spotify-business-model

How Does Spotify Make Money? Spotify Freemium Business Model In 2022

Spotify is a two-sided marketplace where artists and music fans engage. Spotify has a free ad-supported service and a paid membership. Founded in 2008 with the belief that music should be universally accessible, it generated €9.66 billion in 2021. Of these revenues, 87.5% or €8.46 billion came from premium memberships, while over 12.5% or €1.2 billion came from ad-supported members. By 2022, Spotify had 195 million premium members and 273 million ad-supported users.

Understanding the logic of Spotify’s business model

spotify-q3-financial-metrics

In Q3 2022, Spotify announced its financials and showed its key performance indicators. 

It’s interesting to notice the two main components of Spotify’s business model. Indeed, in terms of revenues and users, the business model can be broken down into two parts: 

  • Ad-supported: Free users get the service for free. However, they are shown in advertising and have limited functionalities. By September 2022, Spotify had grown into a 273 million ad-supported user base. 
  • Premium: Premium users get all the content on the platform, unlimitedly, without ads, and with premium features (like skipping songs in an unlimited way). By September 2022, Spotify had grown into a 195 million premium subscriber base. 

When it comes to cost structure, it’s worth noticing: 

  • The ad-supported business has a different cost structure than the premium business. In fact, in the ad-supported business, there is much more usage, as users can stream content for free. Thus, here, Spotify uses advertising to amortize the cost of the ad-supported side. However, the ad-supported side creates a funnel for premium users (most free users become premium subscribers over time).
  • The premium business, with fewer subscribers, generates many times the revenues of the ad-supported users. For instance, in Q3 2022, the premium users generated almost seven times more revenue than the free users. Nonetheless, premium members are less than free members. 

In short, in terms of margins, the ad-supported business has tight margins, it’s still critical to enhancing Spotify’s brand across the world and enabling a self-serving conversion funnel, which channels free users into premium members.

In short, chances are that if to become a premium member, you were a free member first.

Thus, it’s critical to frame the ad-supported business in light of the sales model, not revenues and margins. 

To conclude, we should distinguish between the revenue and sales/growth models.

In fact, the ad-supported model’s aim is not just to generate revenues.

Instead, the primary goal of the ad-supported model is to enhance Spotify’s adoption and to create a self-serving funnel where free users can be triggered into a premium funnel.

Therefore, on the one hand, the ad-supported business is key to amplifying the company’s brand.

On the other hand, the ad-supported business is critical to funneling free users into premium members. 

Spotify is a two-sided marketplace founded on the belief in universal music with streaming access

Spotify is where artists and people who want to listen to music can get together.

When Spotify launched its service back in 2008, the music industry wasn’t living a good moment.

That was also due to the growth in piracy and digital distribution, which were allowing people to listen to music while artists were losing control of monetizing their music.

As pointed on its prospectus, Spotify “set out to reimagine the music industry and to provide a better way for both artists and consumers to benefit from the digital transformation of the music industry.

In addition to that Spotify was founded on the “belief that music is universal and that streaming is a more robust and seamless access model that benefits both artists and music fans.

Spotify mission statement

Our mission is to unlock the potential of human creativity by giving a million creative artists the opportunity to live off their art and billions of fans the opportunity to enjoy and be inspired by these creators.

This mission is critical as it also drives the business model behind Spotify.

Indeed, as a two-sided marketplace, Spotify’s success depends on its ability to match the music offered by artists with their music fans’ preferences.

The more this match is successful, the more Spotify will be able to retain and grow its membership base, thus substantially increasing its revenues.

Spotify key partners and its challenge to gatekeepers

The principal partners of Spotify are:

  • Employees.
  • Users.
  • The creative community.
  • Brands.
  • Investors.

Its primary challenge is to fight the old model where artists had to be signed to a label to have access to a recording studio, mainly when the radio was critical to achieving success.

Spotify’s mission is to allow artists to produce and release their own music.

Spotify monetization strategy: the ad-supported service as a funnel for

Spotify’s monetization strategy is based on two primary services:  

  • Premium memberships.
  • and Ad-Supported Services.

The Premium and Ad-Supported Services work independently yet they are critical to each other.

