“I’d rather be raped by The Pirate Bay than shafted by Hasse Breitholtz and Sony Music.”

Swedish artist Magnus Uggla, speaking of Spotify’s major label ownership and low payments

He actually said something more emphatic than “shafted“, but this is a family blog. You get the idea. It’s in this graph courtesy of our friend Faza at his most excellent blog, The Cynical Musician.

This 2010 graph may no longer be exactly correct on the number of streams at the Spotify end of the equation, but I think it is spot on–so to speak–on the relative numbers. I think that the aggregate Spotify payout rate they use is a little low now, although it may well have been correct in 2010 when there were fewer premium service subscribers to Spotify. The aggregate payout rate will skew higher as more users sign up for the subscription service over time (I’m focused on the total number of subscribers, not where they live, i.e., not the number of countries where the company operates). But what really hasn’t changed is the general message of the graph–independent artists make a lot more money selling CDs and permanent downloads than they ever make on streaming services. This is not news. You can agree or disagree that streaming services do or don’t cannibalize sales of higher margin items, but it seems that you have to be completely convinced that “obscurity is your biggest enemy” and that somehow your being on streaming services solves for that problem sufficiently to make it worth the risk.

And remember that you probably won’t be joining Daniel Ek (the Spotify CEO) on the Rich List anytime soon and that his salary surely must be paid by the venture capitalist investment in his company and not by revenues. Sure there’s some correlation between those two, and no there’s nothing wrong with raising venture money if they send in the clowns once again. But a $180 million rights payment implies a $77 million share for Spotify, and that’s not enough to get you on the Rich List based on cash. Or at least cash from advertising and subscriptions–which makes one wonder if there’s some other source of revenue that’s not being reported. But then Spotify CEO Daniel Ek said that “turnover” (roughly gross “revenues”) for Spotify in 2011 was $250 million and that in an interview translated in PaidContent, “’It is not unlikely that, already this year [April 2012], we have a turnover of more than SEK 6 billion ($887 million),’ he added.”

The point being–your music is worth a lot more than Spotify (or any other on-demand streaming service) is paying for it. And we have Daniel Ek to thank for that realization, the person that Forbes called the most important man in the music business. Do you think Irving agrees? (Thus proving yet again how little the suits know and how little they care about demonstrating to the world how little they know.)

Remember–when Spotify has its liquidity event–IPO or acquisition–you will not participate in that cash. Daniel Ek, venture investors and Spotify employees (and probably the “artist evangelists”) will participate in the company’s $1 billion valuation–that’s how you get on the Rich List. You will not, even though the entire value of the company is based on the life’s work of artists, songwriters, producers, remixers, engineers and so on. The way working people in the music business participate in these things is through current royalties. If you don’t capture the value then, you never will. (Could this be a reason for the “artists are lazy and want to be guaranteed an income forever” meme we here so often from the odd fellows who want to cut off artist royalties because creators don’t deserve it?)

So maybe the unelected Spotify “artist evangelists” should spend less time counting their stock options and more time coming up with a better way to compensate the artists they supposedly represent.

Is it fair? As super agent Ari Emanuel said famously, “Fair is where we end up.” Right now, I don’t think this model is fair to the artists or the indie labels. But I don’t think we’ve ended up anywhere yet, so the whole system needs to make an adjustment closer to fair. And that won’t happen by itself. Given that these services, and especially Spotify, have insulated themselves from situations where they could be forced to negotiate with independent artists (and also given antitrust concerns) about the only way that I can see these deals getting more fair is if artists raise these concerns in a variety of ways and maybe the message will get through the the Spotify board room.

The Basic Math:

The first thing to realize about subscription services is that with one exception that only applies to major labels, they do not calculate royalties on a per-unit price, or in their case a per-stream price. They pay a share of a defined set of the service’s revenues (e.g., from advertising) that is allocated by how many streams you had that month as a percentage of all the streams.

So if you had 30 tracks on the service and the service had 15,000,000 tracks that were streamed an average of 20 times each (realizing that probably 40% of these tracks are streamed fewer than 5 times, and probably 20% of the tracks are streamed hundreds of thousands of times), your share of the month’s advertising pie would be the net revenues multiplied by 30/300,000,000, divided by 30 to get to a per-stream result. I won’t depress you further by doing the math, but you get the idea that it’s not much. It’s just an example, it could be better and it could be worse. This should explain why major labels are rumored to get a per stream minimum (discussed below) and why you don’t.

