Why Internet Radio Pandora Wants What Apple's Got

Image: Eric Millette for Forbes

Pandora’s new CEO, Brian McAndrews: “Musicians should be fairly compensated for their art”

Music publishers, record labels, civil rights groups and even members of Pink Floyd have spent the past year piling on internet radio service Pandora Media. They’ve called its founder, Tim Westergren, a robber baron. They have accused Pandora of making millions off musicians’ work. They claim it’s trying to slash artists’ pay through legislative manoeuverings over royalties.

Chalk it up to the perils of pioneering. In eight years Pandora has moved to the top of the internet radio charts, with 71 million monthly active users. It accounts for 70 percent of internet radio and 8 percent of total US radio listening. Advertising, which accounts for 80 percent of revenue, will hit $643 million this year. Mobile ad sales topped $100 million for the first time in the third quarter of 2013, making Pandora third in mobile ad revenue, behind Google and Facebook. Shares have nearly tripled in the past year.

But Pandora is renegotiating (likely downward) its royalty rates with artists, labels and music publishers.

That put Westergren and Pandora’s new CEO, Brian McAndrews, in the middle of a public relations mess just as they’re facing what may be their biggest existential threat: Apple’s new iTunes Radio. Westergren admits there have been “misunderstandings” about Pandora’s royalty moves but says it’s just trying to balance a system that’s forcing it to carry an “unfair” and “high royalty burden”. Proof point: Pandora has yet to turn a profit, and it’s expected to continue to rack up losses.

“In spite of all the rhetoric, Pandora supports very healthy royalties for artists,” says Westergren, who worked as a struggling musician before turning internet entrepreneur. “We’re going to play music by artists that have never been played on radio before—and play it to a wide enough audience that we’ll create a musician’s middle class.”

The warm-and-fuzzy message has been adopted as well by McAndrews: “Musicians should be fairly compensated for their art.”

Pandora does have a point when it talks about the complicated US music royalty system: Internet services pay higher royalties than cable and satellite radio, while AM/FM radio doesn’t pay a cent to performers. Last year Pandora paid out about 56 percent of its $427 million revenue in performance royalties; rival satellite service Sirius XM paid out 8 percent of sales.

Pandora’s PR problem stems from its support of the Internet Radio Fairness Act of 2012, which many view as a betrayal, intended to benefit the company at artists’ expense. IRFA requires the Copyright Royalty Board, which sets royalty rates, to use the same standard across music services. That would effectively lower Pandora’s payout. Even so, music rights holders would love to see the system changed because they believe it shortchanges them.

“We want Pandora to succeed,” says Ted Kalo, executive director of the musicFIRST Coalition, which persuaded 138 bands and artists to oppose the bill (which quickly died in committee). “But there’s a fundamental compact between these services and the people who create music. Our musicians want to receive a fair day’s pay for a fair day’s work. But by running to Congress to get their own deal, [Pandora has] run away from that compact.”

Former members of Pink Floyd were more blunt, citing “Pandora’s internet radio royalty ripoff ” in a USA Today op-ed. “A business that exists to deliver music can’t really complain that its biggest cost is music,” wrote Roger Waters, David Gilmour and Nick Mason.

Now, a year after endorsing IRFA, Pandora has shifted focus away from the bill. “Pandora will focus on other paths to resolution” and keep fighting against a system that “prevents fair competition in the marketplace,” Westergren says.

That other path includes negotiations over performance royalties with the CRB. Talks begin in January to decide rates from 2016 to 2020. With IRFA off the table, Pandora might be able to wrest more favourable terms from the CRB. Why?

Apple reportedly negotiated its own deals directly with labels—and Pandora believes Apple’s payout is less than what it pays. If true, Pandora could use Apple as precedent for fair compensation. Apple hasn’t disclosed its fee, but there’s speculation it pays labels $0.0013 each time a song is played, plus a cut of ad revenue. That’s higher than Pandora’s $0.0012 per song except for one thing: Apple reportedly doesn’t pay for every song that is played for less than 20 seconds. Pandora says it pays even for just one second of play. How much does Pandora pay for songs played for less than 20 seconds? Former Pandora CEO Joe Kennedy, who retired this year, says it’s “material”.

Plenty of musicians appreciate Pandora for what it is: A way to promote songs listeners want to hear, rather than favouring major artists. Patrick Laird of the instrumental cello rock group Break of Reality says the group gets $16,000 in royalties a year from Pandora off about 44,000 daily plays. “Before Pandora we were a regional group. As soon as Pandora hit, we were being listened to around the country. That exposure has led to a record and single sales. It’s incredible.”

Pandora’s selection process is built on the Music Genome Project, an algorithm that analyses music and serves up personalised playlists. The database has more than a million songs from more than 100,000 artists. “Apple’s unfair advantage is that they get to be on the home screen. I’ll take that fight.”

The fight is definitely under way. Pandora’s shares fell 10 percent in September after Apple said 11 million users tuned in to iTunes Radio in its first five days. Itunes chief Eddy Cue has also said he wants to bring iTunes Radio to 100 countries. Pandora plays outside the US only in New Zealand and Australia.

Still, Pandora has a “market share advantage”, says NPD Group entertainment industry analyst Russ Crupnick. Apple in October said just 20 million users have listened to iTunes Radio. For now Pandora is striking the right notes with investors. It has ramped up its mobile and local ad sales efforts and signed key agreements with radio ad-buying services. Pandora also raised $523 million to fund acquisitions and new tech projects in a stock sale in September. And it’s gained share in October.

“The web is playing all this music that’s never been played on radio before. These are artists for whom it’s found exposure and found money,” says Westergren. “The solution for musicians is how do you make that number 10 times as big. That’s really what artists should focus on.”