Who Wins, Who Loses in Spotify's Long-Term Deal With Universal Music Group

As details of the negotiations continue to emerge, there's still plenty of work ahead.

After about two years of negotiating -- both directly and, occasionally, in the media -- Universal Music Group and Spotify have reached a long-term licensing deal that opens the way for Spotify’s long-discussed IPO. The agreement, announced Tuesday morning, sets royalties in a way that lets Spotify reduce its payments to the label if it hits certain revenue targets, and gives Universal acts the ability to make new albums available only on the service’s paid tier for two weeks after release. Since 2015, the companies had been doing business on a month-to-month basis.

The deal comes at a time when streaming is fast becoming the industry’s dominant business model around the world. Streaming now accounts for 51 percent of U.S. recorded music revenue, according to the RIAA, and subscriptions to services like Spotiify fueled 11.4 percent growth in 2016, after a decade and a half decline. But music executives have spoken of a fragile recovery that would be jeopardized if Spotify’s planned IPO were to fizzle.

By locking in a deal with the world’s largest music company -- Universal Music accounted for 35.7 percent of the recorded music market in the first quarter of 2017, according to Nielsen Music -- Spotify co-founder and CEO Daniel Ek has removed the most significant barrier to Spotify’s IPO. The company, which has been valued at $8.5 billion, is under pressure to go public soon or face financial penalties under the terms of a March 2016 debt deal.

But the major labels also have a stake in Spotify’s success -- not only because they hold equity in the company but also because, with 50 million subscribers, the service is their fastest-growing source of revenue. "The long-term success of Spotify, and others like it, is essential to the ecosystem’s enduring health,” Universal Music Group chairman and CEO Sir Lucian Grainge said in a statement announcing the deal.

Reaching a deal wasn’t easy. For almost two years, analysts have said that the amount of money Spotify pays out to labels -- said to be between 55 and 58 percent of its revenue, although the exact amount differs in various markets and circumstances -- would make it difficult for the company to market its stock to potential investors. At the same time, labels -- and some artists -- have wanted Spotify to limit its free tier, or have the ability to restrict their music to the company’s paid tier, which pays a higher level of royalties. Some high-profile acts, including Taylor Swift and Adele, declined to make new albums available on Spotify because doing so would mean their music would be available on its free tier, which became a point on contention in the industry.

"They gave up their religion" on windowing, according to a major label source who was not involved in the Universal negotiations, referring to Spotify.

Although details of the deal are still emerging, it appears that both sides got what they needed, even if there's still plenty of work ahead. Depending on what subscription targets it hits, Spotify will pay Universal an amount that would work out to between about half of its revenue and its current royalty rate, according to a source familiar with the deal.

"The two big bits are the windowing, which is obviously something the labels have been pushing for for a long time, and the reduced rates in return for ambitious revenue targets," says Mark Mulligan, an analyst at Midia Research. "I think it's one of those rare deals where if Spotify meets its targets, then both sides can genuinely walk away saying that they got what they wanted."

The negotiations took place in an increasingly competitive streaming market. A decision by Universal to give Spotify a better royalty rate could have led to pressure to accept less from services like Apple Music, the No. 2 subscription service, with 20 million subscribers, and Amazon Music Unlimited, a new competitor in the space but one with formidable clout. Although Apple and Amazon are not as concerned about making a profit on music as Spotify is, since they make so much money in other businesses, labels are reluctant to reduce their rates as well. But Universal may have solved that problem by tying lower rates to ambitious growth targets, Mulligan says.

Spotify is also in negotiations with the other two major labels, Warner Music Group and Sony Music Entertainment, as well as independent labels. Spotify would have an easier time going public if it had a deal with at least one of the other majors, but it could probably have a successful offering without locking in every deal first. "They are trying to reduce the headline rate [from which royalties are calculated], and we are looking for ways to make sure we don’t lose revenue," says an industry executive with knowledge of the negotiations. "In a good deal, both sides would share in the upside and also shoulder the risk of the downside."

For artists, however, it’s hard to know how much of a win windowing is, simply because the music business is changing so quickly. As recently as a year ago, a fan who wanted to hear an album that wasn’t available on Spotify’s free tier might have bought a CD or a download -- but fewer CDs are available in stores, and the download market is shrinking fast. Still, restricting the new releases available on Spotify’s free tier could encourage some of those fans to subscribe, which would be good for artists, labels, and Spotify alike -- or it could cause some fans to revert to piracy.

Either way, the deal has one clear goal. "The labels hate the free tier" because it pays so much less than subscription revenue, says Peter Paterno, a prominent transactional lawyer and King, Holmes, Paterno Berliner, LLP. "They’re trying to drive fans to subscribe."

Additional reporting by Dan Rys