Acquired - Season 2, Episode 6: Spotify’s Direct Listing

Episode Date: April 6, 2018

Acquired wraps up a big few weeks of coverage with not an IPO or an M&A or a fundraising round, but what’s still the largest tech exit in recent memory: Spotify’s $30B direct public listing. We dive into what it all means and how we got here: from Napster to iTunes to Facebook (and even some Justin Timberlake thrown in for good measure). Acquired FM is on the scene and spinning all the hits from this new wave music industry titan! Note: We incorrectly described Spotify CEO Daniel Ek’s ownership stake in Spotify as 25%+; that is actually his voting control. His economic ownership is 9.3%, and cofounder Martin Lorentzon’s is 12.4%. We apologize for the error!Sponsors:ServiceNow: https://bit.ly/acqsnaiagentsHuntress: https://bit.ly/acqhuntressVanta: https://bit.ly/acquiredvantaMore Acquired!:Get email updates with hints on next episode and follow-ups from recent episodesJoin the SlackSubscribe to ACQ2Merch Store!Links: Internet History Podcast on the Napster Story with Jordan Ritter Sean Parker’s email to Daniel EkCarve Outs:Ben: Black Panther (and  soundtrack on Spotify!)David: “Silicon Ballet” panel at San Francisco Ballet on Saturday, April 28

Did you read the mission statement on Spotify's F1? No. So whereas last week Dropbox's mission is to unleash the world's creative energy, Spotify's is to unlock the potential of human creativity. You definitely should get some digs in on them. It's an unrestrained hippie world out there. Welcome to Season 2, Episode 6 of Acquired, the podcast about technology acquisitions and IPOs. I'm Ben Gilbert.

I'm David Rosenthal. And we are your hosts. Today we are covering a company making history, the week it makes history, Spotify and their direct listing, which is not an IPO. But if it were an IPO, this would be the largest IPO listing, whatever you want to call it, from Europe ever. And the seventh biggest of all time, debuting at about roughly a $30 billion market cap. Wow. And almost a billion dollars worth of shares on the first day traded.

Yeah, trading hands. Big company, big shakeup in the industry over the last few years with the rise of streaming and a big change to the way that the companies go public. So David, I'm excited to dig in and help understand myself exactly why they did a direct listing, what a direct listing is, and probably more importantly, excited to hear from you more about the history of the company itself. There's always a story, Ben.

All right. If you are new to the show, you should join us in our Slack at acquired.fm. There's over 1,200 people talking about acquisitions, IPOs, tech news as it comes, and helping us do research for the show. And thanks to listeners who were throwing in some interesting stuff about Spotify as David and I were researching. Okay, listeners, now is a great time to tell you about longtime friend of the show, ServiceNow. Yes, as you know, ServiceNow is the AI platform for business transformation. And they have some

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show notes or going to servicenow.com slash AI dash agents. Well, David, before we dig in, I spent a bunch of time, I think, as the news started to trickle out that Spotify was doing a direct listing, not an IPO, you know, several months ago before they priced, before they had a date, before they had an F1, not an S1, to announce- As a foreign company issuer. Oh, oh. I didn't realize that the F1 is because they were not a US-based company. Not because of the direct listing, but because they are a foreign issuer. That makes sense. Before we dig in, some things that you need to know about what is a direct

listing or a direct public offering, which is not an initial public offering. The biggest difference is the company doesn't take any dilution. So if you're thinking about what does a company normally do in the IPO, there's two big reasons. One, they create liquidity for existing shareholders. So everybody who's got stock sometime after that has the opportunity to sell that stock and get some liquidity on that. The other is that the company actually creates new shares, so all the previous shares get diluted, but the company gets to raise money. So they sell the new shares that they've created. They raise millions and millions of dollars to have money in their coffers. With a DPO, a company doesn't take any dilution, and they don't raise any money. So

Spotify doesn't have a dollar more in the bank account yesterday from selling shares that they do today. I guess, to loop that. Don't create any new shares. It's literally just, hey, anybody who is a current shareholder can now sell. There's no lockup. It's theoretically less expensive of a process because you don't have to go do the whole roadshow and hire bankers and all that, which we will get into also. But one thing that was interesting that I was sort of thinking through is one disadvantage is that if you are a buyer of this stock, you have to consider the fact that an insider, somebody who previously had information rights to the company or might be an employee of the company is selling. So you actually have a counterparty who's probably more informed than you on every single transaction of shares in these early days

of trading. Yep, very true. On the other hand, you know, Spotify is a 12 year old company. Certainly the founders and employees early investors they want liquidity um and also you know we'll also talk about this but there's been a robust private market for spotify shares for many years um so trading has been happening there has well before we uh go into the history and facts i found one fun bit of trivia. David, there's a very famous company that did a DPO in the 80s that sort of popularized this. Do you know who it is? I do not know. So in 1984, Ben Cohen and Jerry Greenfield needed funds for their ice cream business.

They advertised ownership stakes through local newspapers for $10.50 per share, with a minimum number of 12 shares per investor. And their Vermont loyal fan base ended up funding Ben & Jerry's Ice Cream in a DPO for its first way to raise capital, raising only $750,000 from 1,800 ice cream-loving Vermonters. Oh my goodness. Talk about an addictive product. I know. Addictive and viral as we will, as we will get into. That's right. And interesting to know, we'll come back to this later. They then did a $5.8 million IPO the following year. So they actually did issue new shares once they were public. So tuck that one away and let's dig in. All right. Well, history and facts.

So as probably a lot of people know, Spotify is a Swedish company founded in Sweden, not Switzerland, as the New York Stock Exchange learned this week. Unfortunately, Sweden is a different country. For those who didn't see the news, there's a chance that a Swiss flag got raised at the New York Stock Exchange. Somebody was in hot water. We'll come back to that at the end of the show.

But it was started in Sweden by two co-founders, Daniel Ek and Martin Lorentzen. Started in 2006. Daniel Ek, the CEO, who's still the CEO, was kind of like a wunderkind of the Swedish tech scene. He started his first company when he was in school at age 13, hired all his classmates. A lot of fun history, which we'll get into. But to really understand Spotify, you have to go even farther back and start with another company that we've also discussed on this show a little bit. An interesting footnote of history called Napster. Yeah. Who would have thought that the very thing that destroyed the music industry and brought the record labels to their Napster to its knees. But as we shall see, there is a very direct and straight line from Napster to Spotify to today. So Napster, founded in 1999 by the Seans, Sean Fanning and Sean Parker.

Sean Parker is S-E-A-N. Sean Fanning is S-H-A-W-N. And then also a third co-founder who uh, who doesn't get talked about as much, but is friend of the show, Jordan Ritter, uh, who's based in Seattle now. Um, and there's a really, really good internet history podcast episode with Jordan about the founding and early days of Napster all the way through the lawsuits with the record labels and shutting down and the aftermath, uh, highly recommend that, uh, if you want more detail than the couple of minutes we're going to spend here on Napster, um, go listen to that

episode on over on IHP. Um, so Sean Fanning, uh, started Napster originally. He was a college student at, uh, Northeastern university in Boston. Um, and he and his friends uh well he was really into hacking computers this was like the late 90s kind of end of 98 beginning in 99 um really into hacking he was really active on irc and in a bunch of communities and forums um sort of trading programs on the internet and um and especially on broadband. So these were the days most people at home had dial up, but colleges all had broadband. And so, you know, having, I was, I was sort of on the tail end of this, but, you know, I remember, you know, the biggest attraction to going to college, you know, there was the education and all that,

but there was getting broadband internet and then stealing files on the internet. Yeah. I remember evaluating colleges based on that like they thought it was the most ridiculous thing but you know nerdy kid going into computer science uh i remember asking like on tour guides like what's the bandwidth in the dorms and it was the whole um remember the internet, that was like a separate backbone that only universities had that was like a faster private internet linking universities. Anyway, this all plays into Napster. So Sean is, he's active in all these online forums. He's trading files, but the, including MP3s, which people are ripping from CDsds you know this is big this is the imac you know and all this is happening rip mix burn rip mix wait i mean don't rip because that would be illegal uh yeah don't burn use itunes buy your music um so he realizes there's no good like front end to this stuff so he's like okay i'm well i'm you know i'm a cs major i'm gonna i'm gonna start coding up a front-end client um for trading files peer-to-peer on the internet he decides to call it

napster um he releases the first version of it and it basically just takes off like wildfire uh first at northeastern uh you know a college in boston this will we will revisit social apps uh on the internet starting at colleges in Boston and taking off like wildfire, uh, spreads to lots of other colleges all around the country. Um, he brings on two folks. One is Jordan Ritter. Who's also based in Boston. Uh, he takes over backend programming.

