Earlier today, we reported that Spotify is shopping around for a new fundraising round and asking for a valuation of $3.5 billion.
At first glance that seems completely nuts.
The company does not own its core asset -- the music it's "selling" is all licensed from third parties, and the terms are probably very favorable to those content owners, not Spotify.
You can get a hint of this by looking at Spotify's 2010 income statement (the last year that's available) where it paid out more in licensing deals than it earned in total revenue.
Again: in 2010 (and 2009) Spotify's cost of revenue was higher than its total revenue. That's no kind of business.
(The details of Spotify's deals with content owners are not known, but longtime digital entrepreneur Michael Robertson explained on GigaOM last December some of the demands that labels make when they license their content. They basically make it almost impossible to build a long-term profitable business.)
But since then, Spotify launched in the United States, and it's been growing nicely.
In January, the company said it had 3 million paying subscribers. Let's assume most of them want the mobile features that cost $10 per month (versus the Web-only version which is $5 per month), and assume an average payment per user of $8 per month.
- Spotify annual subscription revenue (run rate): $288 million.
That seems reasonable, given that 2010 subscription revenue was $71 million.
Now, let's look at the leader in digital music, Apple.
- Total iTunes and App Store revenue (run rate): $8 billion a year. Last quarter, Apple pulled in $2.03 billion in revenue (PDF here) from downloads, including music, apps, and books.
- Total music (iTunes only) revenue (run rate): ~$3 billion a year. Apple doesn't break out exactly how many songs it sells per year. But between June and October 2011, Apple said the total number of songs sold rose 1 billion (from 15 billion to 16 billion). So let's say 3 billion songs per year at an average of $1 per song.
- Music revenue as a percentage of total Apple revenue: ~1.6%.
- Apple's market cap as of today: $555.74 billion.
- iTunes "market cap" if it were a standalone business: $8.9 billion. 1.6% of Apple's market cap is $8.9 billion.
In other words, the "market cap" of Apple's music sales business is only about 3x the annual revenue of that business (if you take the current run rate and extrapolate it outward assuming zero growth).
Spotify is asking to be valued at more than 10x its annual revenue using the same method.
But Spotify seems to be growing revenue at about 200% (3x) per year, which means that it could reach $1 billion a year in revenue by 2013 if all things remain stable. Apple's download revenue is growing only about 40% per year.
So let's assume:
- Subscription music turns out to be a winner-takes-most market like music downloads (iTunes dominates with 70% market share or so).
- Spotify's competition never catches up, and giants like Apple and Google don't enter the market and steal potential Spotify customers.
- Spotify can continue to get equal or better terms as its music licensing contracts come up for renewal.
- The ceiling of demand for music subscription services is a long way away.
- Spotify can continue to afford to operate even though it doesn't have a highly profitable business (like selling iPhones) to subsidize it.
- At scale, Spotify's profit margins will be similar to what Apple makes on iTunes.
If all these things are true, a $3.5 billion valuation actually seems reasonable compared with the leader in the digital music business, Apple.
Of course, those are huge and risky assumptions.
Which is probably why the VCs we talked to had passed on this round.
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