CHAPTER 9

Spotify, Stockholm, 2014

In November 2014, Larry Aschebrook and Spencer McLeod, two venture capitalists from the United States, touched down on the tarmac at Stockholm Arlanda Airport, intent on getting a meeting with executives at Spotify. By then, Spotify was one of the most valuable startups in Europe. Two years earlier, employees had moved into offices on Birger Jarlsgatan, a four-lane thoroughfare that ran south to north from Stockholm’s harbor through the city’s business district. The company was spread across four floors, and the space offered many of the trappings of a prominent startup—a video game area, a Ping-Pong table, and graffiti art on the walls.

Aschebrook and McLeod worked at a little-known venture capital firm called G Squared. Aschebrook had helped start the firm three years earlier to buy shares in startups on the secondary market, an unlisted market where shares traded hands infrequently and inefficiently. He targeted a still-growing universe of large private technology startups valued at more than $1 billion. The companies had been christened “unicorns” in 2013 by venture capitalist Aileen Lee, in an article in TechCrunch that introduced the world to the term with the headline “Welcome to the Unicorn Club: Learning from Billion-Dollar Startups.”

Billions of dollars flowing into the private markets had allowed those companies to avoid listing their shares publicly, making it difficult for startup investors and employees who wanted to sell. It was much harder to sell shares in a private company than in a publicly listed one.

Private companies had historically kept tight control over shareholders’ ability to sell stakes. Updating a company’s list of shareholders could be time-consuming, and many executives didn’t like to spend precious resources on what they considered a back-office function. Restricting such sales also kept employees’ and executives’ interests aligned with the company’s—holding an economic stake meant that they were incentivized to maximize the value of those shares. The restrictions often acted as golden handcuffs, yoking employees to the company long after they had lost faith in its vision. Or they prevented employees from taking the money from the stake and putting it into other things, such as buying a house or paying for their kids’ education.

If employees needed the money badly enough, they typically found other options. They partnered with investment banks on derivatives deals that allowed them to keep their shares but forced them to give up their economic interest in return for cash in hand. Such deals were made out of the company’s sight. Other under-the-table transactions were also conducted. In extreme cases, the company lost track of who should and shouldn’t be on that list of shareholders. Each bespoke transaction typically required weeks, if not months, of negotiations between buyer and seller, and ultimately required sign-off from the company to complete the transfer.

Spotify was high on Aschebrook and McLeod’s list of targets. They had no contacts there but had heard that a shareholder was looking to sell a small piece of the company worth $4 million. They wanted Spotify’s permission to buy it.

McLeod had flown in from San Francisco the night before on Scandinavian Airlines, dining on reindeer for the first time. Aschebrook flew in from Chicago. Meeting up at their hotel, the Nobis Hotel Stockholm, in the city’s Östermalm district, the two men hugged. They sat down to enjoy a beer before taking a walk around, McLeod in a pea coat, the two men inhaling the crisp air of the Scandinavian winter. They arrived at Birger Jarlsgatan 61, known by the large block letters that adorned the drab facade: JARLAHUSET, or Jarla House. As pedestrians strolled by the home of one of Europe’s first unicorns, the two Americans peered into a ground-floor window etched with the Spotify logo. A circular staircase made of polished stone and dark stained wood and an adjacent elevator bank led to upper floors.

For several days running, Spotify wouldn’t see the G Squared executives. Eventually, though, the two venture capitalists secured a meeting with a young company lawyer, Peter Grandelius. Walking into Spotify’s offices on an upper floor, Aschebrook and McLeod found a small waiting room with one wall dedicated to a cartoonlike timeline of company milestones—moments connected by arrows that curved up toward the ceiling and then down to the floor: six million paying subscribers, a new logo unveiling, new markets in Argentina, Taiwan, Greece, and Turkey. A wire magazine rack held the latest issue of Gaffa, Denmark’s largest and oldest music magazine, which gets distributed throughout Scandinavia.