Um, and another friend that he has from, uh, from the IRC Relay Chat community, a guy named Sean Parker. And Sean joins, and he's basically kind of the business head of Napster. And Parker was kind of like a hacker hustler guy. He had a whole bunch of Internet businesses that he started in high school. He decided not to go to college. Apparently, he was making like 80K a year while he was in high school. He decided not to go to college. Um, apparently he was making like 80K a year while he was in high school, just from internet businesses. Um, so they, uh, the three of them get going, they raise $50,000 from Fanning's uncle and they move out to Silicon Valley. Uh, and kind of the rest is history. Again, you can listen to the IHP podcast, but basically

within a span of two years from 99 to 2001, Napster goes from being like the killer app for broadband. I mean, this was the reason I pressured my parents to get broadband at my house when I was growing up so I could use Napster, uh, or use it better than, than dial up. Um, you know, they get sued by all the music labels, uh, and the company shuts down and kind of flames out in a blaze of glory uh all within about two year period so 2000 well the ashes of napster kind of live on it gets resurrected as well no but i mean i'm thinking about the time in my life where i was actually using like napster napster and i had a zip disc that i would store my music on when i would download it and i would like you

know those are only a hundred megs. I'd like delete the old music that I didn't want anymore. So I could get the new songs off Napster. But the, uh, um, I can't believe that was only a two year period. I know it was crazy.

Well, because the, the labels sued Napster, um, they couldn't work out settlements. They sued, they sued Napster. They sued all of the individuals who are working at Napster, the founders all the investors the lps of all the venture funds like

they just went nuts oh my god um and and so quickly and what happens you know i remember this i'm sure you do too is napster gets shut down but then you know a million flowers bloom and it's placed because all this stuff uh kazaa leads to skype um which also will influence spotify uh which we'll come back to anyway sean parker though he exits napster after all this is happened in 2001 but he doesn't you know he does he's not one to rest on his laurels uh he founds a company called plaxo which we've also discussed on this show out in Silicon Valley. They're all out in California now. 2002 starts Plaxo, gets backed by Sequoia, raises money from Sequoia.

I believe Mike Moritz is on the board. And but Sean's still a kid and he's running this now sort of enterprise email, you know, identity company. He ends up getting pushed out after the downturn in 2004. Sequoia and the other board members push him out of the company, leads to a whole lot of animosity, ultimately leads to the infamous Facebook pajama pitch to Sequoia that is covered in the social network, um, which we'll get to, to, uh, so Parker's done with, and real briefly for anyone who doesn't, uh, um, who doesn't have the time to go check that out. Basically, uh, Sean Parker swore that when he was getting involved with Facebook, they would never go in and give Sequoia a piece of this. And finally, uh, Mark Zuckerberg, um, is, is persuaded to go and pitch Sequoia and shows up in his pajamas as a show of this and finally uh mark zuckerberg um is is persuaded to go and pitch sequoia and

shows up in his pajamas as a show of true respect yes true true respect now infamous in silicon valley lore um so parker's pushed out of plaxo uh doesn't sit still for long again. He supposedly his roommate at the time is dating a girl who's a student at Stanford, an undergrad at Stanford. And Parker sees on her computer one day, a site called the facebook.com. Uh, and this gets dramatized in, in the movie, the social network where, where Parker is played by Justin Timberlake, of all people. And it's so good. A girl, he has a try way into meeting with mark zuckerberg and then facebook co-founder eduardo saverin uh because facebook is still back on the harvard campus in boston uh he goes to new york he arranges a meeting with uh with the two of them this is all documented in the social network the company's a few months old uh and he basically talks his way

into joining the company as its president. And Parker has also become close with Peter Thiel at this point. Founders Fund doesn't exist yet, but PayPal has already exited to eBay and Peter is now investing in the PayPal mafia and other folks. And Peter ends up leading the first true investment in Facebook buys 10 of facebook for five hundred thousand dollars um a quite prescient move um and then the we all know what happens after that uh but i think yeah i think facebook i think it worked uh that'll be a story actually that we have already told you can go listen to our episode on the facebook ipo But I think everyone knows what happened. But for Parker, though, in the next year in 2005, you know, remember, he's still super young, he's got to be like, I don't know, 2425. At this point, he has a party at his vacation home in California, ends up getting busted by the police.

They find a bunch of drugs at the party. And as a result, he gets ousted from his role as president of Facebook. Again, all this is in the movie, in the social network. So that was Sean Parker. Sean Parker was born in 79. So that would mean all this is going down in what, 2005. So he's probably 26 yeah yeah seven somewhere 20 somewhere between 25 and 27 um so he's like the adult supervision at facebook

uh uh it's kind of a miracle that facebook survived all this because we'll get into some more stuff here um so you know Parker again, doesn't sit still for very long. He joins up with Peter Thiel, um, who had just at this point started founders fund, the VC firm that, um, Peter, uh, started, uh, and, uh, after the Facebook investment, um, Parker joins in 2006, but he still has music and Napster kind of on his mind. And if you remember, um, Facebook in the original early days, Facebook was actually the Trojan horse to realize what supposedly was Mark Zuckerberg's true vision. Wirehog, which was Wirehog. Yeah, that's right. They were co-developing. It's I think when they were, when they were working on, they were even doing this in

California, I think after they had moved out, they were working on both Facebook, the social network and Wirehog, the music sharing network, and were going to deploy Wirehog to everyone who had signed up for Facebook to be sort of the, exactly, David, the Trojan horse, the way that you bring P2P to the masses. Yep, exactly. And remember, Facebook was only at colleges at this point in time. It wasn't open to the whole public. And so Wirehog was essentially Napster 2.0. It was file sharing, but mostly primarily music and then video file sharing had become big at this point.

BitTorrent and other um applications were were were very popular um and so actually that pitch to sequoia the infamous pajama pitch uh that mark zuckerberg and facebook did supposedly they primarily pitched wirehog not facebook wow um but uh but parker you know he's he's lived through all of this he's been sued by the music industry, by all the labels, had Napster killed. He kind of says, look, guys, now is not the time. Someday, Wirehog, Napster, it'll all come back. But the industry has not changed enough. We're going to get sued.

The Facebook is working. Let's do that. Let's kill Wirehog. So supposedly,er was the one responsible for either before or after he left he stays really involved in the company even after he stopped being president um he's the one who kills wirehog within facebook all right so chapter one sean parker starts napster and that gets brutally murdered by the music industry. Chapter two, Facebook in its own success becomes the dominant thing. And there's no reason to focus on Wirehog there.

Wither chapter three. So for chapter three, we come back to Sweden now and to Daniel Ek, the CEO of Spotify. So Daniel, as we said, he started his first, uh, company in 1996, uh, at the age of 13, he was in school. Uh, it was a website, um, uh, web developer for clients, uh, sort of like, uh, um, uh, uh, Tony Hsieh and, uh, the Zappos guys, uh, when they moved out to california yeah man that was that was the thing to do in uh in high school like that was you could make way more money than anybody else because it's this highly valued skill it was the work didn't have to be good like there was no good i mean there's no like modern frameworks for

doing any web development then so you just throw something together and and adults are amazed that their business is on the internet there's no square space at this point in time no um so after a couple years daniel's making like fifty thousand dollars a month and has 25 employees he's still a early teenager um he ends up he does go to college briefly he goes to the KTH Royal Institute of technology, which is the top engineering school in Sweden. Uh, but he drops out. Uh, he wants to focus on, on startups. Uh, he joins one startup called Traderra and ends up getting acquired by eBay. Then he becomes the CTO of a virtual world, uh, game called star doll. Remember when virtual worlds were a big thing yeah i don't

know about you but i still spend uh most of my time in second life david yeah you might be just about the only person left who does that uh then after that he starts an online ad company called ed vertigo gets acquired by a company called trade doubler which is also a swedish company um that is sort of like the paypal mafia or i would we wave would say the airbnb mafia uh of sweden um and then after that finally uh trade doubler will come back in a second but after that finally finally, Daniel becomes the CEO of a company called you torrent. Uh, and you torrent is a bit torrent client. Um, so now bit torrent is basically, it's a, it's a peer to peer file sharing protocol that is the spiritual successor to, um, to Napster, to Kazaa, to LimeWire, to sort of the first generation of file sharing companies. And BitTorrent is, I don't know fully the technical details, but essentially it shards files, makes it a lot easier to transfer very large files between users. So people are using it for music, but now people are also using it for video, movies, television shows, and the like.

Yeah, it has the major benefit of you being able to concurrently download multiple pieces of a file from different sources so rather than david me taking up you know the hogging the entire way to download that one file that you have i can split it into 100 pieces and grab 100 pieces concurrently from different people so the more people that are hosting the file the more people that um can can share to the network yep the faster it all moves and so this is you torrents based in sweden uh later that year this is 2006 uh after daniel becomes the ceo it ends up getting acquired by bit torrent um and and this is like piracy you you know, which started with Napster has now reached like a fever pitch. There's actually, I had forgotten about this. There's a political party in Sweden that has formed a legitimate political party called the Pirate Party.

Oh, I do remember that. Their platform is like eliminating intellectual property rights from the law period globally and and like there are a lot of people that support this apparently in in the you know national elections at the time they get about seven percent of all votes in the country uh it's crazy and so like you know everybody this is the music industry has been decimated at this point. People are worried. Netflix is starting the transition into video streaming. People are worried. BitTorrent's out there. People are pirating movies.

What's next? Basically, there's no hope in sight for intellectual property on the internet. So has Apple ridden in on their, their white knight horse yet? Oh yeah, totally. 99 cent downloads. 99 cent downloads. So iTunes, you know, is hailed as the savior of the music industry, but easy beats free the classic Steve Jobs ism.