That is the biggest difference from iTunes financially speaking. When iTunes tells you you sold $100 of downloads, if you know what your wholesale price is (which you would because you set it) you know how many units you sold and vice versa. When a revenue share service like Spotify tells you you made $100 of streams, the number of streams may vary from month to month depending on the value of the advertising inventory on the service during that month. Advertising, as you will see, is one of Spotify’s principle products–unlike a download. One model focuses primarily on selling advertising, the other on selling music.

Because Spotify accounts on a pro-rata share of advertising revenue for indie artists, you have to make an assumption about what the revenue will be on average. For indie artists, the revenue calculation is something along these lines:

Ad-Supported Service: 50% of the gross advertising revenue less certain deductions multiplied by the label’s (or the artist’s if the artist is the label) prorata share of performances for the accounting period concerned.

Subscription Service (including mobile): the greater of (a) 50% of gross subscription revenue (less the deductions) multiplied by the label’s prorata share of performances for the accounting period concerned and (b) certain negotiated per subscriber minimum payments multiplied by the total number of subscribers and multiplied again by the label’s prorata share of performances (all for the accounting period concerned).

Rumor has it (to coin a phrase) that some labels (four soon to be three guesses) also get a third tier in the greater of formula which is a per-play minimum. If I had to guess, I would guess that minimum is somewhere around $0.01 per play.

If the artist is signed to a label that is accounting to the artist for the Spotify income, then the artist share will probably be somewhere between 10% and 50% of the label’s share depending on the artist’s deal.

Don’t hold me to these numbers being exact, but I think it’s pretty close to what I have described.

So for the ad service alone, if Spotify grosses $100 in a month, it can take certain deductions from that $100 like sales commissions or other fees paid to advertising agents for sales of Spotify’s advertising, sales, use, value added or similar tax on Spotify’s sales of ad inventory, any fees paid to publishers or societies, and probably some other things. Let’s say those deductions equal 50% of gross (typical ad sales commissions at 35% and publishing at 15%, both calculated on 100% of gross so you can just add the percentages), and that the taxes are zero. (35% and 15% are kind of benchmarks for the maximum caps on these costs in rev share deals so in a good month the actual costs may be lower, but I would bet that the Spotify accounting system sets up these costs at the maximums, just like label accounting systems take a returns reserve at the maximums allowed.) I don’t have time to do the subscription service calculations, but you would add credit card fulfillment fees to the off the top costs, which can be significant. The point is that Spotify (like most subscription services) can deduct most of their third party non-overhead costs off the top.

Spotify then keeps 50% of that net number and shares the other 50% with the label, but allocates the label payment based on the label’s share of total performances. (Remember, the independent artist will be the label and rumor also has it that certain labels get more than 50%.) So when you hear Spotify’s artist evangelists say that Spotify pays out “70% to rightsholders” did you think that the revenue share was 70% and not 50%? That would be an easy mistake to make. A very easy mistake.

Let’s say the label has 1% of the total plays on the ad supported service that month (which is the typical Spotify accounting period). Realize that most independent artists will have far, far less than 1% of the total plays on Spotify in a month, but let’s keep it simple.

So it looks like this:

$100 – $50 out of pocket costs = $50

Spotify’s 50% share: $25

Our label’s 1% prorata share of $25: $0.25 (realize that the total payment to all the labels will equal $25)

Artist’s share for the month assuming the artist counts for all of the 1% market share of the label: somewhere between $0.025 and $0.125 depending on the deal. I can’t get to a per-stream payment because I didn’t feel like making assumptions for number of streams. So if you want to make some assumptions go ahead and divide the label and artist share by whatever number of streams you think equals a 1% market share on the entire Spotify free service in a month. It’s a lot. They have 15 million tracks or so. You should read “Why Spotify Doesn’t Make Sense for Musicians: 70,000 Listens Earns Less Than $300” about cellist Zoë Keating’s publishing her Spotify royalty statements in a public Google doc. And as far as I can tell from the article and the statement, that $300 is the label’s share over 6 months because Zoë Keating is both the label and the artist for these streams. A little quick math and you get to $0.0042-ish per stream before aggregator commissions.

Artist share for the month if there are 5 artists on the label: somewhere between $0.005 and $0.025

So these are very low payments whether you did the calculation in 2010 or last night. There is an undercurrent in Spotify’s defense of its payouts that is starting to sound like a criticism of the label split with the artists. But even if the split was the 50/50 that was established in the “Eminem case,” an extraordinarily low payment is even lower when it’s shared. Spotify can be “shocked, shocked” that artist payments are low, but alarm is a little…well, cinematic.

I would guess that the way Spotify gets to the 70% payout to “rights holders” that was reported in Digital Music News is if they include publishers and if some labels get more than a 50% split. (Otherwise why didn’t they say “labels”–“rights holders” is more inclusive.)

