Reason #3: Current rates are onerous, higher rates are fatal

19Apr07

Ok, I’m on a bit of a roll with posting this week so I’ll move on, at long last, to the 3rd of 5 reasons the new royalty rates suck. (As a side note, someone from Gizmodo nabbed my line but highlights 2 great points from Tim Westergren at Pandora, the second of which is really my point here.)

One of the things I found frustrating in the press and blogs after the CRB decision last month was that many incorrectly thought that the royalties paid to SoundExchange heretofore (2002-05) were actually reasonable. Even Wired’s Eliot Van Buskirk, a savvy observer of the digital music sector who’s been around since the first boom, got it wrong in his coverage of the ruling:

In the old, percentage-based fee system, webcasters paid SoundExchange — the Recording Industry Association of America-associated organization that pushed the Copyright Royalty Board to adopt the new rates — between 6 percent and 12 percent of their revenue, depending on audience reach.

This is incorrect. Under the rates enacted back in 2002, webcasters ended up getting stuck with a royalty rate that has clearly stifled the growth of the internet radio industry. While the rate handed down ($0.000762) doesn’t sound like a lot, it adds up to a lot very quickly when you consider it is calculated per performance (per stream, per listener).

Take a quick example from my former employer, Live365. Given the average length of a song on the Live365 (and probably any) network and 3 blocks of audio ads at roughly 30-60 seconds apiece, one can reasonably expect 14-15 tracks to be played per hour. A quick bit of math yields $0.000762 x 96% x 14.5 tracks/hour = roughly 1 cent per hour. This is a good rule-of-thumb for the current (2005) royalty rates.

I believe Live365’s “aggregate tuning hours” (ATH) as last ranked by Comscore were in the range of ~20m per month.  So the total obligation isn’t difficult to calculate, for Live365 or others. At 25m ATH, a webcaster’s monthly obligation to SoundExchange is 25,000,000 x $0.01 = $250,000. That’s a LOT of money in relation to any figure you look at: revenues, composition royalties, bandwidth, employee salaries, similar royalties paid by other forms of radio — you name it.

When I say the rate has “stifled the growth of the industry,” I’m not kidding. These rates ultimately proved so expensive that Congress had to step in to save most of the industry’s webcasters from extinction by passing the Small Webcaster Settlement Act of 2002. The SWSA allowed webcasters with revenues below a specific threshold ($1,250,000 in annual revenues in each of 2004 and 2005) to pay a royalty rate based on a percentage of those revenues (10% of revenues if annual revenues were less than $250,000, 12% of revenues if more), subject to an annual minimum ($2,000 if annual revenues were less than $50,000, $5,000 if more). Confusing as this may be, it saved the day for the vast majority of webcasters. However, it also created an artificial ceiling that few small webcasters could penetrate, as growth beyond a certain point would result in their royalty burden increasing by 3X-5X or more.  That’s kinda un-American, no?

Bigger webcasters — those above the $1.3m threshold — were left with the penny-per-hour rate. The largest webcasters at the time were AOL and Yahoo, entities that could arguably afford such rates either (1) as a loss leader to support other web offerings, or (2) because they were positioned to sell visual ads across multiple properties, enabling them to attract higher-profile advertisers and thus higher-priced advertising. Live365, OTOH, was the only true “pure play” internet radio service in this league, and it faced a challenge with these rates.

Luckily, Live365 had a unique approach to internet radio and revised its business model to better deal with the exorbitant new fees and stay afloat. Unlike most other internet radio services, Live365 also offered webcasting services, such that an individual or organization could create their own station from uploaded MP3s or a “live” line-in to a computer. While the vision for Live365 had contemplated a free webcasting offering, supported by advertising, this was clearly no longer viable. Live365 webcasting went from free to paid, and the company lost 90% of its DJs overnight, eliminating much of its inherent viral growth in the process. Similarly, a B2B webcasting offering was introduced, sans advertising, to attract fewer, higher-fee customers, targeted through direct sales.

But Live365’s model was unique, and it could not have relied exclusively on a free, ad-based model — that is, the model that one would normally associate with radio — in order to continue as a going concern. So when I was working with Live365’s CEO and our attorneys in late 2005 and early 2006 to put together our testimony and supporting evidence for the CRB proceedings, the case for a lowering of the existing royalty rate seemed clear-cut.

In fact, I was quite confident that, given the evidence (basically reasons #1-3 that I’m outlining here), the CRB would come back with a fair rate that would allow the nascent internet radio sector to turn around and thrive. At the absolute worst, due simply to inertia and a lack of understanding of the sector on the part of the CRB, I might have expected the rates to remain at the levels in place over 2002-05.

But they did not. It appears that an increase in the royalty rates will be fatal in one of several ways, as webcasters:

  • Simply go bankrupt based on new liability they owe, as will be the case with small webcasters and possibly even some of the larger ones
  • Determine that investment is better allocated to other endeavors that can provide a higher, clearer rate of return, as will likely be the case with many of the bigger webcasters and/or their investors
  • Switch to a subscription-only model, which, to my mind, is not really radio anymore and, as evidenced by the lack of success of the on-demand model to date, will shrink the market to a fraction of its current level (estimated by Arbitron at over 1/8 of US population each week)

The only solution I see is for webcasters to eschew the DMCA’s compulsory license for webcasting and instead seek direct licenses with indies and unsigned artists, increasing ‘transaction costs’ and leaving the Majors out of the picture. But as Chris Anderson notes in the Long Tail (and as I’ve long recognized from the MP3.com saga), one needs content from both the ‘head’ and the ‘tail’ to provide a compelling offering to consumers. So I would predict many listeners will simply switch to free, on-demand services that currently do not pay royalties — at least until UMG or other RIAA members pursue these players, as they did with MySpace and Bolt last October.

The whole thing would be so easy to solve: establish a percentage-of-revenue rate, just like satellite and cable radio in the US, and just like traditional radio in other countries. And include a reasonable minimum fee to prevent webcasters from streaming without a business model (i.e. no revenues) and thus paying no royalty to content creators.

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