By Miguel de Braganca from Berklee College of Music's Music Business Journal.
The largest providers of capital in the music business, the major record labels, have been devastated over the last decade by the disruption of their core competency: selling recorded music and investing profits into the development of new talent. Global music sales have been contracting for over a decade, falling from $27.8b in 2000 to $16.5b in 2012.1
It doesn’t take an economist to explain the effect: there is less cash available to fund artists. Furthermore, talent development is a high-risk business. Traditionally, nine out of ten artists who are signed do not generate a positive return-on-investment, though some labels report the fail-rate has improved to eight out of ten.2
With the advent of the 360-deal, the labels are implying that their role in the new music economy is that of an investment bank. Basically, labels provide financing in exchange for active and/or passive rights in all the revenue streams an artist generates. However, unlike a true investment bank, the operations of a major label include product development, distribution, and marketing services for their clients—activities that artists can increasingly perform themselves with competent management and a good strategic plan, due to the technological disintermediation of those label functions. The variable costs of financing talent plus the fixed costs of maintaining diverse, heavily-staffed operations, pitted against a 80% chance of capital loss and decreasing returns on the 20% of investments in the green, does not bode well. Especially given that, on average, spend per artist developed is $700,000 to $1.4 million.3
Given that their traditional model is ailing, labels might increase their profit margins by eliminating all operations except for financing talent—using a combination of analytics and golden-eared A&R to determine expected returns. Or, they could hold on to their current operations and defer a percentage of artist development risk to retail investors by taking advantage of the soon-to-be released crowdfunding provision in the JOBS Act. This second scenario would hopefully result in a higher volume of new artists being brought to market by a more efficient music company—focused on developing and selling talent. Let’s examine this possibility by investigating the JOBS Act and how its integration into the music industry might play out.
The United States JOBS ACT
The US JOBS Act was created to help small businesses by changing several laws that govern financial reporting for emerging growth companies seeking to go public, and, more importantly for the purpose of this article, legalizing the sale of equity in privately held companies to non-accredited investors—providing, in both cases, they meet certain requirements. Some of the act is already in effect, however, the crowdfunding provision is being held up by the SEC, who is overdue in issuing required regulation.4
The crowdfunding provision will allow companies to sell up to $1m of equity, per year, through online “funding portals”. In theory, crowdfunding portals will function like the famous crowd-sourced fundraising platform, Kickstarter, except offering equity ownership instead of product-based rewards. Ordinary Joes and Janes will be able to invest up to $2,000, or, 5% of their annual income or net worth (10% for investors with annual income or net worth exceeding $100,000).5
Small businesses are not the only ones benefitting from the JOBS Act. Ironically, The Atlantic reports that investment bank Goldman Sachs is taking its new emerging growth company, Goldman Sachs Liberty Harbor Capital LLC, public—the JOBS Act has defined an ‘emerging growth company’ as a firm with an annual revenue of under $1b. Liberty Harbor Capital is an investment fund, classified as a business-development company, that buys debt in mid-sized companies.6 Goldman will enjoy reduced reporting requirements, and, a five-year period of financial opacity, that many critics speculate will allow for risky investment behavior similar to the type that contributed to 2008’s financial meltdown.7 If Goldman can leverage the JOBS Act for a potentially positive economic outcome, there is no reason that creative firms in the music industry shouldn’t benefit by ethically employing the legislation.
Reducing The Label’s Exposure to Risk
According to the IFPI’s 2012 Investing In Music report, a major label spends an average of $1,050,000 to break a new act. If a market develops for the asset class, equity-based crowdfunding could help labels hedge their bets on new artists. For example, if a label has identified two hot R&B singers it wants to sign, it may have to pick just one due to economic constraints—likely losing the other to a competing firm. But if the label were to finance one act with proprietary funds and micro-finance the other, they have effectively halved their risk for the price of one artist plus the cost of marketing the securities. By sharing development costs with an additional pool of investors the label will have more capital to develop a larger volume of talent. This will be possible through the crowdfunding provision of the JOBS Act, providing the SEC does not grossly alter their outline of proposed regulations.8
However, it gets complicated. Because of the Act’s annual $1m ceiling per firm, the label’s corporate entity cannot fully micro-finance more than one act, which renders the instrument useless for risk management. What the label must do is create a holding company for each act being marketed to investors and transfer the ownership of the artist-label contract into the new entity. The public can then invest in a specific act through the holding company’s presence on a funding portal. Of course, the label should maintain a large piece of ownership in the holding company. In theory, with this model, the label is free to crowdfund, say, $100m spread out equally over one hundred bands, per year.
Allowing investor participation in all aspects of a recording contract may not be desirable for the label. The label could limit this participation by assigning bundles of rights derived from a recording contract to the holding company, rather than the entire deal. There are two ways to approach this. The first is to bundle particular revenue streams. For example, the owners of the holding company could enjoy their rights to physical/digital sales, sync licensing masters, and touring. The label would maintain exclusive rights to their participation in interactive streaming/internet radio royalties, publishing, merchandising, and endorsement deals. Secondly, the label could limit investor participation by assigning a specific duration of the contract, and products created therein, to the holding company. An example of this scenario could be the holding company’s enjoyment of all rights secured by the label for the initial term and one option. If the artist-label contract is for one term plus three options, the label alone participates in revenue streams created during the final two options. Using the label’s robust quarry of empirical data, the exact formula for valuating artists, creating these rights bundles, and scheduling dividends/returning principal will have to be refined to create an equitable profit-maximizing balance between the label and the investors.