Yep. But iTunes is still, uh, and until the beats acquisition, uh, which we covered, it's still in the purchasing music paradigm, uh, where you're paying money per file. Uh, and then you can play that file anywhere, but it's only one song or one album. Um, it's not like the best experience. And this is where Daniel actually can't play it anywhere. It's like, I mean, until they switched to the DRM free for the dollar 29, instead of the 99 cent stuff, it was still restricted to five devices that had to be authorized in kind of a kludgy way.

You literally had to transfer the MP3 around because the cloud hadn't really blossomed yet, and certainly not streaming. So, you know, they're, they're, if you think about sort of step functions to the user experience,'d say you know that itunes was like 20 better because i didn't have to go into shady parts of the internet to try and find this music that fell off the back of a truck it was like right in my music player which is great but and you knew it was the right song you know the true right right remember all the crappy files you'd get from napster and you know kazan it's like it's like somebody like uh playing uh uh like playing something out of their computer speakers and then re-recording it onto a separate thing so you have this weird like hiss in the background

it was great wild west totally but but it really wasn't you know it wasn't a whole step function better it was you know easy sure it beat free but it wasn't a paradigm shift. It was still all the same downsides of transferring an MP3 around, but with the new downsides where it also costs money. Remember organizing your iTunes file library? I want my life back. I want all those hours back. I meticulously cared about this. I like, I, for a while, tried to get some of those software, some of the programs, I think something about a brain, like brain, sound brains or something

that would go through and like help you by recognizing the audio signature and filling it in. But even that was wrong. And I'm like so obnoxious and meticulous about keeping that stuff accurate that like I have spent weeks, like cumulative weeks of my life. I think this was probably like the biggest, you know, wound

inflicted on our generation was that like, you know, all this product, potentially productive time that we could have been spending playing video games, you know, which we were doing the rest of the time we were organizing our iTunes file file well and i i thought i was gonna have that with me for life like i remember you know you look at your dad's record collection or you know my my parents also had this like rich cd collection and i'm like this is the way like this is my music collection that i'm gonna carry with me forever and i remember i mean we're i'm jumping a little bit ahead but i remember this moment a few years ago where like i got a new computer and i didn't transfer my iTunes library over. I just like have it on an external hard drive somewhere around my house. And it was like this painful, incredible illustration

of sunk cost fallacy where I, I just, I like, um, um, like mourning the fact that there's these hundreds and hundreds of gigabytes that I'm just not not bringing with me into the next chapter of my life and and and did anything bad happen from it like no i i i have access to basically i i think all of that music except for sort of some um you know live stuff here and there and some covers and all that but like you know i hadn't i hadn't opened itunes and listened to any of that in years yep yep so this is really the insight that daniel eck has which is which is two-pronged it's that the user experience for music is not just that the industry is broken but the user experience is broken and itunes is not great for all the reasons we talked about, but piracy isn't great either.

Uh, you know, BitTorrent and all the spiritual successors of, of Napster. Um, you still have the same problem. You got to manage the files. You don't know what you're getting. Uh, it's really, it feels like, you know, all of this feels like technology that's not like productized. And so he has the vision that there's a better way. Uh, there's actually a better way to consume music that is better than pirating better than iTunes. And that is what becomes Spotify. So he decides, you know, yeah, the music industry is hard, but I'm just going to go for it. He teams up with Martin Lawrenson, uh, his co-founder who was

one of the trade doubler co-founders. Remember trade doubler had acquired, um, had acquired Daniel's last company before he joined you torrent. Um, they fund the company themselves. They figured they can raise venture capital. Uh, and you know, they'll do some deals with record labels, get launched. They have this, this new this new you know new paradigm for consuming music of course everybody's going to see how much better it is and it turns out it's quite a slog to get the record labels on board um so this was yeah shocking so this was 2006 when they start the company apparently the name spotify comes from they're in daniel's apartment they're brainstorming names for the company they're sitting in different rooms and they're shouting back and forth and uh with suggestions martin shouts something uh and daniel

mishears it as spotify and immediately googles it realizes that the domain name is available and thus spotify i love these stories like of how these things kind of be they later they later try and justify it as like well it's a mash-up of spot and identify but no that's that's not what happened it's like it's like uh pierre omidyar when asked at an all-hands meeting after the ebay ipo what does ebay stand for he was like well i was gonna i've been trying to tell people that it's like electronic Bay, but I just thought eBay sounded cool. Totally. Um, so they build,

uh, they build the product. Uh, they're working with the labels. Um, but it takes, as I said, forever,

um, to get any deals done. And the labels in particular don't want to go anywhere near giving the rights to streaming, uh, to the U S. Um, so it's actually really fortunate that the company starts in Sweden because eventually after basically two years, they're able to convince the record labels to let them experiment with this new paradigm of streaming. Um, remember Netflix is already around at this point, like the model is proven,

um, but only in Sweden, they won't let them do it in any other companies. Um, so finally, uh, finally in October, 2008, so almost two years after they start the company, they launch in Sweden with free accounts available by invitation to everyone. So they use the invitation, you know, growth hacking, uh, method for free accounts. Uh, but if you want to pay to subscribe, um, anybody can come in and pay to subscribe. So it's like, you gotta be part of the club to get in for free, but you can bypass the line if you pay 10 euros a month to subscribe. That's a great, that's so interesting. Cause it does, I mean, it hits that critical mass where if you're using a viral invite system like that it's not hard to find someone with 50 invites to gmail anymore but at the beginning it's so coveted if you care about being on it and that social i mean that's it's so clearly

not going to be a long-term revenue strategy but it's like hey if people will pay for this now we may as well do it great way to start great way to start um shortly thereafter in february 2009 um they launched in the uk and then they slowly kind of roll out in europe after that um but it's it's really working and it's growing as a personal uh aside here i did a summer internship um with exact targets uk subsidiary in two summer of 2009. And I remember reading all this articles in tech crunch and oh eight and oh nine about Spotify and what a disruptive innovative thing this was and sitting in my dorm room in Ohio state being like, I have, I feel so disconnected. Like I, you know, I'm, I'm here manually curating my iTunes library.

And like, I keep hearing about the streaming music thing. And it was like the most awesome experience to go and do that internship in London and get to use Spotify. But then when I came back in what September of, of 2009 to get plunged into the dark ages back into the U S again, it was this really weird experience. Yeah, totally. Well, so summer of 2009, this is when Sean Parker comes back into the story, rises from the dead up raising 50 million dollars uh in what was their series b at that point uh from wellington partners the hedge fund and lee cashing the um uh the wealthy uh i believe hong kong based uh hong kong or taiwan i believe hong kong based uh billionaire um but sean parker so at some point uh at some point, Daniel comes to Silicon Valley, comes to the U S and he meets with Mark Zuckerberg and Facebook. And apparently Sean Parker's

there too. And he's like, this is it. This is Napster 2.0. This is the way to do it. And, um, but they just closed this round, this million dollar round sean at this time had joined up with peter teal as a as a partner at founders fund and so sean writes daniel this email and we'll link to it i believe he hadn't met him because in this email he says i look forward to meeting you in person i really liked this but i look forward to meeting you i see all these anyway uh so maybe it was that daniel met with zuck and zuck told uh sean parker about it or whatever sean parker went crazy sean parker goes crazy fell in love with this thing totally falls in love with it and so he writes this email which is online on the internet published for posterity we'll link to it it's amazing um and so i'm just gonna, I'm just gonna quote

liberally from this email here. It starts off with, you know, I've been playing around with Spotify. You've built an amazing experience. As you saw, Zuck really likes it too. I've been trying to get him to understand your model for a while now, but I think he just needed to see it for himself. Facebook has been in partnership discussions with various companies to fully integrate music download with the facebook profile most of these deals would have resulted in the wrong user experience and i've done my best to stop them where they didn't make sense remember parker has no formal involvement with facebook at this point in time uh in particular there's no way that itunes could enable the right experience on Facebook.

And, uh, and, and he continues, he says, ever since Napster, I've dreamt of building a product similar to Spotify. What's clear. Oh, good. Go for it. What's clear is that the labels never quite understood the way people really consume, share, consume, share, and experience digital music. And they couldn't admit to themselves that this behavior pattern wasn't changing anytime soon uh rather they'd have to change their the way they did business essentially to make it work and and these are so clearly two kindred spirits like the way that sean parker thinks about music and the way that daniel ek thinks about music like it is you are when you read this thing you're sort of reading the future product roadmap for spotify as laid out by sean parker which i'm sure spotify had already thought through and if you if you find if you find the content of this episode uh interesting you'll just like like love every

word of of reading this so go check it out in the show notes well and this is what's interesting so i don't know it it's probably impossible to know whether spotify had uh already had on their roadmap all the things that i'm about to say that uh parker lays out but essentially this is you know the first key to spotify was what we talked about uh earlier which is really getting the product experience right like it's a better product experience than either itunes or or piracy because you don't have to worry about organizing and files and all, it's just right there at your fingertips, you know, wherever you are on any device. That's great.