Aschebrook repeatedly made his pitch to successively senior Spotify executives that G Squared could become a trusted partner to Spotify when employees or other insiders wanted to cash out. As luck would have it, Aschebrook and McLeod had found a willing partner. From the beginning, Spotify had been more open than most companies about letting its employees sell shares. Ek and Lorentzon believed that employees should have the freedom to sell shares if they wanted. Years earlier, a notice tacked up in Spotify’s break room had provided the contact details of an investor willing to buy shares from employees who wanted to sell.

Grandelius passed Aschebrook and McLeod on to a young executive in Spotify’s finance department, Johan Bergqvist, who began the process of transferring the stake the G Squared duo had come to purchase. But the Spotify executives had bigger plans. They had already approved the sale of a much larger stake, of about $150 million, before the buyer had backed out at the last minute. Did Aschebrook and McLeod have the money and wherewithal to buy a bigger stake? More or less on the spot, Aschebrook managed to raise the required money to buy the $150 million stake, lining up limited partners who had already invested in G Squared’s funds to co-invest alongside the firm.

After McLeod flew back to San Francisco, Grandelius and Bergqvist treated Aschebrook to a traditional Swedish meal and pints of locally brewed beer at Konstnärsbaren, a restaurant near the Nobis.

With G Squared on board, Spotify put up impressive growth. In the final two months of 2014, the company added ten million users, bringing the total customer base to sixty million. Fifteen million paid for the premium, ad-free product. Yet the company continued to face tough competition, including from Apple, which had plunked down $3 billion for Beats Music, a streaming service founded by Dr. Dre and Jimmy Iovine, and Beats Electronics. Deezer had expanded to 182 markets by 2013, while SoundCloud had 40 million users and had reached 200 million listeners through its website and on social media by the middle of the year.

It was once again time for Spotify to go out and raise money to fend off the competition and fund its growth plans. Spotify had already raised more than $500 million over the course of six prior rounds. Executives wanted to double that amount in the next round, and Sterky, the CFO, planned to rely heavily on U.S. investors for the money. The company had historically used the capital-raising services of CODE Advisors, a boutique investment bank cofounded by music industry veteran Fred Davis. CODE had helped Spotify in previous years, such as in a 2011 round when it raised $100 million at a $1 billion valuation.

This time Spotify turned to Goldman Sachs for fundraising help. Senior Goldman partner Gregg Lemkau, attracted by Spotify’s growth, had gotten to know Ek several years earlier over a cup of coffee in London and helped lead a $50 million Goldman Sachs investment in Spotify. The men discussed Spotify’s vast business potential, a landscape that also saw Deezer competing, and what Ek would do if Facebook offered him $1 billion. Goldman’s investment came from what its bankers liked to call the “growth fund,” which they used to get closer to startups they hoped to advise in the future. With its bankers alongside him, Sterky went on a global roadshow, visiting New York, Boston, San Francisco, London, and other cities to meet with potential investors. They quickly demanded answers about Spotify’s latest negotiations with the big record labels.

Relations were icy. In November 2014, Big Machine, then Taylor Swift’s label, caused a stir when it publicly removed her catalog from Spotify’s service. The label argued that streaming cut into sales of compact discs and downloads. Fears mounted that other big-name artists would follow suit.

Ek responded quickly, writing a blog post to say that Spotify had paid $2 billion to artists since its beginning. “Taylor Swift is absolutely right: music is art, art has real value, and artists deserve to be paid for it,” Ek wrote. “We started Spotify because we love music and piracy was killing it. So all the talk swirling around lately about how Spotify is making money on the backs of artists upsets me big time.”

To some extent, Ek was right. The record labels had come to depend on Spotify’s checks. In March 2015, the Recording Industry of America announced that for the first time, U.S. revenue from streaming music had surpassed CD sales. It was about to overtake digital downloads as the industry’s largest source of revenue. But many artists weren’t seeing the benefits, with much of that revenue captured by the largest artists.