Label-backed Artists are a Safer Bet
According to the Startup Genome Project, internet startup companies have an 8% chance of success.9 The success rate of label-backed artists is 20%. That means for investors interested in this asset class, backing a signed artist is 12% more likely to generate profits than financing a Silicon Valley internet entrepreneur.
Amanda Palmer’s successful Kickstarter campaign has shone a spotlight on micro-finance’s potential for funding music. She raised $1.2m by offering her fans future creative rewards in return for their patronage—a pay-it-forward approach.10 There has been much debate in the industry about this approach, but the take away is that Ms. Palmer’s success is evidence that people are willing to put money into artists to further their careers. Equity-backed crowdfunding could take it to the next level.
Despite a period of low investor confidence in the music industry, 11 Forrester Research predicts that 2014 is going to be a turnaround year for the business.12 The number of paid streaming subscribers is growing and emerging markets offer new prospects as their tech infrastructure expands and more people come online.13 Governments are increasing their compliance in the fight against piracy by prosecuting facilitators such as Pirate Bay,14 and, the trend for touring revenue is up. As the labels continue adapting to a digital world the value of the industry will increase.
For this model to be sustainable it is important that the labels adhere to the highest ethical principles, which could prove to be difficult given the widely-reported contractual tricks label’s use to pad their pockets.[i] However, if used with integrity, the JOBS Act can benefit both label and consumer by creating a more dynamic and varied music market. It should help labels develop a larger number of acts and allow more people to enjoy a financial benefit from artists’ success. The act could prove to be an instrument that helps mend consumer-label relations and improve transparency in a misunderstood industry.
By Miguel de Braganca
1. Lewis, Randy. “Global Music Sales up 0.3% in 2012, First Increase in 13 Years.” Los Angeles Times. Los Angeles Times, 26 Feb. 2013. Web. <https://articles.latimes.com/2013/feb/26/entertainment/la-et-ms-global-music-sales-increase-20130226>.
2. Moore, and Wenham. Investing in Music. Rep. IFPI, 2012. Web. <https://www.ifpi.org/content/library/investing_in_music.pdf>.
3. Moore, and Wenham. Investing in Music. Rep. IFPI, 2012. Web. <https://www.ifpi.org/content/library/investing_in_music.pdf>.
4. Caldbeck, Ryan. “Happy First Birthday JOBS Act.” Forbes. Forbes Magazine, 16 Mar. 2013. Web. <https://www.forbes.com/sites/ryancaldbeck/2013/03/16/happy-first-birthday-jobs-act/>.
5. Colao, J.J. “Breaking Down The JOBS Act: Inside The Bill That Would Transform American Business.” Forbes. Forbes Magazine, 21 Mar. 2012. Web. <https://www.forbes.com/sites/jjcolao/2012/03/21/jobs-act/>.
6. Seward, Zachary M. “The JOBS Act Turns 1—and It’s an Utter Failure.” The Atlantic. 5 Apr. 2013. Web. <https://www.theatlantic.com/business/archive/2013/04/the-jobs-act-turns-1-and-its-an-utter-failure/274732/>.
7. Carney, John. “Goldman Sachs Is Going To Start A New Type Of Fund For Its Rich Clients.” Business Insider. 3 Apr. 2013. Web. <https://www.businessinsider.com/goldman-sachs-liberty-harbor-capital-llc-2013-4>.
8. Mandelbaum, Robb. “‘Crowdfunding’ Rules Are Unlikely to Meet Deadline.” Newyorktimes.com. The New York Times, 28 Dec. 2012. Web. <https://www.nytimes.com/2012/12/27/business/smallbusiness/why-the-sec-is-likely-to-miss-its-deadline-to-write-crowdfunding-rules.html?pagewanted=all>.
9. Jimenez, Charlene. “Why 11 out of Every 12 Startups Fail.” AGBeat. Web. <https://agbeat.com/entrepreneur/why-11-out-of-every-12-startups-fails/>.
10. Kickstarter.com <https://www.kickstarter.com/projects/amandapalmer/amanda-palmer-the-new-record-art-book-and-tour>.
11. Lomax, Alyce. “We’re All Thieves to the RIAA.” The Motley Fool. 2 Jan. 2008. Web. <https://www.fool.com/investing/general/2008/01/02/were-all-thieves-to-the-riaa.aspx>.
12. Goldman, David. “Music’s Lost Decade: Sales Cut in Half.” CNNMoney. Cable News Network, 02 Feb. 2010. Web. <https://money.cnn.com/2010/02/02/news/companies/napster_music_industry/>.
13. “Spotify Begins Latin America Push with Mexico Launch.” BBC News. BBC, 16 Apr. 2013. Web. 16 Apr. 2013. <https://www.bbc.co.uk/news/technology-22166416>.
14. Rolander, Niclas. “The Pirate Bay Sails to Greenland But Is Turned Away.” Digits. The Wall Street Journal, 12 Apr. 2013. Web. <https://blogs.wsj.com/digits/2013/04/12/the-pirate-bay-sails-to-greenland-but-is-turned-away/>.
15. Masnick, Mike. “RIAA Accounting: How To Sell 1 Million Albums And Still Owe $500,000.” Techdirt. 7 July 2011. <https://www.techdirt.com/articles/20110707/03264014993/riaa-accounting-how-to-sell-1-million-albums-still-owe-500000.shtml>.