How to beat the record labels on the Web

As a venture capitalist who has done time in the music industry, I'm surprised by the number of entrepreneurs who want to talk about digital music. A week doesn't go by that some smart entrepreneur doesn't call me up to discuss an idea.

These conversations got me thinking about the opportunities for start-ups in the emerging digital music arena, and about why all past efforts at revolutionizing the music industry have failed.

Even in the dot-com era, investors made very little money on digital music start-ups (except for the rare frenzy-driven acquisition or quick-flip initial public offering). But besides losing money, most of these start-ups were bound by another common thread: the vast majority focused on distribution technology and services.

The theory may have been that by controlling the pipes, you control the water. But as we've seen from the demise of Napster and the legal woes of Morpheus and Audiogalaxy, record companies and music publishers closely guard the flow of content from the source. This should cause the next crop of digital music entrepreneurs to forgo distribution.

It's easy to see why digital music distribution is a tough game for a start-up. Consider the major-label record companies.

As anyone who has spent any time with a major will tell you, these are immensely profitable businesses that have absolutely no inclination to change anything they are doing--ever. Record companies make obscene amounts of money manufacturing little silver disks, sending them out through distributors that they own, and getting retailers to push them over the counter at $16 a pop (and paying those retailers a pittance in the process). A truly great business.

As anyone who has spent any time with a major will tell you, these are immensely profitable businesses that have absolutely no inclination to change anything they are doing--ever.

But for a start-up looking to get on the gravy train, watch out. For many entrepreneurs, business deals with entertainment companies are like a weekend in Las Vegas. It's a lot of fun, you've got great stories, but in the end you fly back home quite a few bucks lighter.

The thing that makes major record labels so powerful is their contractual control over music, and their ability to say where, when and how a recording can be played and shared. As many people have said, the only viable music service that people will pay for is one that has a somewhat complete catalog of music that is accurately tagged and cataloged, and has no restrictions on how music is used for personal use. If you think the industry-sponsored digital music initiatives will ever approach this level of service anytime soon, you're dreaming. It will be years--if ever--before the major labels will ever allow the type of license that would create a service that is anywhere near as compelling as Napster or Kazaa.

Why? Because they don't have to.

You have to give the record labels their due. They have stayed brilliantly focused on controlling the one thing that matters--the recordings themselves. Record companies are continually able to source and sign the best artists, and lock up the contractual rights to their recordings.

In 1994, I was sitting in my boss's office at a record company, making a pitch for the company's further involvement in the Internet. "Look, we're a music company," she said to me at the time, "not a technology company." While that was (and still is) incredibly shortsighted, the essence of the statement is valid. Record companies are in a position of power because they know what side the bread is buttered on.

So where are the opportunities for entrepreneurship in the music industry?

The answer lies in controlling the rights to recordings. It's only after start-ups get into the game of signing artists that they will truly be able to control the destiny of downstream distribution. This is no easy task. Record companies have spent decades building up a sourcing system, and have a huge competitive advantage when it comes to expertise in promotion and marketing.

If you think the industry-sponsored digital music initiatives will ever approach this level of service anytime soon, you're dreaming.

But the majors have huge vulnerabilities when it comes to their cost structures, and the amount of units they need to sell to break even on a title. And, as in all instances where sleeping giants get unseated, it will happen first at the fringes.

There is a long history of small labels making inroads into overlooked genres, and while these independent efforts have historically grown up to be fodder for major acquisitions, it won't be long before a burgeoning independent makes better strategic use of distribution technology. Often, one loose brick can bring down the whole wall.

So my advice to the plethora of music start-ups focused on distribution? Give it up.

Distribution technology and services are just ways of helping someone else sell their valuable assets, and are certainly not a basis for entrepreneurship. It's the control over the assets themselves, and not the pipes to deliver them, that will drive shareholder value in new music companies. The online distribution of music is not about technology. More than enough technology exists to produce any consumer music service you could possibly imagine. The game will really get interesting when the very heart of the music industry--the creation and sourcing of music--is challenged.