Shira Ovide has written a good column for Bloomberg BusinessWeek regarding Spotify's IPO. In the article, she highlights a crucial difference between the Netflix and Spotify business models. It's a distinction that I've discussed in depth with my students. It's a wonderful lesson in marginal vs. fixed costs. Here's an excerpt from Ovide's column:
However much Spotify resembles Netflix in spirit and business approach, the services diverge in a way that makes Spotify’s path to profit significantly trickier. The video streaming company’s programming expenses don’t rise as it lures more subscribers. But as Spotify gets bigger, its streaming music costs increase; it can’t grow its way to profitability. Spotify’s product—35 million songs—costs the company more as more people sign up.
Ovide does acknowledge that some costs will fall as Spotify continues to grow. As the company gains more clout, it can negotiate better royalty deals with content providers. Still, growth alone will not drive strong profits. Marginal costs will remain positive, unlike Netflix. Ovide argues that Spotify will have to diversify its revenue streams, as it has begun to do and as its chief financial officer discussed recently. Ovide raises one other possibility, but she dismisses it as unlikely - that is, could Spotify develop its own content, as Netflix has done. In other words, could it sign up musicians directly, disintermediating the record labels. That's a highly risky strategy that could undermine the entire business though.
The future will be fascinating to watch. As a Spotify customer, I enjoy the service a great deal. They clearly have lowered the cost for me to listen to the music that I love. Will advertisting be a key revenue stream moving forward? In the past, that has been the path to profitabilty for a number of companies. Yet the Facebook crisis suggests that people are growing a bit more concerned about what a reliance on advertising can do to online platforms. The Facebook mess should cause Spotify to tread carefully as it tries to drive new revenue through advertising. The challenge will be to develop this revenue stream in a responsible manner, and in a way that does not scare off customers who are now waking up to the downside of "free" online platforms.