Nonetheless, the growing importance of streaming revenue to the largest labels meant that Spotify had more leverage than in previous negotiations. Throughout the spring of 2015, Goldman Sachs shopped the Spotify deal around. The market was increasingly awash in capital and Spotify had little trouble attracting interest.

Around the time that Sterky was talking to investors, Ek and McCarthy were engaging in secret talks for the Netflix veteran to replace the CFO. Spotify had begun to think about going public, and McCarthy would bring a big name recognizable to Wall Street into the company’s management team.

Leaders and the senior executives they hire often engage in an elaborate corporate mating ritual. McCarthy and Ek met in New York and Los Angeles. McCarthy had remarried and was living with his second wife in Woodside, California. At first the CFO job wasn’t discussed outright. Neither a founder of Ek’s success nor an executive of McCarthy’s stature wanted to be rejected. The men talked in generalities. Eventually the generalities worked themselves into a specific offer. Contract and compensation negotiations soon followed.

McCarthy agreed, acquiescing to move with his wife to Stockholm to be closer to Spotify’s management team. First, Spotify needed to wrap up the funding round.

In April, reports surfaced that Spotify was close to raising $400 million. By June, it had raised more than $500 million at an $8.5 billion valuation, with reports suggesting that the company was planning to use the proceeds to get into video and podcasting. One of the investors was Goldman Sachs Investment Partners, an in-house hedge fund focused on venture and growth equity investing out of the firm’s asset management division. It was wrapping up a new fund, called Global Private Opportunities Partners II, filled with money from clients of Goldman’s private bank. Other investors in the round included Wellington Partners, Baillie Gifford, the hundred-year-old Scottish investment manager, and investment firms TCV, Northzone, Balyasny Asset Management, and Senvest Capital. Nordic mobile operator TeliaSonera paid $115 million for a 1.4 percent stake.

The round included a contract term called a ratchet, which gave the investors the right to take a larger share of the company if later funding rounds came in at a lower valuation. If all went well, they would never have to use it. Ek presented as one of the startup industry’s most forward-thinking leaders, according to one person who invested in that round. Under his direction, Spotify’s engineers had pioneered many aspects of agile software development that would later become commonplace. “What Daniel appreciated that few others did at the time, he appreciated that there was a source of sustainable competitive advantage,” the investor said, recalling his investment thesis. “The bear case on Spotify at the time was anyone can get access to this music, so there will be no differentiation. When Apple launches, they are so well funded they will wipe the floor with Spotify. What Daniel understood was his moat was the data effect of the business by having captured millions of listening hours.” Spotify compared patterns across millions of listeners, came up with insights, and employed those to help introduce new artists that matched user preferences. In this way, it could keep users engaged and using its service.

By most measures, the round was a complete success. It was by far the most money that Spotify had ever raised at once, and it did so at a valuation more than twice as high as the TCV round just two years earlier. Ek nevertheless pushed ahead with replacing his CFO, and Spotify officially announced the change on June 17. News coverage played up McCarthy’s experience taking Netflix public in 2002 and helping usher it from a mail-order DVD business to a streaming video behemoth. The Wall Street Journal’s story suggested that McCarthy’s hiring was a sign that Spotify was preparing for an IPO.

Before there was an IPO there would be summer vacation. Spotify’s offices emptied out in August as the company’s employees took off to enjoy the good weather. There would be plenty of time to work in the dark, cold winter days of winter.

In the United States, McCarthy had spent the first half of the summer preparing for his move to Stockholm. It would be the first time he or his wife had lived outside the United States. They found an apartment in Östermalm, home of hole-in-the-wall pubs, designer boutiques, a large park designed in the sixteenth century, and the Swedish History Museum, with its displays of Viking artifacts. Their building featured a wooden Otis elevator fit for two.

But when he went to Spotify’s Jarla House offices, on August 7, a Friday, he was in for a dose of culture shock. He arrived just after 9:00 a.m.… to a largely empty office. Looking around at rows of open desks, McCarthy could make out just two people on the entire floor. A Spotify IPO would be hard to pull off if he didn’t have a team around him that he could trust to work hard, the new CFO thought.

