Pressure is rising on privately-held Spotify to secure licensing deals with major music labels so that the Swedish streaming provider can raise capital in an initial public offering to pay back its investors while expanding its business model beyond distributing songs.
Spotify is said to be focusing its immediate attention on Universal Music, a unit of Vivendi (VIVHY) and the largest of the major worldwide music labels, said two music industry sources. The two companies are said to be closing in on a deal though they've been close and talks could break down, according to a third source close to the negotiations.
Deals with Warner Music, controlled by the Ukraine-born businessman Leonard Blavatnik, and Sony Music, a unit of Sony (SNE - Get Report) , remain further afield, one source said. Spotify continues to stream music from Universal, despite licensing contracts that expired more than two years ago. Talks with Universal have been ongoing for more than 18 months. Warner and Sony also continue to honor separate contracts that officially ended about 18 months ago.
The licensing deals are viewed as an essential step before CEO Daniel Ek can file for an initial public offering, which could give the company much-needed capital to pay off equity and debt investors while allowing the company to expand into video. Spotify has made clear that it plans to grow its video content business, taking a page from Netflix (NFLX - Get Report) which has had great success underwriting and owning exclusive TV programming.
Yet the on-going talks coupled with the fact that Netflix remains unprofitable is likely to push an IPO into 2018, says Santosh Rao, who heads up research at Manhattan Venture Partners, the venture capital firm. Spotify will want to have its financial house in order before offering shares to the public. It need only look at Pandora (P) , the internet-radio service that is still in the red nearly six years after going public. Pandora shares are trading at 27% below its 2011 offer price of $16 per share.
Spotify, meanwhile, faces rising debt-service obligations the longer it waits to go public.
A year ago, Ek secured $1 billion in debt financing with the stipulation that investors, including the private-equity firm TPG, the hedge fund Dragoneer Investment Group and individuals brought together by Goldman Sachs Group (GS - Get Report) , would be able to convert their debt to equity at a 20% discount to a public offering's initial price. The size of that discount grows by 2.5 percentage points every six months, The Wall Street Journal reported a year ago.
Although the penalties are not viewed as prohibitive, they do get more expensive the longer Spotify waits to hold an IPO. The company was last valued at about $8.4 billion in June 2015 when it raised roughly $400 million.
"Spotify can't go public without the music labels, and the clock is ticking on the [debt financing] deal they cut," Max Wolff, market strategist at 55Capital, a hedge fund, said in a phone interview. "Spotify doesn't want to be the guy with the empty bank account...They need these deals done, because they really need to come out for an IPO, and they can't do that without the labels."
Spotify declined to comment on the negotiations as did Universal and Warner. Sony Music wasn't immediately available for comment.
Spotify remains unprofitable despite sales of more than $2 billion from 50 million subscribers paying at least $9.99 per month and another 60 million to 70 million who access the site's advertising-supported free platform. While Spotify has the most subscribers in the industry by far, it is being chased by Apple (AAPL - Get Report) Music, Alphabet's (GOOGL - Get Report) YouTube and Google Play Music as well as Amazon (AMZN - Get Report) Music Unlimited, rivals that happen to be among the largest tech companies in the world. Apple's Eddy Cue last month said his company's subscription music service had gone "well past" 20 million subscribers.
Spotify's interest in video stems from the potential to sell mobile video advertising, the fastest growing segment of the ad industry. Combining music with music-oriented videos and even exclusive TV serials could grow Spotify's user base in the same way Netflix acquiring the rights to Mad Men and the Orange is the New Black helped to fuel its growth. Netflix had 93.8 million worldwide subscribers at the end of 2016.
Central to Spotify's talks with music labels is establishing how to split the pie on streaming revenue, a growing business that offers the labels and artists the healthiest business model they've since the internet forced the industry to sell music by individual song rather than CDs. For years, Spotify has paid as much as 70% of its streaming revenue to the labels though other reports have put that split at 55%.
During talks late last year, Spotify was said to have pushed for a rate under 50%, leading to a temporary breakdown in negotiations, said a source. Though the labels are small stakeholders in Spotify, the music industry is keen to support Spotify's development, at least to act as a counterweight to Apple, Amazon and Google.
"The position of labels is really clear: they do not want any single partner, including Spotify to get too powerful," Mark Mulligan of MIDiA Research, a media and technology consultancy, said in a phone interview from London. "The labels have had platform dependency in the past. They had it with iTunes, they had it with MTV, and they don't want Spotify or any other streaming service to have that kind of dominance."
Sony BMG holds a roughly 5.8% stake in Spotify followed by Universal Music at 4.8% and Warner Music at 3.8 percent. EMI and Merlin are also stakeholders.
The music labels are also pushing Spotify to make its paid service more compelling than simply not having advertisements. Some proposals under consideration include limiting song selection or making some new music accessible only to paid subscribers for a few weeks after they've been released.
"There's a lot of pressure on Spotify to differentiate that paid tier in more ways than they currently do," Jan Dawson, an independent equity analyst who runs Jackdaw Research, said in a phone interview. "The labels want to push everyone to paid streaming."