But that's only the first thing. The second key to Spotify is Facebook and distribution. So yeah, so Sean in his email to Daniel says, my goal for the second generation Napster, once we'd gotten around to cleaning up the messy interface, which he actually rails on as an aside, he rails on napster's interface for most of this this uh letter he so clearly holds himself as like a product designer and is just massively ashamed that they weren't able to sort of clean it up anyway which is funny because he was basically i mean he was

technical but he was basically the business dude at napster like he was not the product designer yeah so my goal for the second generation Napster was to implement social and sharing features. This would have dramatically increased the volume of sharing happening through the system. Based on the comment you made to Zuck, I suspect you're moving in this direction. You should build this capability directly into the client using Facebook to connect, to authenticate, and then leveraging the viral communication channels to spread spotify rapidly around the world that he says you guys are likely going to be the first major success story

with facebook connect which facebook had just launched which was their login platform and he says if you need some on its own has been has been quite the topic of discussion well cambridge analytica and all that um then he says if you need some help navigating Facebook platform, in particular, the viral channels, I'm happy to lend a hand. And this is really how Spotify becomes a $30 billion company. So also, this email is a masterpiece of, you know, if you're a VC and you're trying to get yourself into a deal, an investment or win a deal, like this is how you do it. Take notes. Uh, because shortly thereafter founders fund comes in and Sean adds another 15 million to the round that was already closed. Uh, Daniel says, of course, I need to have you involved. And, uh, uh, and then founders fund and Sean end up,

end up investing. Um, but this is, this is it. And so at this point in time, this is the end of 2009. Um, the company Spotify believes they're about six weeks away from being able to launch in the U S they've been working on deals with the record labels forever. Sean knows dealing with the record labels takes longer than you think. He thinks it's about 12 weeks away, you know, in the next quarter, they'll get out in the U S turns out to take another two years until they, until they're finally able to launch in the U S it's not until 2011. Um, but that also is very fortuitous for the company because they basically take those two years and they do two things. They foster their relationship with Facebook through brokered through Sean Parker.

Um, and they essentially re architect the entire product to rely on Facebook connect and social login, and then distribute every action that every user takes. Uh, and we'll get into this, uh, within Spotify gets distributed out to their Facebook account to the newsfeed. And this is really what drives Spotify's viral growth. This is, you know, it's Farmville for music. Like you really are just seeing every update that every one of your friends takes in Spotify in your newsfeed. Ben, listen to Wake Me Up Before You Go. I mean, I seriously seriously i remember turning publishing on and off specifically when i was listening to certain songs like i hope this doesn't go

out on my facebook and i was one of those people david did you ever use um um audio scrabbler or yes which became last or move with yeah merge with last fm i was like i i had that hooked into itunes so i was always scrabbling to my last.fm account and then when i realized uh so that i enabled the switch for that to get published to facebook but like no one else like it was very much a like homebrew computer club type thing to be sharing all your music data on facebook before spotify and then i remember when spotify lit up in the u.s it was like holy god every single person's listening, you know, um, habits are, are showing up here in real time. You know, it's either like you farmed a root vegetable or you listen to, you know, I don't know what was popular music at this point in time. Like, uh, so hard to remember Justin Timberlake.

Here's the thing that's actually not hard to remember is I'm pretty sure I heard a great quote once that was your music taste for the rest of your life is whatever you're listening to senior year of college. So I would bet if we go look at what you and I actually listen, like I was listening to a ton of Radiohead and what I listened to today, a lot of Radiohead. I think that's the way it works. Colleges think, uh, that's, uh, so it works colleges. That's why it's important. It sets your habits for life. Uh, so 2011, basically Spotify has now had time to build this relationship with Facebook. And in July of 2011, they launched in

the U S but September, 2011 is the biggest moment in Spotify's history. And that is 2011 Facebook F8, their big annual conference. During the keynote, Zuckerberg invites Danielek up on stage and announces a major partnership between Facebook and Spotify. And it's two things. One, at that F8, Facebook had announced, launched Open Graph and the platform the year, well, the platform had been launched many years before, but Open Graph launched the year before that basically allowed lots of people to now insert activities that people were doing in non-Facebook apps like Spotify, like Zynga into the newsfeed. They launched the ticker in 2011,

which is basically like a real-time firehose stream. I think this was kind of in reaction to Twitter of everything, literally everything all your friends are doing, streaming by you. And it was like that little, you had your regular newsfeed, but then up in the top right corner, you also had the real-time ticker.

Yep, and it was basically just garbage that got overwhelmed with marketing that all these companies were hacking into facebook um but so in this partnership not only is um is spotify a launch partner for the ticker so you know all what all your friends are listening to playlists they're making everything uh is getting pumped into the ticker and the news feed they also if you have spotify installed on your computer and you're on facebook there are play buttons on all of these things uh in the ticker and in the news feed you just click the play button on the song right within facebook it starts playing the the music and so if you don't have spotify installed

this is a big incentive to now install Spotify. And you know what? We sort of, what's the right way to say this? We sort of criticize and poke fun at the, wow, they really hijacked Facebook for this purpose. But this is like the exact perfect product usage fit match, where it was an amazing, amazing experience as a Facebook user to suddenly have like real time music available as a play button from that little thing. Like, at the very least, it super valuable to see uh to have social music recommendations and this is a thing that like we it's sort of assumed today that's like oh well spotify's cool playlist will show me what my friends are listening to or based on my listening habits or um you know a friend will tweet out what they're listening to but this was like so

crazy breakthrough that i it basically takes the way that people used to word of mouth recommend new albums to their friends or old things they had found that were cool and bring them into the primary way that you were interacting online. And I just think like it was a brilliant move on Spotify's part to be able to get this distribution and um um you know partner with facebook in this way but talk about a perfect uh a perfect reason for facebook to have a platform yeah like facebook was never going to do this they canned wire hog they had a million other things to do and and this made their service so much better at least in you know maybe not as as uh crazy as they went with the implementation but this notion of of being able to experience my music based on what my friends are are listening to actually i think you're right like it is unfair to lump spotify into this whole group of companies zynga

being you know primary offender number one of just hijacking the news feed like it actually was a pretty good product experience now do i care that like ben is listening to wake me up before you go or somebody i went to middle school with is like no so they overdid it but like this and i think you see this now like of all these companies and there was a whole wave of them you know zynga there were a bunch of social newsreader apps there were social shopping sites like all this stuff all these companies are dead because they weren't actually like useful products that people wanted but spotify is still around and is a 30 billion dollar company now it's like the only what i mean zing is still around but that's mostly because of their real estate holdings but uh yeah and i one other point on on spotify is while it's

significantly ratcheted back on facebook like you don you don't really see this in people's news feeds anymore, Spotify themselves gained enough of a critical mass where most people, or let's throw out most millennials in the US who are going to be on Spotify are on Spotify. I don't know if that's a totally fair assumption, but let's just take that at face value for the moment. They have that experience in the sidebar on Spotify where you can see what your friends are listening to that is snagged from the Facebook friend graph. And so, you know, they're not using it as necessarily as a growth vehicle anymore. But I would say maybe once every other week or so I will listen to a song because it's in that sidebar on spotify and it's still um you know hearkening back to that it added to the facebook experience it adds to the spotify experience to have a current view of what your social network is listening to yep yep well regardless it certainly works for spotify so basically overnight, like, I mean, literally in 24 hours, they get a million signups, uh, from this, uh, cause it's all over everyone's new speed. Wow. Um, and then within the month they've doubled their user base. They were, well, almost doubled. They were just over 3 million users, um, primarily across Europe at this point in time. They just launched in the US. And by the end of September,

there are, I believe, over 6 million users. And over 2 million of those are paying. Wow. The US is a heck of a market to enter. Yeah. Well, especially on the back of Facebook and Mark Zuckerberg bringing you on stage on the keynote. Right.

So 2 million of the 6 million from the u.s were were uh premium uh that was i that was worldwide so six got it six million worldwide two million paying premium and that's a lot of money like that's also that's not so different from today i mean today it's in the high 40 but um i mean that it's really interesting from the earliest days they had an incredibly well converting freemium model. Yep. Incredibly well converting. And they tweak it over time.

So originally it was free to listen on desktop and then you had to pay to go mobile. They tweaked that so that it was free on mobile as well, but only shuffle mode. So you still can't pick specific songs. You only shuffle playlists um yeah it converts really well um so basically you know on the back of that like that's the rocket fuel that that spotify needs to um to reach escape velocity and take off into the large company it is today. So they finished 2012 the next year with 20 million active listeners. So huge growth, like over three X from 2011, uh, 5 million paying subs. So almost three X growth on paid, uh, 1 million paying subs in the U S at the end of 2012. Um, and then they just start raising a ton of money to keep pumping it into marketing and product development to, uh, 2012, there is a hundred million from Goldman Sachs at a $3 billion valuation.

2013, there is 250 million at a $5 billion valuation. They also funny aside, kind of just like Dropbox. This is the era when everyone wants to be a platform. So Spotify also gets caught up in this builds the spotify platform uh allow app developers to build apps based on music it's like wait really yeah of course this is all buried in history now but completely missed that lots of hype they launched it late 2011 they kill it in 2014 but it's like this is the future you know you can build apps with music and it's like what anyway fortunately so funny it's so funny to watch

these companies try and launch these like broad-based platforms that don't make sense and then you kill it and then years down the line launch another platform that is like highly targeted something that really makes sense like spotify connect today is freaking awesome like the ability to play spotify out to various partners sonos and you know everyone that can hook a a speaker or a playback device into spotify it's worked so well and like that turns out that was the killer way to integrate with with spotify for things coming out of spotify yeah yeah totally but they get there um and they just keep raising more and more money they they ultimately end up raising i believe about two and a half billion dollars in the private markets.