“We’d just arrived, and I thought I was dead,” McCarthy later recalled.

He discovered that his team would soon return and work diligently toward his goals. An IPO would be unlikely for another reason entirely. Spotify’s accounting system was woefully unprepared to track the royalties from music streaming. Downloading distinct music files was simple by comparison. When Apple sold a song for 99 cents, it could reliably split the proceeds among the parties entitled to a cut. When it sold the same song again one hour later, or two days or three years later, it would repeat the same process.

The mechanics and royalty considerations of streaming were complex. Now platforms like Spotify had to keep track of the minutes that users spent listening to millions of individual songs and figure out how to apportion a static pool of royalties based on that. McCarthy knew that if Spotify was going to have to answer to public market investors, it needed to be able to handle the task flawlessly. He had little patience for mistakes.

Pär-Jörgen Pärson, whose Swedish venture firm Northzone became one of Spotify’s earliest outside investors when it led Spotify’s Series A round in 2008, and a member of the board, remembered those early days when McCarthy was just getting started. “He couldn’t really see himself listing a company where he hadn’t 100 percent control over the numbers,” Pärson said later.

McCarthy began to design a fitness regimen to get Spotify into shape for the public markets. He went shopping for a new ERP system, the combination of accounting, compliance, risk management, and financial planning software that companies use to track bills and receipts. He settled on one sold by NetSuite, whose 2007 initial stock sale had used an auction.

As McCarthy settled in, he set out to build his team. Sterky stepped down from the CFO position to focus on financial planning and analysis while plotting a graceful exit. McCarthy needed someone to run investor relations, the job of communicating with shareholders on an ongoing basis. He also needed a general counsel. One person he considered for the general counsel’s job was Wilson Sonsini partner Bob Sanchez, who had worked closely with McCarthy when he was at Netflix. Sanchez was listed second only to Larry Sonsini on Netflix’s IPO filing, and he’d been one of McCarthy’s first calls when he had a legal question. The job would require Sanchez to leave Big Law, develop a different skill set, and probably take a pay cut. McCarthy thought of it as a good opportunity for Sanchez. Trust was a factor, too. McCarthy and Sanchez could lean on each other in a new environment, working in tandem to take Spotify public.

Perhaps more than anything in his first twelve months, McCarthy would obsess over the company’s cash position. He had learned, with Netflix’s aborted 2000 IPO, that it never hurt to have company coffers stocked full of cash just in case something unexpected happened. He liked to cite one of his favorite blunt maxims (which he first heard from Andy Rachleff, the cofounder and former general partner of Benchmark Capital) that “cash is oxygen to a business, and oxygen is life.”

And he wanted Spotify to be on a stable financial footing when it came time to negotiate with the record labels. “I didn’t want the record labels to ever believe that they could slow-roll us in the negotiations and prevent us from going public because we were thinly capitalized,” he said later.

By January 2016, he had once again gone out to investors to raise more money. Stock markets were not cooperating. The NASDAQ slumped 8 percent in January, its worst monthly showing since May 2010. He realized that if he was going to raise another pile of cash by selling stock, it would likely be at a lower valuation than what Sterky had commanded in June 2015. In Silicon Valley lexicon, the event would be a down round, a sign to the outside world that Spotify’s position was weakened.

McCarthy decided instead to sell a convertible bond. Convertibles are debt instruments that pay interest and can be exchanged for equity at some predetermined point in the future. The conversion feature gives buyers upside they wouldn’t get with a regular bond, an option that lowers their risk and results in a lower interest rate for the company than it would otherwise pay.

Uber Technologies, a ride-hailing app that had gotten an early investment from Bill Gurley, had already issued convertible bonds, removing a barrier to technology startups that often had no profits to speak of and were used to raising equity from venture capitalists. Investors had come to view convertibles as a less risky way of getting into the world of startups, acquiring a piece of a high-flying tech company with downside protection.

