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Digital firms pay heavy price for labels' support

A stark truth facing any aspiring digital music service these days is that working with record labels is going to carry a hefty price.

The last 18 months have seen the major music labels accept new technological and business models — such as dropping digital rights management and allowing ad-supported free music — that have given rise to a new generation of digital music services. But the flip side of this willingness to experiment is a demand for higher upfront advances for licensing music and in some cases a substantial equity stake in the company.

Ad-supported download service SpiralFrog, for instance, paid more than $3 million in upfront advances to Universal Music Group alone before it even went live, and has paid additional millions in licensing fees since the original term expired. Imeem is said to have paid advances as high as $20 million and gave labels equity in the company. (Imeem disputes that figure but the equity stake is now a matter of public record.)

Sometimes the price is so high it sabotages the deal. A mobile messaging company recently walked away from negotiations in which a label demanded 85% of the company’s gross revenue, even though the deal didn’t involve any music licensing.

Labels say it’s just the cost of doing business in today’s music industry. Critics say it’s stunting the establishment of a viable digital entertainment marketplace.

With CD sales in continuing decline and digital revenue still not making up the difference, labels are unapologetic about their insistence in mining every new revenue stream to its fullest potential.

“If you were opening up a retail store on Madison Avenue, I think you have to get a lease for the space,” one major-label executive says. “If you want to build a legitimate business, there are costs associated with doing it, and that’s no different in the virtual world than the physical world.”

Truth be told, digital services — or their forebears at least — bear some of the blame for the deal terms getting to where they are today. Just a few years ago, revenue-sharing deals weren’t that uncommon. However, according to former EMI digital executive Ted Cohen, labels soon soured on that model as services began gaming the system so that labels ended up with nothing.

That led to labels building “perceived value” of music into subsequent agreements along with various other checks-and-balances and advances designed to mitigate the risk of entering experimental deals. But even Cohen, now a consultant working on behalf of several digital music services, says the practice has gotten out of control to the point where economics are simply unsustainable.

“What was once considered a major advance — $500,000 or $1 million — is becoming a $2 million or $5 million advance and really over-the-top requests for equity,” he says. “The deals are still unrealistic. If you raise $15 million to start a business, and have to spend $12 million just to pay off the content companies, that leaves you with $3 million to run a company. I don’t know anybody able to do that.”

Many rankled by these front-loaded deals accuse labels of going for the quick buck in order to meet quarterly revenue objectives at the expense of cultivating a lasting partnership — essentially treating digital music startups as quick-fix ATMs rather than long-term investments.

“They’re trying to match every dollar against a lost dollar, not nurturing new markets,” Digital Media Assn. executive director Jonathan Potter said at Billboard’s Music & Money Symposium in March. “That’s not helping build a business. You need each party to have an equal incentive.”

Yet one of the more controversial label demands — an equity stake — may in fact prove advantageous for services entering into such a deal. Labels receive dozens of partnership requests almost daily, many of which they don’t think have any chance of surviving with or without their help. As such, they are only too happy to forget about them once the check clears.

But if the labels have an equity stake in the company, they have more skin in the game and a greater incentive to nurture the company along. Imeem, considered by some as the poster child for predatory label deals, is actually a case-in-point.

Sources on both sides say Imeem’s relationship with labels is proving extremely fruitful as a result of the equity deal–with Imeem executives advising some label execs on technical matters and some label execs clearing the lines of communication to their imprints. Imeem would likely prefer more access to labels’ potential advertisers, but the deal is still young.

Imeem, however, is considered the exception, not the rule.

Unwieldy usage restrictions and expensive licensing fees have already forced several promising partners out of the digital music space (Yahoo, Virgin, AOL). If the music industry wants to collect that Madison Avenue rent from the services of tomorrow, it may need to invest a bit more democratically today rather than trying to recoup the losses of yesterday.

“Here’s the big disconnect,” Cohen says. “In the physical world, they’re paying Wal-Mart for the privilege of selling their music. In the digital world, they’re asking the partner to pay them for the privilege of selling. The middle ground should be both sides treating each other with respect and both sides making money.”

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