The ad-supported service is what allowed Spotify to scale and it is also the crucial ingredient in the paid members’ acquisition in Spotify. 

That’s because the ad-supported serves as a funnel, which drives more than 60% of Spotify’s total gross added Premium Subscribers.

At the same time, the ad-supported service is a viable stand-alone product.

Premium service monetization explained

Spotify service provides Premium Subscribers with unlimited online and offline high-quality streaming access to its catalog.

Premium Services, include standard plans, Family Plans, and Student Plans.

The aim of each package is thought to appeal to Users with different lifestyles and across various demographics and age groups.

Also, in some markets where subscription services are not yet the norm, Spotify offers prepaid options.

 Spotify counted over 182 million Premium Subscribers in 2022. Those members are activated via several marketing channels:

  • By getting converted from the ad-supported services platform. 
  • By engaging ad-supported users by highlighting the critical features of paid plans.
  • Via product links, campaigns targeting existing Users, and performance marketing across leading social media platforms.

Ad-supported services monetization explained

spotify-audience-network
Spotify Audience Network is the underlying advertising infrastructure that supports its ad-supported user base. The Spotify Audience Network was born as the result of the acquisitions of Anchor and Megaphone. By 2022, Spotify had 273 million ad-supported users.

The ad-supported service has no subscription fees, but it offers limited on-demand online access to the Spotify catalog.

The ad-supported service is a critical ingredient to the Spotify funnel in terms of the acquisition of paid members.

At the same time, that represents a viable option for users that can’t afford the paid plan.

On the ad-supported service, Spotify monetizes from the sale of display, audio, and video advertising delivered through advertising impressions.

The revenues comprise primarily the number and hours of engagement of Spotify Ad-Supported Users and their ability to provide innovative advertising products.

A key ingredient is Spotify’s demographic segment primary made of users between 18 and 34 years old, which represents a massive opportunity for monetization via advertising:

maus-by-age-demographic-spotify

Source: Spotify prospectus 

In addition, thanks to the growing Spotify Audience Network, the company is strengthening its potiion in the audio-advertising industry. 

This is key to understand, as over time if the Spotify advertising network becomes scalable, advertising revenue can scale pretty quickly. 

It’s, therefore, possible a scenario where ad-supported users become the key asset for the company.

In other words, the ad-supported base has been employed today as a strategy to grow the premium members’ base. 

In the next decade, as Spotify’s advertising network strengthens, it might be possible to see the ad-supported business model take over or at least get much closer to the subscription-based business model

Spotify evolving business model: membership or ad-supported?

The Spotify business model is still evolving.

Even though its revenues primarily come from paid members, the company might try to push more on its ad-supported services, and enter more and more into the digital advertising space.

Therefore, a business model that is subscription-based might become advertising-based in the long run.

As of 2021, 87.5% or €8.46 billion came from premium memberships, while over 12.5% or €1.2 billion came from ad-supported members.

Spotify acquisition costs

Each company needs to tap into a distribution strategy that guarantees a stream of users to have a sustainable business model.

Much of Spotify’s costs are based on royalty and distribution costs related to content streaming.

Those are paid to specific music record labels, publishers, and other rights holders, for the right to stream music to Spotify Users. 

Of course, the revenue generated on lower-priced plans (such as the Family and Student Plan) carries a lower cost compared to other plans. 

The acquisition costs also depend on targets which can include measures such as:

  • The number of Premium Subscribers.
  • The ratio of Ad-Supported Users to Premium Subscribers.
  • And/or the rates of Premium Subscriber churn.

Some of the licensing agreements that impact Spotify costs include Universal Music Group, Sony Music Entertainment, Warner Music Group, and Merlin.

Spotify key metrics

Understanding the metrics that an organization looks at to evaluate the growth of its platform.

In a way also highlights the vision that the company has about its users, its business model, and what it’s important for its financial success.

A set of metrics that Spotify looks at comprises:

  • MAUs (monthly average users).
  • Premium subscribers.
  • Ad-supported MAUs.
  • Premium ARPU (average revenues per user).
  • Premium churn.
  • Content hours.

