggest songs and post and share the same. The website had the logo of Spotify and it branded boththese 2 brands together in the eye of the user.]The advertisements for each and snapshots of their websites are mentioned in the Exhibits.
Revenues for Spotify: is the “freemium” model making moneyMusic Ally, an industry wide internet source, published the annual financial statement of Spotify in early2010. (Statement attached in the Exhibits)According to them, almost 60 percent of company revenues are coming from subscriptions and rest iscoming from advertising. As of 2009, Spotify had a total of 7 million users of which around 250,000 werepaying subscribers. In July 2010, the company said it had 500,000 payed users, and in late October 2010,it was rumored to have 650,000 paying subscribers. Roughly speaking, Spotify adds approximately41,600 new paying subscribers per month.A cursory look at the revenue statement of Spotify as published on Music Ally shows that the companylost more than $42 million during 2009 and 2010. This does not present a rosy picture on its own but acloser look at the revenue statement will show that the loss as a percentage of revenue was muchsmaller than the prior year. This shows that as the service matures and gains popularity, it is gainingscale and also leverage.The biggest cost item on its income statement is "Cost of sales", which mainly includes music licensingcosts. The music licensing costs were bigger than revenue. This means that even before paying for itsactual business costs-on offices and salaries and database servers, Spotify has spent more than it takesin. Amongst all this negativity in the numbers, the good thing although is attributed to the following: Spotifys growth is through the roof: Revenues grew a stunning 458% from 2009 to 2010. Thats impressive for any business, but even more so from one that starts from an already relatively high base of eight figure revenues. These numbers do not seem to show any sign of abating in the coming years Spotifys losses are narrowing: Losses were 147% of revenue in 2009. In 2010 they were only 42% of revenue. Not a very impressive number but taken in the context of an industry in which it is almost impossible to make money and the growth that is projected, seems likely to narrow down in the coming years Cost of sales v/s revenue growth: The biggest cost item on Spotify’s sheet ‘licensing fees’ grew at a rate of 345% between 2009 and 2010 while the revenue grow at 458% during that same period. The fact that costs are growing at a lesser arte than revenue suggest a bright future for the service in the coming years.According to analysts at a successful website called “business inside”, a successful freemium businessgenerally has the following attributes: A large free user base A low marginal cost to serve each new subscriber A product whose value to the user increases over time.
We can do well to analyse Spotify on each of these parameters individually:It already has a huge free user base. Spotify already has many millions of free users (see chart inExhibits). Its product is highly critically praised. Whats more, Spotify has been a large beneficiary ofFacebooks new platform product, which allows music services to turn users activities into viral socialsignals. With a continued presence in the 12 most developed nations and further expansion on thecards, Spotifys user base should only increase from here.Spotify also appears to have a low marginal cost per subscriber. The key cost-per-subscriber is theroyalties Spotify must pay to content owners. Once it has made the initial payment there is very lesstransaction cost because it does not have to bear the cost of each new subscriber. This is because itprovides a platform akin to a peer-to-peer architecture where users can share their music with others.We can presume that the pricing structure followed at Spotify is such that most of the users turn out tobe profitable relative to the amount of service they have access to. These profitable subscribersprobably offset the costs of those who consume music 24 hours a day. Right now it can easily raisemoney privately and seems to have good relationships with the music industry, but this high cost base isgoing to be a problem for Spotify.The final question is whether Spotify becomes more useful to users over time-and the answer is yes.And this is important, because it will allow Spotify to convert more free users to paid users over time. Asmentioned earlier Spotify operates on a “free pays paid” model and this is shown in the conversion ratioit operates on. It boasts of a high conversion rate on active users, around 15% (chart mentioned inexhibits).These ratios are higher than the average conversion rates seen across this industry. The key,this person explained, is that Spotify creates an "emotional connection" between the user and theproduct (and it is, indeed, a very pleasing product to use).The underlying idea is the same: freemium products that succeed do so because their value to the userincreases over time.As explained earlier, at first, Spotify is just music. Then it becomes music, plus their playlists, which theyhave taken a lot of time to put together, plus their friends playlists, which they can access easily in thesoftware thanks to Facebook integration. Once the "emotional connection" with the product isaccomplished it becomes much more compelling to pay up.What does the future hold for SpotifyA big step taken by Spotify in the last one year was the launch of its service in the United States. Eversince its launch in July 2011, the service has become a corner stone of the music industry and this showsno sign of abating.It also partnered with the biggest social media platform on the planet Facebook in an effort to helpusers access, discover and share more music. As c0-founder Daniel Ek says "Ownership is great butaccess is the future, people just want to have access to all of the worlds music." With Facebookintegration, users can do exactly this and also almost instantaneously.
