Tech

Leila Abboud is a Bloomberg Gadfly columnist covering technology. She previously worked for Reuters and the Wall Street Journal.

Music streaming service Spotify has followed Uber's lead by choosing to raise $1 billion in convertible debt, instead of a more traditional round where investors buy shares.

Now it better hope its valuation rises from here, just as that of the ride-hailing app has done since it issued convertibles last year.

Otherwise the Sweden-based company will have given private equity firm TPG, hedge fund Dragoneer and Goldman Sachs clients a sweet deal at the expense of its own founders, venture backers and employees.

According to the Wall Street Journal, the debt comes with strict terms, namely that if Spotify goes public in the next year then TPG and Dragoneer can convert to shares at a 20 percent discount to the IPO price. If it doesn't, that discount will start increasing. There's also a coupon -- a feature more common to private equity than venture funding -- which means Spotify must pay 5 percent interest a year. This too will rise after a year, by 1 point every six months until the company goes public.

So why did Spotify do this? It probably wanted to avoid a "down round" equity funding, valuing it lower than the $8.5 billion ascribed in June. Investors have been pushing back on sky-high valuations for fast-growing, loss-making tech companies, hurting both publicly listed ones such as Twitter and Square as well as private peers. CB Insights tracked 58 venture-backed firms that have raised money at lower valuations since the start of last year. Fidelity has marked down Spotify shares by 27 percent since August, the WSJ wrote.

So Spotify is betting it will be worth more after a year than now, making the exacting terms of the convertible more palatable than selling equity.

Despite Apple Music's launch last year, bringing a deep-pocketed rival, Spotify remains the biggest streaming service with a presence in about 60 countries. It has 30 million paying subscribers and about 100 million who listen free with advertising, compared to about 10 million paying customers at Apple Music, 6 million total at France's Deezer, and 1 million at Jay-Z's Tidal.

Streaming In
The proportion of U.S. music revenue from streaming is rising
Source: RIAA

But like other streamers, Spotify makes losses because it has to pay high fees to the music labels. On about 1 billion euros ($1.1 billion) of revenue in 2014, Spotify suffered an operating loss of 165 million euros, with some 70 percent of costs going to pay labels. 

When Deezer filed for an IPO last year, its prospectus showed how hard it is to turn a profit in streaming: its cost of sales was 84 percent in 2014. Deezer pulled the IPO because of poor demand, although its boss told Bloomberg TV on Wednesday that it could revisit a listing. Pandora Media, an Internet radio station, has also struggled because licensing costs eat up half of revenue. 

Closing the Box
Pandora shares are below their IPO price
Bloomberg

So the game for Spotify is to increase paid subscribers to cover costs, while holding off Apple and developing its brand internationally. As it expands it will hope to grow its advertising business. In time, Spotify could also try to follow Netflix and develop artists just as the video streaming service creates its own series.

Streaming probably won't end up as a winner-takes-all market, so there's room for Spotify and some others to succeed. But with the convertible, Spotify has just put itself on the clock to a flotation. The Uber convertible reportedly included incentives to do an IPO within four years since the coupon would increase after that. Spotify's terms mean its own countdown starts after a year. It needs to get its groove on.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Leila Abboud in Paris at labboud@bloomberg.net

To contact the editor responsible for this story:
James Boxell at jboxell@bloomberg.net