One similarity between convertible bonds and venture financing was that companies still issued new stock; but for the bonds, it was at the time of the conversion from debt to equity. That wouldn’t come until later, meaning McCarthy could raise money without having to suffer the embarrassment of a down round.

With Goldman Sachs’s help once again, McCarthy held a series of talks with investors, flying back and forth to the United States. It was his first fundraising effort since leaving Netflix almost six years before. He found a small group of willing investors in San Francisco. David Trujillo, a portfolio manager at TPG Capital who had also led the company’s investment in Uber, helmed the negotiations. Two others joined in—Sixth Street, which was TPG’s credit investing arm, and Dragoneer Investment Group, founded by Marc Stad. Clients of Goldman Sachs also participated.

Over the course of several weeks in February, McCarthy hammered out a financing package that would dwarf anything he’d ever done. In return for $1 billion, he agreed to allow investors to convert their debt into shares at a 20 percent discount to the IPO price if Spotify went public within the next twelve months. If the IPO took longer, the discount would increase. The interest rate on the debt faced a similarly laddered approach.

The terms meant that Spotify would be required to issue a certain amount of shares at the IPO. The bet was that the amount would be less than if Spotify had used the fundraising round to raise equity.

Some insiders worried that the company was raising too much money at too high a price, recalled Pärson, the Spotify board member. “There was a lot of internal discussion,” Pärson said. McCarthy felt that if Spotify could succeed in offering an attractive product, the terms were acceptable, Pärson said, while those who came down on the conservative side of the debate “thought he was just racing far too much to expensive terms.”

On February 19, the board of directors voted to allow McCarthy and his team to proceed with the financing. TPG and Dragoneer emailed signed copies of the term sheets and exclusivity letters the same day. Over the following few days, Spotify collected approvals from existing shareholders. On February 22, McCarthy signed a letter of exclusivity on behalf of the company. A twenty-one-day due diligence period began.

In past rounds, the company had set an outlandish valuation and waited either until venture capitalists came calling or the company’s performance caught up to it. This time McCarthy had accepted the terms imposed on him in his haste to get a deal done. He was making a bet on the company’s future and the ability of the employees to make it perform. It was a risk he was willing to take. For the first time, the company was starting to bring in more cash than it was paying out, a positive sign that would look good to potential public market investors. The clock had started ticking on Spotify’s IPO.

On the evening of March 29, news of the convertible bond transaction hit the Wall Street Journal, in a piece that highlighted, in the first sentence, the “strict guarantees” that Spotify had agreed to. When the article appeared in the print version of the newspaper the following day, it was the first time many employees had heard about the fundraising. It elicited a company-wide email from McCarthy to explain senior management’s thinking at the time.

“As some of you have read in the press this morning, we’ve signed a deal to raise $1B from institutional investors,” McCarthy wrote from Stockholm. The money, he suggested, might allow the company to host a secondary share sale when it came time for the IPO. In other words, if Spotify didn’t need more money, it wouldn’t issue new shares in an IPO.

When the deal was done, McCarthy had raised twice the amount he’d sought. He added $1 billion to Spotify’s coffers. The cash suddenly gave the company some leverage it hadn’t had. “Having a war chest, turning cash-positive, all of a sudden the company started to see that they could actually dictate their future in a way that they didn’t think was possible just a year prior,” Pärson said.

The size and speed of the round left a deep impression on McCarthy. For twelve years at Netflix, he’d had the capital markets wrapped around his finger. He knew how to appease investors and was skilled enough to experiment with raising various types of funding. Something had changed in the intervening years. The relationship between startups needing money and the investors willing to provide it had been dramatically altered. There were now mind-boggling amounts of capital available to private companies, provided by venture capitalists like G Squared, who raised it from pensions, endowments, and wealthy individuals and invested it in promising technology startups.

In covering the news of Spotify’s fundraising, the Financial Times quoted an investment banker on the implications of the trend. “We are going to see an increasing number of companies delaying their IPOs as long as they can raise private money so easily.”

McCarthy put it much more succinctly. “The rules had changed.”