Is There a Music Tech Bubble?

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Venture funding is slowing and valuations are falling... but the sky isn't falling, either.

The stock market is faltering. The heavy flow of venture capital funding constricted sharply in the fourth quarter. Some high-flying technology companies, bloated with easy money, are starting to fall back to earth. The coming hangover might affect some digital music companies, but experts say not all valuations are suspect and that good ideas will continue to find financial backers.

What could be more emblematic of a bubble than overvalued technology companies? Turn to any technology blog or financial outlet and you'll see talk about "unicorns," those private technology companies with valuations over $1 billion made possible by easy access to money. Fortune's "The Year In Unicorns" recounted 12 months of warnings and irrational exuberance. The Economist warned of a coming "techquake" for the 150 unicorns currently on the planet (according to CB Insights). Prominent venture capitalist Bill Gurley spent 2015 predicting imminent doom for highly valued technology companies that lack financial fundamentals.

Now investors are starting to pull back. Fidelity wrote down its investment in Snapchat, a photo-sharing service most recently valued at $15 billion, by 25 percent. Blackrock did the same with its stake in Dropbox, a cloud service for hosting and sharing files that was last valued at $10 billion. Square, a mobile payments platform co-founded by Twitter co-founder and Chief Executive Jack Dorsey, had a November IPO at a $2.9 billion valuation, less than half of the $6 billion at its last private funding round just 13 months earlier. Venture-backed companies raised less money in the fourth quarter than they had in any of the four prior quarters, according to the latest Venture Pulse report.

While some unicorns will undoubtedly fall, not all startups are necessarily overvalued. Artist manager Troy Carter believes some technology companies are actually undervalued. "We're seeing a lot companies that are living up to their valuations, when you look at growth and you look at revenue," says Carter, who has invested in a range of tech startups -- including Spotify -- through his AF Square angel fund. Notable investors from Mark Andreessen and Sam Altman of Y Combinator agree, dismissing the idea of a bubble and arguing taht many tech companies are actually undervalued based on their proven ability to lead a growing market.

Perhaps unsurprisingly, market leaders, the ones either creating or reshaping industries, are faring the best. Uber, the ride-sharing app that's changed transportation in many cities, "is valued at 4 times the total value of taxi spending in the world last year," Max Wolff, Chief Economist at Manhattan Venture Partners. "They argue they are creating a bigger value by making it easier [to get rides]."

Spotify could be one of those undervalued companies. Its proponents could argue the company will not only disrupt the existing music market, it will make the market large enough to merit an $8 billion valuation. "The idea is people are valuing these companies, in hot spaces like music, based on markets these companies are building as opposed to their cash flow today," adds Wolff. "That always lends itself to aggressive valuations." He believes Spotify and its competitor Deezer should get credit for convincing fans to pay for streaming. Spotify in particular converts about 35 percent of its free users. "[A] five percent conversion rate on freemium is generally considered good," says Wolff.

These sky-high valuations aren't based on a company's current financials. "They can be profitable if they want to," adds Santosh Rao, head of research at Manhattan Venture Partners, which valued Spotify at $5.7 billion a year ago. "Right now they're investing." And why not? Rao believes the market is sending messages to mobile-first companies like Spotify that growth is more important than profitability. This strategy routinely receives criticism within the music industry from people that want Spotify to better compensate the creators behind the music. But in purely financial terms, the strategy could pay off soon. Rao forecasts Spotify will reach profitability in late 2017 or early 2019.

Spotify and competing subscription service Deezer, which just announced $109 million in new funding, are just two of thousands of companies to take advantage of readily available capital. Last year, global funding for venture-backed companies grew to $128.5 billion (from $89.4 billion in 2014) and more than doubled the $50.2 billion spent in 2013. In the United States, total funding jumped to $72.4 billion from $57.4 billion.

Runaway funding has lost momentum, however. After more than tripling in the previous three years, global venture funding fell to $27.2 billion in the fourth quarter of last year, the lowest level since the third quarter of 2013 and 30 percent lower than the third quarter of 2015. Funding in North America followed the same trend. It's probably not a coincidence these declines occurred as bubble fears spiked and tech unicorns were being put on death watch.

Yet for every Spotify or Deezer or even SoundCloud, which just raised $32 million in debt funding, there are dozens, if not hundreds, of smaller digital music startups looking for capital. These budding companies won't be immune from the problems at larger companies, says Jon Vanhala, a former digital music executive now with Crossfade Partners. "It gets a little a bad at the top, worse at the bottom. That's always been the case."

A slowdown in music investments would come at a bad time. The streaming marketplace is rather established at this point. Spotify is one of a handful of standalone streaming companies competing with Apple, Google and Amazon. New market entrants -- successful ones, at least -- are unlikely. That said, there are a variety of segments, from live music to virtual reality, that need funding to adapt and evolve. There's ample room left for business-to-business services that improve how music fans find concerts, buy merchandise and concessions at venues, and receive information within that environment. Virtual reality can offer an entirely new way of experiencing music. The industry should be thinking about life after streaming.

The current market and investment slowdown doesn't mean innovation will greatly suffer. Less of the easy money that drove valuations skyward will merely separate the good company from the mediocre one. One digital music investor, who asked not to be named, says funding will continue in a correction -- for the right companies:

"High quality can always find financing."