They also in late 2015 and then into 2016, as, you know, Facebook is now no longer Facebook has vastly locked down its platform. You're not getting all this crazy distribution. They really catch the next wave really well well too, and time it well with machine learning and recommendations. Uh, they launched the discover weekly playlist, uh, machine learning generated, uh, algorithmically generated playlist, unique to each user with new songs that they think you'll like, or songs that you don't know well, that they think you'll like. They launched that at the end of 2015 radar which is new music from artists you like launches in 2016 along with the daily mix and this drives kind of the next wave of of growth

in the company um and engagement and so by the end of 2016 they have 40 million paying subscribers which like that's a huge growth and just to take a pause on sort of internal innovation, it's worth pointing out that the Discover Weekly playlist was very much an experiment within the company before they launched Daily Mixes, before they came out with Release Radar, before that got promoted to like a first class thing on the home screen. It was just one of the playlists available to you, like 70s, 80s, 90s, discover weekly. And they had this framework, which were playlists on which they could sort of test this new concept of can we algorithmically generate stuff that people will want to listen to and be accurate in that and improve in that.

And it's really interesting. I mean, the innovation that the company had that they have sort of a few innovations over their lifetime, but that ultimately made them a $30 billion company, it was streaming should be the way that this that this world works. And we're going to persevere with the music labels to make that happen. Facebook is this amazing distribution vehicle. So we're gonna, you know, that that's, that's our sort of innovation number two. And we're in the wave of number three right now and they really had a nice framework internally to be able to um not only test something but then like now we're seeing really double down on it as it was working and promoting it to like a first class piece of the platform yeah and i think it also it's a good point we didn't really cover earlier this has always been

a thread through spotify's product history but um is best expressed in in these in these playlists and discover weekly and radar and daily mix is this idea of the playlist like playlists had been around you know since recording cassette tapes you know in the 80s um and then certainly itunes had playlists but what was great about spotify is they really made playlists the first class citizens so like and this was part of what they got the labels back on board with is whereas itunes is a singles focus like you you are buying individual songs you can buy albums but like people buy songs with spotify the focus is on playlists and that kept people engaged engaged with artists um and and listening a lot more

and when the labels were getting paid labels and artists are getting paid based on number of streams keeping people streaming more listening more aligns incentives a lot better yep absolutely um so end of 2016 40 million paying subscribers now some of those are family plans some of those are family plans. Some of those are student plans. We talked about this in the beats episode. You know, it's not quite fair to say that, um, you just multiply that by 10 and that's how much they're $10 per month or euros per month, um, is the, is the cost. And that's how much they're making per month. But even if you multiply it by five, be really conservative, that's $200 million or euros in subscription revenue per month um

that's a lot of a lot of revenue i mean that is a serious business wouldn't it be great if they could keep you know a ton of it instead of just like you know like 10 of it wouldn't that be great well they keep 30 yeah well ultimately so i guess where i was going with this is ultimately there during that year and in 2016 um their uh uh gross margins on the premium stuff is uh is 16 percent um the ad consolidated stuff they actually lose i'm sorry the ad supported stuff they actually lose 12 so it's a negative 12 gross margin margin, and they're consolidated as 14%, which jumped up the next year due to a deal negotiation. sorry the the uh direct listing not the ipo is is certainly that it's you know that it's incredibly low margin business relative to a lot of these other technology behemoths that have uh have really become huge in the last few years yep well to get us there quickly uh company's growing

as we mentioned earlier there's always been a robust secondary trading market for the stock they've raised all of this money. They don't need to raise any more money. We'll get into the business model in a minute in narratives. But at the very least, they have a very nice cash flow dynamic where their subscribers pay them up front every month the $10 or €10 a month subscription fee. They don't pay the revenue share. Spotify doesn't pay the revenue share out to the labels until after the end of the month. So just like Amazon in this regard, they have a positive or a negative working cash flow cycle that allows them to be cash flow

positive, even if they're not net income positive. And in the meantime they had hired uh the guy named barry mccarthy as their cfo who is their cfo he had been the former cfo of netflix also took a short detour after that to be the coo of clinkle uh sad we're we're not going to talk about that one here that would be my only goal for this episode was to get to yell clinkle oh my goodness one of my friends in business school did his summer internship at clinkle that's for another episode anyway fortunately for barry he moves on quickly from clinkle and becomes the cfo of spotify and barry is the one who really leads the charge saying why would we do an ipo and give 7% of the offering a raise money when we don't need it, take delusion of the company, give 7% of the offering to banks.

Let's just do this direct listing. Um, so they do, they set a reference point. So there's no, there's no pre sales like in an IPO. Uh, they set a reference point for trading of $132 share or, uh, which equates to a market cap of about 23 and a half billion that's where shares have been trading on the private market um they announced that they're going to do the first trade publicly on uh tuesday april 3rd which they do it opens the first trade happens at 165 dollars a share and 90 cents right around the 30 which is totally way higher like the reference price was 132 reuters reported that it would be between 145 and 155 um you know it just just kept

climbing up to the day yep and so that's about a 30 billion dollar market cap it ends the day at 149 dollars a share or 26 and a half billion dollar market cap still up um as we alluded to the folks at the new york stock exchange mistakenly raised the swiss flag outside the exchange let's start with s instead of the swedish flag it's okay that's quickly rectified uh but this morning here we're thursday morning two days later um still trading about 150 dollars a share so right around just below a 27 billion dollar market cap. Yeah. And the really important thing here sort of for the future of direct listings is, you know, will it, will it sort of settle here? Because the thing that everyone was really worried about is there's

going to be all this incredible volatility. They didn't hire bankers to stabilize. you know, that if it ends up falling below $132 a share, that's below the last place it was trading in the private markets. But, you know, all indicators are positive right now. And Spotify did a few really intelligent things to sort of mitigate some of the possible risks of doing this direct listing and having all the volatility. The first of which being, they actually did hire investment banks. And as you sort of read a lot of these articles, it becomes clear that it wasn't one, it wasn't two. They paid Goldman Sachs, Morgan Stanley, Allen & Company. Morgan Stanley is technically serving as financial advisor, but ultimately,

they're going to pay 44 to 50 million bucks in banker fees. Yeah, advisory fees. It's quite comparable to what they would have paid if they had actually IPO'd. It's sort of shy of... Recently, if you look around, Snapchat paid over $60 million. But if you look, Dropbox was only around $30 million. Mongo was at like $17 million. Stitch Fix was at $7 million. They're actually, despite the fact that they are doing a direct listing and there's lots of other reasons why that's awesome, they are paying a hefty fee out to banks to help, I think to help stabilize or help craft the messaging or, or something.

Yeah. I'm not sure exactly what the banks are doing. I think it's probably their institutional sales forces that are marketing the stock to large institutional investor clients, hedge funds, mutual funds, and the like. I think that's probably what they're paying them for,

which is really what a bank would do in an ipo process it's just that they're doing it on an advisory basis instead of taking literally buying the shares from the company and then reselling them to those investors so yeah should we get in from that yeah one other thing the other really smart thing that spotify did leading up to this is they um you know they encourage sort of second market uh trading for their employees and they um you know the more volume gets out there to be traded the more certainty they have around what it's going to be in the in the public markets and so um i don't know exactly what they did i this i think they waived they wa they waived basically their right to be the ones purchasing when employees are selling their shares to kind of encourage this. All right, listeners.

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Vanta.com slash acquired. Should we get into narratives? Yeah, let's do it. Let's do it. So one thing that's interesting to take a look at before we get in before totally doing narratives is what the cap table look like. So Daniel X still owned 25.7% of shares. And Martin owned 13.2%. So that's almost 40% among the two co founders. That's like a Dropbox level of ownership. It's more than Dropbox.

Yeah, they took on so much capital. I mean, they've raised $2.5 billion and it's been 12 years. Yeah. Well, they raised at such high valuations along the way. And again, you know, this is narratives here. They raised at such high valuations. Their revenue numbers were so impressive. But the question is, how much of that is going to flow down to the bottom line after the labels take their 70% cut? percentages are so high and you say, why are they so high? Growth is an amazing leverage point. And profitability or close to profitability or at least running a lean operation and generating a

lot of cash is also a really high leverage point. So both of these companies grew like wildfire, monetized from an early day. And that just, and, you know, that just gives them a lot of, of, uh, ability to, um, to raise it really high valuations and bring a lot of cash into the business with a lot of certainty in the future. Yeah. But the difference between Dropbox and Spotify, as I'm sure you'll get into, I actually didn't look up what, do you know offhand what Spotify's overall gross margin is? Um, I do, I do. So it actually went up last year because of a renegotiation with the labels where Spotify said, look, we want a higher take rate. But if we don't grow and hit our numbers, you get to take more money. And so it went from, if you look at their consolidated gross margin

from 2015, 16, and 17, it was 12%, then 14%, and then a huge jump last year to 21%. So they're definitely betting the farm on future growth here right now. And being nicely compensated for it from the labels. Yep. So it's 21% gross margin? 21%, yeah. And for folks that haven't stared at gross margins all day, what you would want from a technology company is really high fixed costs and really low variable costs so that would be a really high gross margin because you your actual cost of revenue is uh

is is very low so if you look at something like a facebook they tend to hover around an 85 percent gross margin and uh google i think is high 80s, low nineties. Um, but Dropbox getting back to that comparison, uh, is, uh, just under 70. So 67% gross margins currently at Dropbox. Uh, so all of this is significantly higher. And, and Ben, just like you were saying, like the reason this is important is like, you know, tech companies require a huge amount of fixed costs in the engineering, in the servers, all the stuff that you need, the employees that you need to build the companies. But then the business models tend to be so scalable on a marginal cost basis. Like it doesn't cost Facebook anything to sell another ad or Google anything to sell another ad word.