MAUs

Spotify tracks MAUs as “an indicator of the size of the audience engaged with its Service.

This is defined as the total count of Ad-Supported Users and Premium Subscribers that have consumed content for greater than zero milliseconds in the last thirty days from the period-end indicated.

spotify-mau

In 2021, Spotify had 406 million monthly active users. Growth compared to 2020 345 million monthly active users. 

Premium Subscribers

Premium Subscribers are users that have completed registration with Spotify and have activated a payment method for Premium Service. 

premium-subscribers

Premium Subscribers were 180 million in 2021, compared to the 155 million premium subscribers in 2020.

The plan that most contributed to Spotify’s revenue growth was the Family Plan.

While the Spotify free service kept enabling the upgrade from free to paid, which also helped the company grow its revenues. 

Ad-Supported MAUs

That is the total count of Ad-Supported monthly active users that have consumed content for greater than zero milliseconds in the last thirty days.

ad-supported-mau

Ad-Supported MAUs were 236 million in 2021, compared to 199 million in 2020. 

Premium ARPU

This monthly metric shows the revenue recognized in the quarter indicated divided by the average daily Premium Subscribers in that quarter, divided by three months.

spotify-premium-arpu

As Spotify increased the growth of its revenues by enabling more people to join its Family Plan, the ARPU, or average revenue per user declined in 2019.

Overall this had a positive effect on revenues, as Spotify tries to covert more free accounts to paid users, getting them into the basic plan, and over time, making users switch to higher-paying plans. 

Premium Churn

That represents the premium members’ cancellations in the quarter indicated divided by the average number of daily Premium Subscribers in that quarter, divided by three months.

premium-churn-spotify

We have old data about the churn, which in 2017 was 5.5%, compared to 6.6% in 2016. The churn is a critical metric in the subscription-based business model.

Indeed, when the churn rate is growing over time this creates a sort of “leaky bucket syndrome” for the company, which it doesn’t matter how much effort is placed to bring in new customers.

Those are burned over time, as the churn rate speeds up. 

What affects the churn rate?

There are several factors that can affect it. From products issue, like bad onboarding, unclear UX/UI, bad support, or low quality of the offered service.

It’s important to diagnose what’s causing a growing churn, to prevent the subscription-based business to lose traction, slowing down, and potentially lose its core customer base. 

Content Hours

That represents the aggregate number of hours. Users spent consuming audio and video content on Spotify.

content-hours-spotify

We have interesting past data (Spotify isn’t sharing this anymore), that shows, that users were spending an average of 40.3 hours per year on the platform, more than doubling, compared to 17.4 hours spent in 2015. 

Spotify user-generated content

It’s easy to think of Spotify as a modern tech achievement, made of automated algorithms able to find out any taste a music fan has.

Yet an exciting aspect of Spotify is its user-generated content, in which music listeners can easily and quickly curate and save their playlists to share with other Users.

As of 2017, Spotify had over 3.2 billion User-generated playlists, which generated over 500 million streams daily and accounted for approximately 36% of Spotify’s monthly Content Hours!

user-generated-playlists-spotify

Source: Spotify financial prospectus 

personalized playlists, automatically created by Spotify technology accounted for approximately 17% of its monthly Content Hours.

Curated Playlists by Spotify editorial team which carefully curates them that allow Users to listen to music in specific genres account for approximately 15% of our monthly Content Hours.

Spotify marketing strategy

Spotify marketing is based on four main strategies:

  • Brand marketing: made of online and offline brand marketing campaigns.
  • Marketing for artists: Spotify’s artist marketing program uses billboards, other forms of traditional media, and digital outlets to highlight artists and their work.
  • Premium Service discounts: Spotify offers bi-annual campaigns discounting its subscription offerings with a three-month subscription to the Premium Service. Those campaigns have proven very effective in driving the growth of paid memberships.
  • Conversion Marketing: Ad-supported users get the highlight of key features that encourage conversion to its subscription offerings. These include product links, internal campaigns and user emails, and performance marketing across leading social media platforms. The Ad-Supported Service is the main funnel that drives more than 60% of Spotify added Premium Subscribers!