Another way to look at this is that for every $100 of gross revenue on the free service a label with a 1% market share makes $0.25. (Or for every $1 million of gross revenue, $2,500).

The subscription service will be somewhat better depending on the negotiated per-subscriber minimums, but also remember that the conversion ratio from the free to the premium service is relatively low so “better” is relative. Remember, Spotify has cleared over 15 million tracks, so in reality, the artist net is probably a lot smaller due to the proration. By the way–there is nothing particularly magical about the Spotify deal compared to other subscription deals or rev share deals. So don’t start looking for something sinister in the calculation. The shenanigans are probably not in the rev share, it will be other places, like on what doesn’t get included in gross for example.

Rumor has it that the way Spotify (and most other subscription services) define advertising revenue is as monies received by Spotify for sales of in-stream advertising, sponsorships and promotions and display advertising, sponsorships, promotions that appear on the Spotify client during playback.

I hear that subscription revenue is defined as revenue from the various subscription “tiers” from subscriber fees, access charges, perstream charges and subscription fees from the subscription service, as well as referral fees, bounties, affiliate fees and the like from sales of products and services offered by means of the subscription service. Does this include Spotify’s “sponsored playlists”? Not clear.

Oh, but of course it must be said that both these calculations exclude hardware that plays Spotify sold through the service. Now call me suspicious, but whenever I see something specifically excluded from one deal, I know that it is so easy to change that “ex” to “in” and it makes me wonder what other deals might say (with you know who, perhaps). Particularly in the absence of MFN treatment.

And then of course if you are going to Spotify through an aggregator, you have to deduct the aggregator’s commission.

Now there’s a business, eh? I understand now why the need so much venture money to cover their burn.

This is not to knock Spotify as a service but the numbers are what they are so it’s important to keep that in perspective. I don’t quite understand what the comparison between the Spotify subscription service and iTunes is meant to prove, and I also don’t see how Spotify could be the second highest income source for record companies. If you take the claim that Spotify has paid $180 million to labels in 2011 on a worldwide basis and you wanted to see if Spotify was the second highest revenue source, one way to do it would be to determine how many CD sales it would take to equal $180 million. If Spotify was second, you would expect CD sales to be less than $180 million. (Which seems totally implausible to me, but let’s go with it for a minute.)

In order to make that calculation, you’d have to make an assumption about the blended wholesale price of CDs if you wanted to get a feel for the unit sales. If you took a fairly high average wholesale price, say $9, that would mean that 2011 CD sales were under 20,000,000 units on a worldwide basis. If you took a fairly low average wholesale price of say $3, that would mean that 2011 CD sales were under 60,000,000 units on a worldwide basis. Adele alone has sold 22 million. So I feel like there’s some missing data there somewhere. But then I didn’t go to Harvard and I’m just not as smart as these city fellers. $180 million is not nothing and it definitely gets you a NARM board seat, but I don’t quite follow how it makes Spotify the number 2 revenue source behind iTunes but ahead of CDs on an industry wide and global basis. And neither does Glenn Peoples.

So what is appalling about Spotify is not that the payouts are small, not even that that they refuse to disclose the kind of detail an artist would need to know in order to determine whether using the service is a good idea–that’s nothing new, for years major label royalty statements have given artists just enough information to almost but not quite know what’s going on.

What’s appalling is that they are getting so rich off the backs of the artists, songwriters, producers, remixers, and indie labels that provide them with their sole product.

As I told the Austin Chronicle in a recent interview:

“To me, it’s a lot like the record clubs,” offers Castle, referring to the mail-order companies of last century, like Columbia House and BMG. “Record clubs were owned by the labels, and once you got put out by the record club, you became part of this giveaway program. The royalty rates for artists and songwriters went way down, and if you worked at one of those labels that had a record club, there was no way they were going to let you hold back those records because the profit was just too great.”

When I worked at A&M, I did everything I could think of to put bombs in the recording contracts that would disincentivize record clubs from putting out our records. 12 month or “reasonable” holdbacks, no reduced rate mechanical licenses, everything I could think of. Did it stop them? Sometimes. But it slowed them down.

And even if the “Information is Beautiful” graph may need to be updated, what definitely hasn’t changed is that it looks like the people who are really making the money out of Spotify’s cash flow are selling the advertising. That’s another point of disclosure that it would be nice to know. Maybe that was announced and I missed it, but I’d love to know which adserving networks Spotify uses–and if it has an ownership interest in any of them. And whether the $1 million each that its US launch partners reportedly paid for the privilege ended up in the pockets of any artists (Chrysler, Coke, the Daily, et al).