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Pandora cozies up to the music labels as it prepares to take on Spotify

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The company's CEO argues that free, on-demand music is killing the business

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In an op-ed column published today, Pandora CEO Brian McAndrews starts off with an anecdote about a "music executive" who visited a college classroom. When he asks who listens to terrestrial radio, most students hands go up. When he asks who listens to internet radio, they all go up. Everyone keeps their hands up when asked if they stream music on demand. But when asked if they pay, all the students put their hands down.

The story is a setup to argue that free, on-demand music is devaluing the art made by musicians and harming the recording industry overall, an implied dig at competitors like Spotify. The only problem with it is that, anecdotes aside, it doesn't reflect the reality of the music business. At last count, Spotify has 75 million monthly users, of which 20 million pay for premium features. Half of those customers signed up in the last year. Apple, which launched a paid music service recently, has managed to sign up between 5–10 million people in just its first six months. There is plenty of free music out there, and yet tens of millions of people are choosing to pay.

So why is Pandora trotting out this straw man? It's part of a new direction for the company, which over the last year has made several big moves that will drastically reshape its business. For years, Pandora had a contentious relationship with the music industry, which was unhappy with the royalty rates it paid, rates set by a government body, not over a negotiating table. That conflict prevented Pandora from expanding internationally, with its service available in just three countries.

Pandora wants to expand internationally but needs the labels permission

But in early November of this year, Pandora signed a new deal with Sony/ATV, agreeing to a significant increase in royalty payments in exchange for locking in the rates it pays and acquiring the ability to expand its product offering. That expansion was quickly clarified when it acquired a large part of Rdio, leaving the service to declare bankruptcy, but ingesting its tech and talent so that Pandora can launch its own on-demand streaming service.

Pandora is now arguing that free tiers should be killed off, just as Apple did when it prepared to launch its on-demand streaming music service. Both companies are keenly aware that Spotify and YouTube have become the villains, portrayed by musicians as thieves and Nazis. They want to side with artists and labels by avoiding the free tier, but know that it will be tough to catch Spotify if they can't match its free option.

"The value of music will continue to spiral downward."

McAndrews argues that if a free tier continues to exist, "the value of music will continue to spiral downward to the benefit of no one." On-demand music should have a short-term free trial, then convert to paid. Internet Radio, meanwhile, which is the bulk of Pandora's business, should continue to exist as an ad-supported medium.

But bringing users in with a free option and up-selling them on premium features has been far and away the most successful method for converting people to paid streaming. While users can listen to any track on Spotify for free, they can't listen to music on-demand or offline on their mobile device, which is where 75 percent of listening happens these days. And all that free Spotify listening is interrupted by ads.

Most people don't want $120 worth of music a year

McAndrews talks a lot about the "intrinsic" value of music, as if $14.99 for a compact disc or $9.99 a month for streaming was the objectively correct price to charge. But as music industry veteran turned venture capitalist David Pakman points out, the price and demand for music is actually quite elastic. Before the rise of digital music, when people bought physical records, tapes, or CDs, the average consumer spent around $48 a year. Today, if you want to pay for streaming music, you're being asked to pay $120 a year. Is it any surprise then, that a smaller subset of people are willing to pay up?

Music labels can continue to try and stuff the genie back in the bottle, but nothing will restore the golden age of record sales that peaked in the late 1990s. Spotify's free tier may eventually be curtailed, but that would be of no long-term benefit to the industry. If musicians and labels wanted to capture more value, they would find ways to offer consumers more choice, not less, when it comes to the pricing and experience around their art. That's why, even as McAndrews rails against a grey market for music, Pandora plans to offer free ad-supported radio, paid premium radio, and now its own on-demand service.