Spotify, Stockholm, 2013
Less than a year before Facebook’s IPO, the social media company partnered with Spotify, a Swedish streaming company, to offer users of Facebook the ability to listen to music through its website. The partnership was the first step into the United States for Spotify, founded by Daniel Ek and Martin Lorentzon in 2006.
Spotify was not yet the undisputed market leader, and it faced stiff competition from the likes of French streaming service Deezer, which had designs on getting into the United States, and Germany’s SoundCloud. Spotify initially offered its music services for free through Facebook, supporting the business with ads, but by 2012 it had launched a premium version that required a monthly subscription. It needed the revenue from subscriptions if it was ever going to turn a profit. The music business was notoriously difficult to break into, run by a triumvirate of record labels that controlled access to the libraries of most popular artists. In 2010, the music industry, including the Recording Industry Association of America, successfully persuaded a New York court to shut down music piracy website LimeWire. (Spotify later hired several senior engineers and executives from LimeWire for its U.S. expansion.)
Even though Spotify, by paying for the rights to use the music it streamed, was offering an alternative to piracy, the three labels—Universal Music Group, Sony Music Entertainment, and Warner Music Group—drove a hard bargain. Spotify paid out roughly 70 cents of every dollar in royalties to the companies that owned the music. After taking their own cut, the labels then paid the artists. Most artists outside of the most popular acts received just pennies on the dollar.
Yoked to the record labels, Spotify would never be able to improve its gross margins, a measure of how much revenue a company keeps after paying for the cost of its product. Spotify’s success came down to bringing in money from subscriptions and ads, and then paying as little as possible to the record companies.
The unfavorable economics had proved troublesome for Spotify when it came to raising money from venture capitalists. Investors fretted that the record labels would gain leverage in licensing negotiations that took place every two to three years, slicing into Spotify’s margins. And yet Spotify’s U.S. launch was beginning to attract attention from venture capitalists who had yet to play a major role in the company’s funding. In 2013, Technology Crossover Ventures, where Barry McCarthy was executive in residence, began to look at making an investment. The company had already invested in Netflix and Facebook, and now partners Christopher “Woody” Marshall and others turned to McCarthy to vet Spotify.
McCarthy, who had come to understand the streaming service and content acquisition business during his time at Netflix and now served on the board of internet radio pioneer Pandora, conducted months of due diligence. He traveled to Stockholm to meet with Ek and others on the management team. He obtained access to a data room to pore over financial and subscription information.
McCarthy liked what he saw. He thought he recognized an iconic founder in the mold of Netflix’s Hastings, and he could tell that the company had some wind to its back in a difficult industry. “I thought this was pretty interesting—I knew subscription and I knew music,” McCarthy said. “It was a natural fit.”
When it came time to negotiate with Spotify over the investment, TCV found Spotify to be tough negotiators. Startup fundraising had evolved in the years since Hambrecht & Quist. Promising companies in technology, healthcare, biotechnology or other industries funded themselves across numerous rounds of private financing: initially a seed round, collected from angel investors, friends, and family, and then, as the company grew, more formal investors, such as venture capitalists, for ever-larger checks across rounds denoted by letters of the alphabet. The Series A round came after the seed and was followed by Series B, Series C, and so on.
At each round, investors bought shares at a certain price and in numbers that represented an ownership interest in the company. The price and number of shares outstanding placed a value on the company. Startup employees and founders used this number as a marker of a company’s success, and for promising companies it was often written up in press reports and discussed at cocktail parties. Startups hoped to raise more money at successively higher valuations.
A down round, when the company raised more money at a lower valuation than its last fundraising, was to be avoided at all costs. It would signal that something had gone wrong since the last fundraising—that the company’s position had weakened.
Negotiations with venture capitalists played out in several ways, depending on the strength of each party’s hand. If investors lined up to buy a stake due to a company’s promising business model or strong growth prospects, or if there was a lot of money from investors to put to work, the company could lead the talks. If the company’s growth was slowing or the larger fundraising environment had cooled, investors would have the upper hand. Investors could demand a greater share of the company or include more investor-friendly terms in the agreement between the two companies.
When investors handed over the check, the story of how the talks went would be exhibited in the number of shares the company passed back. At a higher price, the company would raise the same amount of money by selling a smaller stake. Lower prices, on the other hand, meant that the company would have to sell more shares to raise the same amount of money.
When it came time for Spotify to raise money, cofounder Lorentzon was a formidable sparring partner who showed he was willing to walk away if he didn’t get what he wanted. In one presentation, he turned his back on investors to show off Spotify’s search feature, only to pull up a long list of offensive song titles. With help from Spotify’s CFO, Peter Sterky, Lorentzon liked to set ambitious targets for the price of the private shares it sold to new investors. Then one of two things would typically happen: either investors grew desperate enough that they agreed to pay the price the company had set, or months of delay would allow Spotify’s growth metrics to catch up with their ambition. The practice meant that Spotify was good at issuing as few shares as possible—never giving up too much to raise the money it needed. The price of the shares was then used to set the company’s top-line valuation, the number that appeared in media reports.
A similar pattern played out in Spotify’s negotiation with TCV. But what McCarthy and his colleagues at TCV may not have realized was that they were largely bidding against themselves. When TCV finally did invest, it ponied up $250 million in 2013 at a valuation of $4 billion. McCarthy put in some of his own money as well.
TCV had also negotiated a board seat along with its investment and wanted McCarthy to fill it. Ek, who needed to sign off on the idea, agreed.
In February 2014, Spotify announced McCarthy’s appointment, placing the former Netflix CFO on a governing body that also included Lorentzon and Ek; Sean Parker, the founder of Napster, one of the original music streaming services before it was shut down for piracy in 2001; and Klaus Hommels, a German-born, Swiss-based venture capitalist and early backer. Spotify had more than six million paying subscribers and another eighteen million using the free version.
The Spotify board seat allowed McCarthy to rectify a mistake he had made the previous October when he joined Clinkle, a buzzy but secretive mobile payments company founded by Stanford computer science student Lucas Duplan and backed by Silicon Valley royalty like Andreessen Horowitz, Peter Thiel, and Marc Benioff. Though McCarthy had long wanted to graduate out of the finance department and into a more important operating role, Clinkle wasn’t what he thought it was when he walked in the door. The company didn’t have a product and was struggling under the mismanagement of its twenty-something CEO.
It was a rare blunder for an ambitious executive and could have tarnished his reputation had he not quickly rebounded onto Spotify’s board. “[Clinkle] was a mistake,” McCarthy said later. “I should’ve done my own diligence. I didn’t. If I had, I’d like to think I wouldn’t have joined.” A year after he got involved, Clinkle rebranded itself in a last-ditch attempt to turn around the business and attract customers. It failed.
Other than TCV, Spotify’s investor base didn’t include many Silicon Valley venture capitalists. Over its lifetime, the company had funded itself largely with money from European VCs. The record labels had also invested, throwing in with a streaming music pioneer that provided a new revenue source even as it undercut their sales of compact discs and digital downloads.
That TCV was the only company willing to invest in the last round told Spotify executives that they needed to broaden their base of investors in the United States, home to the deepest capital markets in the world. Little did they know that one investor was about to knock on the doors of their Stockholm office largely unannounced.