Spotify raises $1 billion (and investors seize their IPOrtunity)

After years of speculation, is Spotify finally about to go public? Last June Spotify raised $526 million in equity funding from investors and on 29 March 2016 a spokeswoman for Spotify confirmed that the company had raised a further $1 billion in convertible debt. The terms being reported in the press — Spotify has not made these public — suggest that the company has a stark choice: either go public within the year or face increasingly tough financial penalties.

The reported terms are as follows. If Spotify does an IPO in the next year, those who invested in this latest round of funding will be able to convert the debt into equity at a 20% discount (increasing by 2.5% every six months after the first year). Annual interest on the debt starts at 5% and increases by 1% every six months. The investors will be restricted from selling their shares for the first 90 days following the IPO.

What does this mean in practice? Let’s take some simple example figures.

I invest £100,000 in Spotify on the terms described above. After six months I will have earned £2,500 in interest. After the next six months I earn another £3,075. This interest is capitalised (i.e. added to the outstanding debt rather than paid in cash). Spotify now owes me a total of £105,575.

Let’s say that Spotify floats at this point, with a share price of £20. I can then convert my debt into equity at a 20% discount. In other words, the debt owed to me is cancelled and in return I receive shares at the discounted rate — for every £16 of debt, I receive one £20 share. So my £105,575 will buy me 6,598.44 shares worth £20 each (and £131,968.75 in total) on the day Spotify goes public. Once 90 days have passed, I will be free to sell my 6,598.44 shares in the market.

With every six further months that Spotify delays going public, the terms become increasingly favourable to investors, with the double whammy of a rising interest rate and a deeper discount (if Spotify goes public after 18 months, again assuming a share price of £20, my initial £100,000 investment would buy me 7,049.69 shares).

Why are investors putting this pressure on Spotify to do an IPO? What’s in it for them? And are there any benefits for Spotify itself?

Shares in a private company are comparatively illiquid assets. This means that, as long as Spotify remains private, its investors will struggle to find a buyer for their shares quickly and at an acceptable value.

An IPO offers some early stage shareholders (usually including management) a chance to sell some of their shares straightaway as part of the public offering itself. The majority of shareholders will be restricted from selling their shares for a further period (most likely 180 days) but will then be free to sell their shares immediately at market rates on the stock exchange. Either way, an IPO allows investors much more easily to realize their investments.

And what about Spotify?

Well, in theory, there should be lots of compelling reasons to go public.

Most shares offered as part of an IPO will be new shares. This raises cash for the company itself and, unlike debt, does not need to be repaid. Although Spotify’s UK and French businesses have in some years turned a profit, the business as a whole is lossmaking. Spotify needs to keep raising funds in order both to grow and to see off its increasingly heavyweight competitors (Apple and Google both being recent entrants into the streaming market). An IPO will raise sums far greater than even the comparatively large amounts Spotify has been raising in the private markets.

There are other reasons: the added prestige of being a public company; the lower cost of capital that comes with it; the ability to make use of its (more liquid) public shares in stock options (to attract new employees) and to finance M&A.

And yet, the impetus to go public is clearly coming from investors, not the company itself. In his 27 September 2013 ‘Lunch with the FT’ interview, Spotify’s founder Daniel Ek expressed his concerns with the ‘quarterly capitalism’ that comes with being a public company and expressed the view that, for Spotify, being private had been better ‘in pretty much every regard’.

Ek and Spotify are not unique. There is a growing trend of ‘unicorns’ (Silicon Valley terminology for private tech companies valued at $1 billion or more) delaying going public or even ruling it out altogether. A 1 January 2015 Wall Street Journal article cited research that showed that the median age of tech companies going public has grown from five years old in 2000 (at the height of the dot com boom) to 11 years old in 2014 (the exact age Spotify will be if it does an IPO a year from now).

Why is this?

In part, this development is down to Wall Street and the public markets having learned their lessons from the dot com crash. Now, when tech companies do go public, they are still more likely than not to be unprofitable but they also have much more cash on the balance sheet and their valuations are far more reflective of actual earnings.

However, the scepticism cuts both ways. Tech CEOs like Ek are increasingly suspicious of the public markets — they see them as short-termist and difficult to communicate with. They would prefer to rely on private funding and retain control of their company. And a flood of private investment in the last few years has increasingly made this possible. Private funding rounds such as Spotify’s latest have been dubbed ‘private IPOs’. They have seen new types of private investors (such as hedge funds) investing previously unthinkable sums of money. When Spotify can raise $1 billion on the private markets it is no surprise that the likes of Ek question the benefits of going public.

But all of this is moot as far as Spotify’s investors are concerned. For all the talk of ‘private IPOs’, they are still holding illiquid assets. If they are to realise their investments in the company, a real IPO is the only way to go. Hence the terms that accompany Spotify’s latest funding round. Whether Ek likes it or not, Spotify looks to be headed towards the public markets.

And yet, might there be trouble ahead?

The press are reporting that the company is most likely to do a dual listing in Stockholm and the US. Market conditions, in the US in particular, are nervous to say the least — the US IPO market has just had its slowest first quarter since 2009, with the smallest proceeds for over 20 years. Most strikingly of all, there was not a single US IPO in January.

Spotify’s streaming rival Deezer pulled its own Paris IPO in October last year — its executives blamed the difficult market conditions as well as the recent poor market showings from Pandora and Netflix (there are no public listed music streaming services so these companies are seen as the best indicators of how Deezer or Spotify might fare post-IPO).

Spotify is ahead of Deezer in a number of respects. Both its subscriber base and valuation dwarf its streaming rival. And yet Spotify will need to answer many of the same questions. Does it have a viable business model? How does it expect to become profitable? How will it compete financially with Apple and Google? Can it weather current market conditions? Can it fare better on the public markets than Pandora and Netflix?

So much for the potential benefits to investors and Spotify itself of a Spotify IPO, as well as the potential obstacles. But what about musicians? Should they care about any of this?

Many musicians are already suspicious of Spotify. The company has received plenty of bad publicity for the small payouts some artists have received (it was widely reported in 2013 that Lady Gaga had earned just $167 (£108) from one million plays of ‘Poker Face’ on Spotify). Others, such as Billy Bragg (who claims to make respectable money from streaming), point the finger at the labels for failing to pass on streaming revenue to artists (this is the topic of an ongoing lawsuit against Sony in the US). Whilst many musicians feel ripped off by Spotify, the irony is that the company itself remains unprofitable. This should also be cause for concern to musicians. Spotify claims to pay 70% of its revenue to rights-holders, which is surely unsustainable. It seems obvious that the company will try to negotiate more favourable royalty rates as its bargaining power increases, which will surely result in even smaller payouts to artists themselves.

And many artists and their representatives also have concerns about a Spotify IPO. They point to the fact that the major labels have acquired minority shares in Spotify and Soundcloud as part of their licencing deals with these companies. Following Spotify’s IPO, the majors will be able to sell their stakes in the company for hundreds of millions of dollars, and have no compulsion to pass on any of the money to its artists.

And yet there may be a silver lining, at least for some artists. During a call with investors on 4 February 2016, Warner CEO Steve Cooper stated that Warner would share with its artists any cash proceeds it made from the sale of its stakes in Spotify and Soundcloud. Neither of the two other majors have yet followed Warner’s lead (perhaps unsurprisingly in the case of Sony, given the lawsuit described above) and many have expressed scepticism as to the sincerity of Cooper’s promises. But it is an interesting development that artists should sit up and take notice of. A successful Spotify IPO might yet be good news for them as well.