Dropbox, It does cost them in storage, uh, to bring on new customers, but especially as after they've moved off AWS, it doesn't cost them that much. You know, they're still making 70% gross margins, right? Not the case with Spotify. That's right. That's right. So getting into the narratives, um, uh, a quick snapshot of their business today, they're unprofitable. In 2017, they did $5 billion in revenue, which is awesome. But they took a $1.46 billion loss. So you would hope to see that sort of change soon, where they're actually generating a profit rather than generating a billion and a half dollar loss when they have 5 billion in revenue, but they're not

there yet. On their balance sheet, they have $582 million of cash available. So about half a billion bucks of cash. Now, if one thing that's interesting to note, so they didn't raise any money because this wasn't an IPO. They've got half a million dollars of cash available on their balance sheet, but they're losing a billion and a half every year or at least at their current run rate. So unless they get profitable fast, they will actually need more money to continue funding the business. Now, yeah, I think there's a yes but here um yes but if you look at you know because of some of the dynamics we were talking about earlier with the negative working cash cycle they actually are cash flow positive operating cash flow positive so in 2017 they generated 179 million euros in operating cash flow um now they still lost money, on a cash basis for the year,

right. Um, because they're having to pay off, uh, interest on, um, on the debt that they have, the convertible debt that they have. Um, so, you know, yes, they will eventually need to turn, um, that income positive. That's the bet here. Uh, but they are cashflow positive on a, they are cashflow positive, but it's not anywhere near the levels that dropbox is at i believe well i can look it up quickly i believe dropbox is um generating right around half a billion in operating cash flow right now and growing quickly spotify growing too but like they're kind of hamstrung by these margins yeah yeah and thanks for that correction that's a that's a that's a great point and not to be overlooked um and the

last thing i'll say is growth is spectacular like if you look at revenue growth from 2016 to 2017 they went from 3.6 billion up to that that 5 billion number um you know when you're generating that much revenue to be growing like that is is really really, I mean, they're, they're in a, they clearly, uh, um, you know, hit a high pressure valve when they were, uh, uh, looking around for what market to enter. Um, this doesn't look like it's going to stop flowing anytime soon. Um, they, uh, they have 159 million monthly active users, 71 million of those, which is almost half are uh are paying paying premium subscribers which means they're they've um switched off the ad tier and into the paying tier um which is they have double the number of apple music subscribers i actually don't know if that's subscribers or

or monthly active users but they sort of brag that they're double apple music um so you know that that i think it's i think it's huge growth i think it's subscribers i think it's paying yep yeah i think that i think that's true too uh so real quick i looked up dropbox so dropbox 2017 330 million dollars in cash flow from operating activities uh spotify 179 million dollars so roughly a little less than twice as much for Dropbox. Cool. Thank you. So if you look at what Spotify says in their F1, they're advertising that streaming is the tidal wave on here. And it's very early days, and it's growing globally. That smartphone growth is a huge driver,

that Spotify is the market leader in a huge way, and even this behemoth Apple can't catch them. They use data in a huge way to provide this personalized experience. They're running as an operationally lean business. And they really saved music. They are not shy about this story. The way that they opened their F1 they they are not shy about this story the way that they open their f1 is really by talking about um the incredible decline that the music industry was in and uh and how streaming sort of pulled them out of it and saved the music industry and so the way they talk about themselves you know the the skeptics would argue that um you know they are really at the mercy of these these, and they have no bargaining power,

and they have no pricing power. And what Spotify says is, look, the music labels love us because we saved the industry. And there's all these ways for both artists and labels, for everyone to do better, because the way that we enable people to listen to music actually creates growth for music yep and i think all that is is true um you know it's uh uh sean parker and napster 2.0 working with the music industry yeah so what would the skeptics say um you know it's i haven't heard as much about this in the last call it six months but for the few years before that, Spotify was a trope. It's a terrible freaking business. The suppliers have all the leverage. The music labels take a huge cut. the uh in their um agreements where uh basically for spotify to get a better rate they have to go and agree and get all of the major labels the sort of four or five major labels that make up 85 percent of the the music listened to on spotify to agree to this new lower rate um it's a you know

it's a total cartel and unlike uh the the technology business of uh let's let's look at netflix for example where they actually um license the shows and pay an upfront cost of you know you look at house of cards 100 million dollars to create house of cards internally or a not license that netflix creates the shows that netflix creates the show or or pays a license fee sorry i conflated those to uh existing back catalogs from from other existing produced shows they pay a one-time fee up front and they own that for a certain number of years whereas uh and and so they can generate as much revenue as they want for it they get to keep the revenue and it's just a sort of a one-time cost but if you look at what Spotify is doing, compare and contrast, every single stream

has a percentage that's paid out to the music labels, and therefore, Spotify cannot outrun their costs. Yeah, it's this difference between variable and fixed costs. Netflix has an even greater amount of fixed costs versus Spotify, both because they're paying upfront a fixed price to license the the shows and movies that they didn't make and then a lot of money to actually make their own content uh but then when they all their revenue they just keep all the revenue um they don't have to pay a percentage of their subscription fees to the movie studios it's the opposite what you're saying with with spotify where uh a percentage a

large percentage of their subscription revenue is getting handed right back to the label so as the subscription revenue grows so does the amount that they have to pay yep it's a good good succinct explanation uh you know skeptics also argue they they have catalog parody with apple music whereas if you look at something like in netflix um i have all this great stuff available on netflix oh gosh there's this entirely non-overlapping subset of stuff available on hbo go maybe i'll pay for both i'm sorry hbo now um maybe i'll pay for both and and there's actual um um people actually do subscribe to multiple of these things and if you look at a music subscription service, basically no one subscribes to multiple, uh, because they have the same back catalogs and skeptics would say that congratulations, you

have algorithmically generated playlists. Uh, I don't think that's differentiating enough to make people switch or, uh, make artists want to launch with, you know, any sort of exclusivity or anything like that, because it's still only ever going to be this subset of the market of listeners they could release to by releasing on both. And lastly, that music is something that's just going to be owned by the platform owners. So sure, you've done well, Spotify, but you had a 10 year or nine year head start on Apple Music. And God, they're growing so much faster than you are. They will catch you soon. I think when we did the bundle, when we did the beats episode,

was it 36 million subscribers? I believe that Apple music is at now. So roughly half of Spotify is paying subscribers and that's in, uh, uh, two years, two and a half years since it launched. Yeah. I mean, it's a bit of a farce for Spotify to say we have twice as many subscribers as Apple music. Like you are almost a decade older than Apple music and they're, they're coming up fast. And for all of Spotify is really brilliant. As we talked about distribution tactics, uh, you can't beat being the default player on the device. Uh, but then also, you know, there's another, there's another, um, I don't know. So that was what the skeptics would say. I mean, I use Spotify. I don't pay

for Apple music. I'm, uh, I highly ingrained in the Apple ecosystem. Like maybe they're the ones who can do it. Yep. Well, I was going to say there is another, um, player, you know, lurking in the shadows here, uh, which is what do I do? Uh, I use Amazon music and that's Jeff Bezos. Your margin is my opportunity. Even if your margin is very small, uh, David, that's because you don't like music. I do like music. I actually converted. I now pay for Amazon music, uh, but it's cheaper. I think it's seven bucks a month, six or seven bucks a month. Um. But because it's baked into Prime, either...

So when you pay for it, it's... Your 12% gross margin is my opportunity. Welcome to Bezos land. Yeah. Because it's all bundled. It's all part of Prime. Amazon can have a totally different business model. So Amazon Music Unlimited, which is what you pay for,

is cheaper than Apple and Spotify, just as good. I mean, maybe there's some small things on the margin that Spotify does better with algorithmic recommendations and Apple being baked into the device. But ultimately, especially in an Alexa world now, being the default on Alexa, that's very powerful. Apologies to all the speakers of our listeners who we just activated lady a uh you know uh and price is is meaningful to a lot of people and then there's the free tier for amazon which is you have complete control it's a limited catalog but it's most of the stuff that you care about if you're a casual music

listener. And then it's just completely free with prime and you can play directly. You're not limited to shuffle mode. You can play on any devices. You know, it's, it's a big disruptive force. Yep.

Yeah. I'm not going to bet on it, but good case. I think, I'm not going to bet on it, but good case. Well, I think it's, why wouldn't you bet on it? I don't think Amazon gets music. Like, I think, I mean, we've seen them try it with Amazon MP3. Like, they've taken multiple stabs at music. I think it's an animal that you have to have the right DNA to create.