In November of 2011, the company launched Spotify Apps, offering listeners a more immersive musicexperience. For example, when streaming a particular artists track, a user can access a Songkick app andsee if the artist is performing in their town.Spotify does not want to add customers who are already using iTunes, it knows that out of 500 millionpeople listening to music worldwide, a very small percentage is actually tuning in through iTunes, itwants to reach out to all these 500 million people and the user base of iTunes alone.With a wave of expansion on the cards and further integration with social networking sites, Spotify isclearly changing the way music had been perceived till now and distributed. The system seems to be awin-win for all the members of the ecosystem. There are the record companies which now have a wayto reach out to the global music fan and gets paid for his records. There is the music fan who can nowhave unlimited access to his favorite songs for a fee or if he is not irksome about the ads, can also have itfor free. Couple it with the notion of seamless connectivity and integration with social networkingplatforms only shoes that Spotify has succeeded where other platforms have failed, in giving theindustry a legal, fast and easy to use service to transfer music. It only remains to be seen if it can fulfillthe expectations everyone places on it, and if numbers are to believed, it will do so.
Exhibit 1: Balance Statement for the year 2010Source: Music Ally
Exhibit 2: Current Spotify user baseExhibit 3: Conversion rate across industry
Exhibit 4: Spotify and Virgin MobileSource: Virgin Mobile websiteExhibit 5: Spotify and SEATSource: SEAT Spanish website
Exhibit 6: Spotify and VolkswagenSource: Volkswagen website
Exhibit 6: Spotify ad after 1 year of US launchSource: Spotify website
References:“Branding for Startups- A Case study for Spotify” by Yu Dai and Alberto Pietrobon, presented at the KTHIndustrial Institute, Sweden in 2012“10 Business Models that rocked 2010”- a study done by analysts at “Board of innovation”“Business models in the Music Industry” presented at the Eurosonic Noorderslag, January 14, 2011“A year after launch, U.S. Spotify users have listened to 13B songs, shared 27.8M” by Devindra Hardawarhttp://venturebeat.com/2012/07/21/a-year-after-launch-u-s-spotify-users-have-listened-to-13b-songs-shared-27-8m/ [accessed on August 5, 2012]“A conversation with Daniel Ek” by Eliot Van Buskirkhttp://www.grammy.com/news/daniel-ek-on-spotify-community-and-musics-future [accessed onAugust 5, 2012]“Steven Levy on Facebook, Spotify and the Future of Music” by Steven Levyhttp://www.wired.com/magazine/2011/10/ff_music/all/ [accessed on August 5, 2012]“Spotify’s revenue model”http://entrepid.sg/spotifys-revenue-model/ [accessed on August 11, 2012]“How Spotifys Business Works” by Pascal-Emmanuel Gobry, published October 12, 2011http://articles.businessinsider.com/2011-10-12/research/30269526_1_spotify-revenues-cost [accessedon August 11, 2012]“Is Spotifys Business Model Sustainable?” by John Paul Titlow published July 15, 2011http://www.readwriteweb.com/archives/is_spotifys_business_model_sustainable.php [accessed onAugust 11, 2012]“Free drives paid” by Camilla van de Boom published February 16, 2012http://www.businessmodelsinc.com/2012/02/16/2150 [accessed on August 11, 2012]“Why Spotify Will Kill iTunes” by Maxwell Wessel published July 22, 2011http://blogs.hbr.org/cs/2011/07/why_spotify_will_kill_itunes.html [accessed on August 11, 2012]Wikipedia entry on Spotifyen.wikipedia.org/wiki/Spotify [accessed on August 13, 2012]Official Spotify websitewww.spotify.com/ [accessed on August 13, 2012]