Hey Mr. Deejay, Show Me Your License

Covering fees to play music may hold back the hottest Internet music services

Are digital music services doomed to a life of ugly licensing wars?

The tale of an underdog music startup, brought to tragic demise by greedy record labels, is so familiar it’s practically a cliché. The road to iTunes is littered with the corpses of reimagined Napsters.

But a new class of wide-eyed digital music startups hope to change all that. Free or “freemium” services like Pandora, Spotify, Slacker, Turntable.fm, Rdio, Grooveshark, Radical.fm, and CBS-owned Last.fm are competing for ears and a piece of an $800 million pool of audio ad dollars, according to eMarketer’s 2011 spending prediction (other revenue streams—like display ads—are also available to most). But before they can mature into ad-ready businesses, the services need permission to distribute music (something ad-supported terrestrial radio has never worried about). Last week a group of Nashville songwriters sued Grooveshark for streaming unauthorized music after Universal Music Group and EMI had done the same. “When you are changing the way a multi-billion dollar industry operates, you are bound to draw some ire,” said Grooveshark svp of business development Paul Geller.

Investors don’t seem worried, as the startups have accumulated almost $400 million in venture backing. And despite a lack of profits, Pandora’s June IPO valued it at an unprecedented 19 times 2010 revenue. CEO Joe Kennedy smartly parlayed the company’s licensing challenges into a plea for public sympathy. Pandora’s near destruction by royalty battles in 2008 was widely documented, boosting its name recognition and scale.

Unlike Spotify or Grooveshark, Pandora’s streaming service doesn’t offer its more than 100 million users music “on demand.” Yet the company paid just over half of its revenue in licensing fees in the first nine months of 2010, according to its S-1. That rate expires in 2015 when it’s expected to increase.

The question is what Pandora and its smaller competitors can afford. Jim Cady, CEO of Slacker, which offers both on-demand and programmed radio, says it’s really a question of scale. Slacker can’t survive on advertising dollars alone, which is why the company also offers a premium download service. Spotify and beta-mode Radical.fm also supplement their ad revenue with subscription dollars.

“In a fully mature market, licensing fees won’t be so high because [streaming services] will be able to send twice as many commercials as they are now,” Radical.fm CEO Thomas McAlevey said. Can that happen by 2015? Pandora hopes so.

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