I think that could be, and we talked, um, an animal that you have to have the right DNA to create. I think that could be, and we talked about that a lot on the beats episode. I do think though, there's an element of segments of the market. Like there are a lot of like, how big is Spotify's Tam really of people who are going to pay 10 bucks a month in the world for music? Like they already have 70 million people doing it. How many more people will do it? Especially when there's an alternative out there of like i could get something that's like 60 is good for free yeah i mean for free that yeah so i think amazon will take share on the from spotify's free tier

or better yet since it's a growing market will take the share that would have gone to spotify's free tier or better yet since it's a growing market will take the share that would have gone to spotify's free tier i i don't i wouldn't bet on them for the the subscriber revenue yep well i think there you have the narratives on spotify yep all right into what would have happened otherwise let's do it um well they could they could have ipo'd they could have ipo'd yeah um now they are generating cash from operations um so they don't need the capital they've already raised a lot of capital um the here's a crazy thing that could happen i was foreshadowing this a little bit earlier with the ben and jerry's thing but they could ipo like now that they're publicly traded i mean six months or a year or two years

like if they need to raise cash i mean it's it's like doing a you a dilutive secondary offering that a public company would do. In a secondary offering, yep. Yeah, yeah. And they could just do that as their IPO. And as I was thinking through this, David, I want to make sure I'm thinking about this right. So let's hypothetically say they did this direct listing and started trading at, um, what, one 65. Um, and it's up to one 50, right. It's fell to one 50, but it's a one 50

right now. Um, let's say it goes up to one 80 or 200 in the next year or so. Um, and then they go and do an IPO at 200. They basically get to raise cash later and take less dilution. Yep, yep, yep. And so like if there were these liquidity reasons why they wanted to be public, but they thought about it like, huh, I don't think we actually need the cash right now. So let's not take the dilution. Let's take some dilution later if we do need to raise capital like you could see that this is maybe only chapter one and that the the dilutive offering happens later yeah i mean i think the question though is will they need capital i think they they don't in in their current business model

they will need capital potentially if they try and move to the netflix playbook of we are going to develop our own artists and make our own content now that's been bandied about in music and you know there was the famous taylor swift you know exclusive with apple and then that didn't work out ben thompson's written a lot about this does it make sense in music to have exclusive content in the way it does with video unclear um yeah because here's the thing is in in video since people are used to paying for multiple or switching between if somebody launches something like stranger things then you're gonna switch to that provider or you're gonna add provider if you want to watch that uh if you're going to switch to that provider or you're going to add provider. If you want to watch that, uh,

if you're an Apple music subscriber and Taylor Swift drops her new music video only on, on Spotify, you're not switching. Like you're highly, highly ingrained with all these playlists and configuration and friends that you've made in one service or the other. You're probably not going to do it for a new album.

I mean, maybe for like two or three artists that are all like if jay-z and beyonce here's the thing they actually do with title like if if you look at like it hasn't worked for anyone yet well i think it doesn't work because it doesn't make sense for the artists like especially in today's industry as an artist you make your money from shows and from branding and merchandising. So you need maximum exposure. Maximum reach.

You wouldn't want to artificially limit your audience. Whereas in video, it's a lot different. You have a lot more niche content and people are used to, oh, this is an HBO exclusive or whatever. Like, you know, the paying directly for content is a lot more ingrained in people's psyche. Yeah. Plus, you also have the actors who, actors act in content across, you know, and publishers essentially like just because um yeah will smith did that exclusive movie i forget what it's called with netflix that doesn't mean will smith can't go do his next movie with disney or fox or well fox is part of disney now or you know universal or

whoever whereas in music like taylor swift becoming a apple exclusive or spotify exclusive that means she's not gonna ever release content on the competitors like that doesn't make sense yeah yeah something would have to change in the ecosystem where um people would have to actually subscribe to multiple multiple providers which i don't think is going to happen or people artists would actually start generating more of their revenue from streams rather than from streams being their top of funnel and then monetizing fans more through shows and all that yeah so yeah i don't think they need the cash. Yeah, well, then it makes sense that they didn't do an IPO.

Yeah, which I think was the whole argument of Barry McCarthy, the CFO. Right, right. And it's super the thing they touted, which I don't think is the main driver, but it's super employee friendly because they they don't have this six-month lockup period. In fact, the only group, I think Tencent is restricted from selling shares for some amount of time, but that was a one-off thing in their agreement, and all employees were free to trade on day one. Yeah, so Tencent is a 7.5% shareholder of Spotify. They did a deal with Tencent at the end of last year and to 2017 where they essentially swapped equity stakes in spotify and with tencent music entertainment which is their spotify competitor in china and this is spotify was never going to be able to launch in china just like facebook and google haven't this is a way

to get access you know to likewise tencent tme tencent music entertainment was not ever going to be dominant in the u.s or europe or the like this is a way to go global essentially for both companies so it makes sense that there'd be a lock up for um for those well should we get into tech themes let's do it let's do it um well mine so i in these ipo ones i want to broaden to sort of tech and investing theme um this big uh the big one for me that that i think is the i'm going to use your phrase the thing that's been bandied about in the press a lot recently uh has been are we going to see more direct listings because you know if this can be a shift away from the sort of walled garden of Wall Street and paying the banker fees and, you know, having to ingratiate yourself to that world,

which people have just railed on for, you know, particularly in Silicon Valley, how dumb the process is. I mean, there's Dick Costolo has done a lot of great interviews about how silly it felt to go do the exact same presentation 80 times on the road show and have to really be a dog and pony show. And so to the extent where Spotify can put up one stage presentation that they video recorded and then everybody can just look at that and then they don't fly to New York and bring half the company and ring the gong and throw the parties and give the interviews. Maybe this is the way of the future. Yeah. Well, there are a bunch of problems, too. Like, you know, the Dropbox IPO last week, like, you know, it was a big day, as we said, in Silicon Valley here. Lots of Dropbox employees and investors.

But, like, it wasn't, too, because they're all subject to the lockup. Like, you know. Right. And then, you know, then the lockup comes you know uh right and then and then you know depends then the lockup comes off but like maybe that depresses the stock a lot of people are selling sometimes companies you know will re-lock up their employees investors to prevent the stock being depressed um traders build the lockup into their models yep yep it just you know it kind of sucks and you know the plus the having to create new shares to sell to

the public, if you don't need the cash, and you always have to do basically a minimum of 7% of the company, like, why would you do that? You know, I mean, in these later rounds that drop by that Spotify was raising, they were selling, you know, 1% or less of the company. Why would you now sell a huge amount of the company? Yeah, I mean, the criteria that I basically came up with this fourfold for will we see this in the future? One is I think you have to be a household brand name like Spotify. Like one of the things the bankers do on the roadshow is like really familiarize the institution and large blocks of potential share owners with with the company lots of people were already very familiar with the company yeah you have to not need the cash so you know that that already limits lots of companies um you have to have this very cash

efficient business model um and uh we need this spotify price to hold steady and if if it doesn't i think it'll scare off people from doing this for a long time. Um, and, and it's not that volatile right now. It's done a nice job of staying around where it should be, but it's, it's bounced around a little bit. So I think the next few days are going to be a telling very telling. Yeah. Well, I think there's one nuance I'd add to your first point, which I totally agree with is you have to be a known name. I don't think you have to be like a consumer household name. You have to be known amongst the institutional investor community. Um,

but that's also happening because those, those mutual funds, those hedge funds have been investing in private companies over the last five years. So they know these names, these, these stocks, uh,

um, you know, whether it's, whether it's T-Row price or tiger or Wellington or, you know, like all of these, I don't know about T-Row, but, or, but all those other firms were already shareholders in Spotify. Uh, so they already, and these are the biggest owners of public stocks, uh, in the market. Um, so a lot of that education and marketing is kind of already happening while companies are private. I have one self-serving tech theme that I thought was just fun to read in there, F1. Do it.

So they list podcasts, and they have a services section section and they list new content offerings. And one of them is video and one of them is podcasts. And I have been noticing like, you know, as, as much as I have held the belief that, um, Spotify, uh, and SoundCloud, anyone else that's starting to work in podcasts, um, just isn't, doesn't do it well relative to dedicated podcast apps. You know, it's now the dedicated podcast apps. I don't know if it's like this on everyone's app, but at the top of the home screen on my little homepage for Spotify, it's listen to these podcasts. And they say in their F1, which this is a big market stat about

podcasts, that there were 348 million podcast listeners across all platforms worldwide at the end of 2016 going up to 484 million in 2017 which is a growth of 39 year over year wow and their quote on that is this engagement presents a significant opportunity for spotify as we believe we have the ability to enhance the podcast user experience with a better product that is focused on discovery seriously notoriously the problem in podcasts think about the dynamics are very different the problems are very different but think about the issues with the music industry when spotify came along and just fixed them from a product perspective just like dropbox just fixed you know file sharing uh a different type of file sharing uh the podcast

and this is where the podcast industry is today like the market is there it's growing like there's huge but like the the industry and from a product perspective is completely broken like somebody somebody needs to come along and just fix it. Mm-hmm. Mm-hmm. I still don't know if it's going to be them. I like the bet on the industry right now, and I just think it's kind of fun that they had in their F1. Yeah, yeah.

I don't think it's going to be Spotify either. Like, it's hard for big companies to do this. Anyway. It's kind of hard for me to believe that Spotify is worth $30 billion. I mean, maybe I'm getting in to grade the DPO right now, anyway it's kind of hard for me to believe that spotify is worth 30 billion dollars i mean maybe i'm getting into grade the grade the dpo right now but like i mean think about like uber just had the share tender for like 50 ish billion and like you look at airbnb's most recent private valuation like i i is spotify really a $30 billion company? Yeah.

