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Signs of intelligent life in the music business - May 26, 2008

Required reading: "Should Societies Pursue Equity?" a white paper released last week by Will Page and David Touve. Page is the executive director of research for the Mechanical Copyright Protection Society--Performing Rights Society Alliance, the U.K.-based royalty collection agency for songwriters and music publishers. Touve is a doctoral candidate at Vanderbilt University and a former online music entrepreneur. The white paper asks the musical question: Could a licensing system for music start-ups based on giving performance-rights societies equity in the company that would pay out either at the time of an acquisition or as a percentage of future revenue, in exchange for a blanket license to use the society's catalog, help resolve the current legal stalemate between rights owners and innovators.

Page and Touve start by recognizing some important realities:

• Start-ups generally lack the cash reserves needed to pay standard licensing fees, as well as the human and legal resources to negotiate and administer complex licensing agreements. That typically leaves them with the unpalatable choice of signing a license they can't pay for, or hoping to get big enough by the time they're sued to deal with the problem then.
• Since online music is still a nascent business, start-ups often have to adjust their business model as they go along, assuming they even have one. Thus, traditional royalty arrangements, based on a percentage of revenue and defined use cases, will be no better than a shot in the dark in most cases. Coupled that with the fact that online start-ups generally pursue growth in users over revenue in their early years and it's clear that a traditional license structure is likely to drive start-ups out of business before rights owners see any royalty revenue.
• Both start-ups and rights owners have a shared interest in successful innovation that creates new markets for recorded music.

Their proposed solution is to give rights holders an equity stake in the start-up in exchange for a license. From the paper:

Rights societies could consider accepting the currency with which start-up firms generally operate - equity. Furthermore, a method for exchanging this equity for licence terms should be standardised if at all possible.

It would be ideal to adjust the percentage of equity preferred to the imagined financial prospects of individual firms. However, rights societies must accept that predicting the eventual value of start-up firms, at moments close to their birth, is neither an exercise with which societies are well versed, nor a calculation even those with experience can do with great reliability. Any standardisation of equity could be based upon the series of funding round and valuation levels.

[snip]
Given a nascent firm’s royalty obligations often exceed its ability to pay, rights societies could structure the terms for equity transaction by way of rights societies could structure the terms for equity transaction by way of convertible debt. In this way, the equity transaction might be aligned with the ongoing use of music, rather than according to opaque metrics, or as compensation for showing up to the party without a lawsuit.

The use of convertible debt would allow rights owners to swap the debt obligations for stock if the company is acquired so they share in the deal, or to gradually swap debt for equity as additional funding or increased revenues warrant.

Page and Touve go to discuss the record companies experiments in taking equity in lieu of royalty payments, as well as potential problems that could arise in appropriately allocating the capital gains.

What makes their proposal so refreshing is its fundamental recognition that music rights owners' real problem in the online music world is not legal but economic. The problem is not that their exclusive rights have been devalued by unlicensed uses of music (or not only that). It's that up to now they've lacked a mechanism for capturing a reasonable share of the value that gets created online.

On an open network like the web, exclusivity does not create value because it's effectively impossible to maintain. Rather, value is created ad hoc, through innovative, personalized, customized uses of content. Capturing that value is the province of those who provide the tools to enable those innovative uses.

The real trick for rights owners is not monetizing content through direct payments but figuring out how to capture the value that others create by using the content.

There may be a hundred reasons why Page and Touve's suggestion will not work as hoped in the real world. But ultimately, finding a way to align the economic interests of rights owners and innovators is the only avenue to building a robust online music business.

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