Is Spotify's business model broken?

Financial numbers for privately held Spotify have surfaced and the music service appears to be in a world of hurt.

Greg Sandoval Former Staff writer
Greg Sandoval covers media and digital entertainment for CNET News. Based in New York, Sandoval is a former reporter for The Washington Post and the Los Angeles Times. E-mail Greg, or follow him on Twitter at @sandoCNET.
Greg Sandoval
3 min read
Spotify CEO Daniel Ek Sarah Tew

Spotify's financial performance in 2011 was abysmal.

As revenue increased 151 percent from 2010, the on-demand streaming music service saw losses widen 60 percent for the same period, according to documents posted today by PrivCo, a company that sells data on non-publicly traded companies.

A Spotify spokeswoman told CNET that the numbers posted to PrivCo.'s site were accurate. But it turns out that the figures aren't exactly new. They were first reported in August by The Wall Street Journal, which tucked them into a story titled "Spotify to launch in Canada" and the revelation failed to generate a lot of attention. I wonder why?

Spotify's financial performance for the years 2011 and 2010. PrivCo

Spotify is the hit music service that attracted a large and loyal following in Europe before making the jump to the United States last year. The privately held company is now building a large audience in this country.

But there have long been skeptics who say that Spotify won't ever generate profits while supplying users with free music and paying the royalty rates it does. The company offers songs free of charge to new users, which it must still pay for, and then tries to convince them to sign up for a monthly subscription fee. How's that working out?

Spotify appears to be struggling.

In 2010, Spotify, which is led by founder and CEO Daniel Ek, reported a net loss of $37.5 million on $97 million in revenue. For 2011, the company's revenue increased to $244 million, but losses also widened to $59 million, PrivCo reported.

PrivCo said Spotify's business model is "unsustainable" and wrote to its clients that "Something must change soon on Spotify's business model if the company is to survive."

Spotify isn't in any danger as long as it's able to convince investors music is still a worthwhile venture. According to reports, the company has recently received new funding based on a $4 billion valuation. I haven't met any industry watcher who has heard that figure and not smirked.

Spotify reported cost of sales was 98 percent of revenue in 2011. Greg Sandoval/CNET

Spotify's play is to build market share and the strategy for accomplishing that in the online music sector is old but proven. Give away songs for free and you'll find an audience. This method isn't cheap and the trick for music services has always been about getting into users' wallets once you get them to your site.

For Spotify, the question is can the service eventually shift enough users to the company's paid-subscription offer to make any profit?

That hasn't been determined yet. While multiple music industry sources have told me Spotify has improved its ability to convert users of the free service to the paid service, some insiders worry Spotify still isn't drawing enough people into the free service so it can later funnel them to a subscription plan.

Spotify should have enough investor money to keep going for a while. It will be interesting to see if the service can continue to expand into new overseas markets, while paying for free music and maybe also spend more on advertising, which is what some at the labels want to see.