I mean, the thing is like, we're just so divorced from fundamentals at this point, you know, like Spotify is definitely a $30 billion company. If you, if you value it on a revenue multiple a hundred but their margins their gross margins are structurally very different from you know other tech and software companies um so if you value it on a you know well you can't do a ppe basis because they don't have earnings but if you value it on a cash flow multiples of cash flow basis it's still nutty you know like uh even so let's say they do 300 million of operating cash flow uh in 2018 i don't know if that's what they're projecting but let's just assume you know then that's a uh what hundred times uh hundred times operating cash flow that they're trading at so like you're telling me that if you buy spotify today uh you are assuming you know

so much growth that you're willing to pay a hundred times the cash flow because cash flow really is how you should be valuing these companies a hundred times its cash flow today no i mean it's not crazy like other other um it's not crazy relative to other stocks trade that way too but i think this gets back to something i mentioned a little bit before like what's the tam how many how much growth is left in spotify you know to to be willing to pay a hundred times cash flow for something you have to be willing to believe that there's so much growth that like that's gonna because essentially what you're doing right now is you are paying for 100 years of cash flow of Spotify. Like the cash

flow will repay your investment in 100 years. You believe that there's a lot of growth that it's going to be a lot shorter than 100 years. But like, I don't know, can Spotify double probably can they 10x? I don't know. I don't think so. Yeah, I mean, it's interesting how my anecdotal evidence is so much different than the numbers. Like what I said at the opening of this episode, and I said, it feels like pretty much everybody that is a millennial that is going to buy, you know, is going to subscribe to Spotify is already subscribed to Spotify. But if you look at, you know, what they, they, their reported user growth, I mean, they, let's see, our 159 million monthly active users have grown 29 year over year as of december of

2017 so and their premium subscribers have grown 46 year over year so yeah to your point will they 2x probably will they 3x seems like they could get there will they 10x yeah so then the other bet you're making is like well maybe they can improve their margins that's like a big bet you know or can they offer another product i mean like the other the other piece here is they've got this audience you know can they start meaningfully doing ticket sales to concerts um can they enter video in some way can they become the the provider of podcasts and then figure out how to monetize that i mean there's yeah the quite how much do you model in uh possibility of a bolt-on business yeah whereas like when i look at spotify is a great company for sure i think i'm

going to be very um laudatory in grading this direct listing because I think it was the right thing to do. But just in terms of comparing, I can't help but compare Dropbox and Spotify's first public offerings because they're listings because they're back-to-back. With Dropbox, personally, I feel a lot better making that bet because the bet on Dropbox to me is a bet. Like, will the increase? Will more people have a use case over time to share files in a like semi-professional sort of way versus with, um, Spotify, like are more people going to listen to music and want to pay for Spotify who aren't already now they're going into more countries, but like how many more countries can they go into? Um, you know, they're not going into china they did this deal with tencent um so they do have exposure to china um i don't know

well i think it's time to go into grading and uh listeners i want to i want to sneak in a couple tech themes first yeah i'll go for it all right i have three sort of interrelated tech themes that really we've covered all throughout the history and facts but i think um i think are are important here and that's the importance of a couple key product decisions and only a couple key things like with spotify it was you know the focus on playlists it was we didn't talk a lot about this but it was doing a desktop app not a web app because that enabled almost zero latency when you click play the file streamed and played immediately whereas some of their competitors

because there were competitors remember groove shark and some of the others um they were all web apps the performance was kludgy people don't want to wait for music um just like a couple key product decisions that can really make the difference early on but then you have to couple that with distribution too like spotify would have done well without facebook but it wouldn't be a 30 billion dollar company without facebook um yeah and uh and then i think the related one to both of those that we just see time and time again on this show is like to do all that. You have to be like, you have to have such tenacity as a founder. You have to have a vision. It has to be right. But then you got to like work at it for and focus maniacally for many years, uh, years and years. It took so long for Spotify to even get

off the ground and then to go country by country. And five years later come to the u.s or i guess three four years later come to no five years five years after founding come to the u.s um it just takes a long time yeah daniel x only 35 i thought he was a little older but yeah maybe he's only 35 i think that i think i saw that in the f1 i mean i mean looking at those companies he started those companies before spotify spotify has been 12 years and it's just um impressive passionate motivated founder yeah totally all right that's what i got all right so on grading listeners to clarify though we did just talk about um you know do you feel like this is actually worth 30 30 billion dollars um the way that we grade is was you know on on the typical acquired format was it a good idea

for the acquirer to pay this money for the acquiree um The way that we grade IPOs and now DPOs is, was it a good move for the company to do this transaction? Was this the right move for them? And so, we're basically looking at three options here. Do what they did, IPO, or don't do anything, stay private, um, you know, keep, keep doing what they were doing. Uh, sure. Seems like a great call. I mean, they, they couldn't do nothing. They had to, they had to get liquidity. Um, they didn't need to raise money. It seems like they're not seeing any of the downsides that, that would have come from, from um potentially doing this direct listing instead of the ipo i mean the whole wall street community was a little freaked out and trying to naysay that gosh there's going to be all this volatility and it's going to drop below the last price that it

was trading in the private rounds and the demand's not going to be there and you know lots of things but i don't think we're seeing any of that so it seems like it was a great decision and a gutsy one at that yeah caveat that we're still early it's only two days in very early so a lot will depend on what happens over the next um couple weeks but but thus far yeah thank you for that because we may need that we may need that clause but the fears were about what happened immediately after trading like the whole point of doing an ipo the argument of the bankers is we're there to stabilize the stock stabilize trading if you go back and listen to our facebook ipo episode they definitely needed the bankers to stabilize trading in the stock because it was a rocky

rocky start um but you know without the bankers there, what'll happen? And, like, everything's been stable. So, yeah. Yeah, I don't know how to assign a grade to it, per se. Like, it feels weird to grade this against... We gotta figure out what our actual sort of format is for these IPOs, because, you know,

it's sort of like either it was an A, probably not an A+, or it was like a C. It seems rare that we're going to ever have an IPO decision that was an F or a DPO decision that was an F. We might. Maybe if we revisit the Snapchat IPO. Oh, there you go. There you go. Well, you go there you go well do you want me to yeah i mean i'll say a we just have like a lot it's kind of silly for these on the scene ones to do any grading at all but um you know all signs are positive right now yeah i mean if there is uh stability now now I do have some questions personally about a $30 billion valuation for Spotify, but that's what the market is saying.

Or at least that's what 3.2% of shareholders who have sold have managed to get the market to say. Right, right, which is not a large float. So that may be artificially uh artificially supply constraining the stock and raising the price uh driving the price up um but you know as long as there's not like panicked trading which it seems like there's not this seems like a good new path for companies to get liquidity get out on the public markets it would be great for silicon valley if like this becomes a viable path um so so far so good yeah hey and if it does like barry mccarthy the cfo is going to be hailed as a genius yeah yeah no kidding yeah formal clinkle former clinkle employee hailed as genius story 11 come come a long way it's come a long way it's true uh carve outs carve outs um so uh i can't remember if i've actually mentioned on the show or not but uh i know i've talked a

bunch about my my wife jenny uh she is uh the head of um audience engagement and education at san francisco ballet here in san francisco and the ballet so if you if you live in san francisco uh you should come to the ballet anyway because it's awesome uh the athletes the dancers are amazing it's wonderful to watch always um but they're doing a big festival at the end of the season coming up at the end of this month in april um and uh festival of new works it's going to be really cool uh and jenny is uh hosting a number of um of panel discussions around it but one is going to be called silicon ballet bringing ballet and technology together the intersections of tech and ballet and it is uh it's at the end of the month april 28th at 5 30 p.m uh is it

starring you and jenny uh actually neither of us are are speaking on the panel um but they're gonna be some really cool uh participants so uh if you're in san francisco and silicon valley uh come come to the ballet always but uh but come see this panel it'll be really cool awesome well i finally saw black panther and that movie was amazing and everybody should go see it and it's uh remaining few few days in theaters um and even more awesome was the uh so kendrick lamar uh put together the soundtrack and he um did a couple of songs himself and guessed it on a couple of other songs and then handpicked a bunch of other artists and it's just powerful like it's a really uh um it's maybe one of the best maybe the best marvel movie i mean the the the um

the amazing sort of uh societal themes that are going on right now that they managed to pull into the movie and make extremely accessible and deal with really difficult topics and have a really cohesive story with great character development and stunning visuals. I think I'm like the last person to like be talking about this and be aware of this. But if you haven't seen Black Panther yet, I highly recommend it before it leaves theaters. That's awesome. Yeah, I haven't been able to get to the theater to see it but i definitely want to it uh it looks awesome or go on spotify and listen to the soundtrack well that's what i was gonna say is can you get a playlist of the soundtrack on spotify you can you can all right we'll link to it in the show notes we will spotify's new viral growth mechanic via the acquired podcast that's

right all right listeners if you aren't subscribed and you want to hear more you can subscribe subscribe from your favorite podcast client um if you feel so inclined we'd love a comment on breaker um if you haven't tried that out it's a a cool podcasting app. Please comment or like this episode and create some virality of our own. And if you're on iTunes or Apple Podcasts, we'd love a review there too. And of course, always appreciate sharing with your friends if you like this episode. So thanks so much for joining us and we will see you next time. See you next time.