Hit streaming service Spotify eyes U.S. music fans

Add in all the startups that have crashed and burned in the same time period and it starts to look as if no service could ever rival iTunes' traction with customers and critics.

Until now.

The Sweden-based startup Spotify, launched for public access in October 2008, has momentum like no other digital music service of the last six years. It offers on-demand music streaming, in both free and premium services, and now claims to have more than 6 million users in Sweden, Norway, Finland, the United Kingdom, France and Spain. At one point it reported signing up new members at a rate of 50,000 per day, although that figure has fallen since September, when the service restricted its free version to invited guests in the United Kingdom.

Spotify has won high marks from reviewers for the ease with which it provides access to a catalog of more than 6 million tracks from majors and indies alike and the unobtrusive way it delivers advertising.

Spotify's recently launched mobile version -- available for the iPhone and Android-powered devices in Europe to premium subscribers who pay the equivalent of around $15 per month -- has won similar praise. Although Spotify doesn't comment on its fund-raising activity, it has reportedly won $50 million worth of backing from investors -- at a valuation of $250 million, an almost unheard-of sum for a music venture in today's stingy venture capital environment. The European service also has the full support of the major labels, which reportedly negotiated a collective 18 percent stake in the company.

Yet this momentum will be tested severely as the company prepares to enter the United States -- the No. 1 music market in the world -- with a launch expected either late this year or early next, depending on how fast it completes its negotiations with the majors.

"It's been talked about so much I don't think it can meet everyone's expectations," says Forrester Research analyst Sonal Gandhi. "If the Spotify experience can be as good as hyped, it has a lot of potential."

With negotiations ongoing, U.S. labels are reluctant to comment on the service. According to music industry sources, the labels are impressed with Spotify's achievements but want the service to start generating real revenue. To do so, it must take care not to let the usage model outpace the business model.

There are certainly early signs of success. In August, Per Sundin, managing director of Universal Music Sweden, told the Swedish press that his company now earns more revenue from Spotify than iTunes. But that's in Sweden, where the service was born and where iTunes doesn't have the dominant hold on the digital music market it does elsewhere.

"We've seen income from Spotify follow a steep growth curve since launch," says Paul Smernicki, director of digital and direct-to-consumer at Universal U.K.'s Polydor Records. "Excluding mobile, they are pretty high up the list as a revenue stream for us. But we're certainly not in the same position as Sweden."

Scott Cohen, the London-based founder/VP of international at the digital distribution and marketing company the Orchard, says Spotify is already boosting income for labels in two ways.

"First, the more tracks are streamed on Spotify the more downloads occur on other services," he says. "We are not seeing any cannibalization. Second, revenue streams from advertising have been steadily increasing and have overtaken many niche stores in Europe."

But the ad-supported free service alone can't generate the revenue Spotify needs to pay for the music it plays. The company reported a net loss of $4 million last year, and its decision to limit its free service in the United Kingdom to invited guests implies a high burn rate.

That means Spotify has to increase the number of users for its premium service. So far, however, music subscription services like Rhapsody and Napster haven't been able to reach a mass audience. In its most recent quarterly earnings report, RealNetworks said Rhapsody has about 750,000 subscribers. Napster had 700,000 subscribers when Best Buy acquired the company last year, but hasn't released updated figures since.

While Spotify plans to make mobile access a key element of its conversion strategy, the mobile music market has also yet to take off. Spotify has confirmed it will launch in the United States with a "slightly different model" than in Europe, although it has yet to disclose details.

THE AD-FUNDED MODEL

Calling Spotify a free ad-funded music streaming service would be accurate but unfair. The company has paying customers, but they number less than 10 percent of its user base, according to comments from CEO Daniel Ek at a recent London conference. And company executives say that's unlikely to change.

"We expect the large majority of our users to stay with free," says Gustav Soderstrom, who left his job as director of business development at Yahoo to join Spotify as its head of mobile. "We're monetizing it through ads and through selling downloads (through its partnership with 7digital), so it's a significant revenue source."

So far, no ad-funded service has been able to turn a profit from advertising and download revenue alone. Which is why Spotify doesn't intend to. Using the "freemium" model, the company hopes to convert a portion of its free user base to the premium tier.