How licensing affects Spotify’s business model 

licensing-model-spotify
Spotify licensing deals affect its business model. The company runs on both a free service, which is ad-supported, and a subscription premium service. They have different economics.
The ad-supported business had a 10% gross margin in 2021, compared to 29% of the subscription-based business. That’s because the more the content gets streamed on the platform, the more that increases royalty costs for Spotify. That is also why the company invested in developing its content. Thus, in part transitioning from platform to brand.
Spotify licensing deals affect its business model. The company runs on both a free service, which is ad-supported, and a subscription premium service. They have different economics.

From platform to brand

Source: open.spotify.com/

Started primarily as a platform the company has also in part transitioned into a production house.

This is part of the transition to becoming a strong consumer brand. But it has also to do with a business model evolution. 

Where the licensing model makes Spotify’s future costs to monetize its users, too volatile.

The company has also been trying to develop content, which makes its costs more scalable as the platform keeps growing.

This is what I define as the transition from platform to brand

Spotify during pandemic times (2020-2021)

During the pandemic, music and entertainment have become among the areas with the largest growth, where all else is falling.

Indeed, Spotify kept growing in the first quarter of 2020, adding six million premium subscribers and ten million ad-supported/free accounts for 286 million members. 

Spotify during the economic slowdown (2022)

As the economic slowdown and potentially a recession hit the business world in 2022, Spotify is among the few tech companies that keep growing its topline revenues. 

spotify-q3-financial-metrics

Driven by a strong premium members base and a fast-growing ad-supported base, Spotify kept growing fast.

Yet, the economic slowdown has influenced (in the short term) the company’s cost structure. 

spotify-operating-expenses-in-economic-slowdown

Spotify kept investing in growth initiatives through the slowdown, also finalizing a few more acquisitions, especially in the podcasting space. 

In the short-term, these increased operational costs have reduced the company’s profitability and cash position. 

Yet, long term, these growth initiatives might make Spotify’s business model even more solid. 

In fact, premium members are still the core of Spotify’s business model. 

spotify-premium-subscribers-driving-growth-during-economic-slowdown

And podcasting is driving even more adoption from the ad-supported user base.

spotify-podcasting-driving-growth-during-economic-slowdown

A few key considerations here on how the Spotify’s business model is changing: 

  • Ad-supported users become premium members over time, thus, nurturing Spotify’s self-serving funnel. 
  • Once ad-supported users have been converted to premium members, Spotify can retain them for a long-time. In short, the company has a very low churn rate. 
  • By converting, Spotify is also strengthening its advertising network, thus making it possible for the ad-supported user base to generate much more revenues (at much lower costs) in the future. In short, the advertising side of the business has the ability to scale in the coming years. 

Podcasting as a key driver for future growth

Another key driver for Spotify’s growth is podcasting, as the company keeps investing in this trajectory.

Indeed, 19% of the Total MAUs engage with podcast content, and as reported by Spotify, consumption grew at triple-digit rates year over year.

Spotify’s experimentation with monetizing the Metaverse

In May 2022, Spotify announced a partnership with Roblox, a virtual island on top of the platform, to enable artists to sponsor their content further.

As the company highlighted: 

Today, we are introducing Spotify Island, a paradise of sound where fans and artists from all over the world can hang out and explore a wonderland of sounds, quests, and exclusive merch.

As Spotify further explained: 

Spotify is the first music-streaming brand to have a presence on Roblox, a virtual universe where users can create and play games and share experiences with friends. Through this interactive world, we’re creating a place where fans can link up and create new sounds together, hang out in digital spaces, and gain access to exclusive virtual merch. Spotify Island is an audio oasis that has it all. 

A vibrant fauna depicts Spotify Island on Roblox with singer Sunmi on a screen

The Spotify Island on Roblox (Source: Spotify)

Each part of the creative journey within the Spotify Island leverages independent artists on the platform to create tracks, part of the adventures within Roblox:

 

Summary and conclusions

  • Spotify started in 2008 as a freemium service aiming to create a two-sided platform connecting artists with music fans without having artists go through traditional distribution channels and gatekeepers.
  • In 2021 Spotify made over €9.6 billion in revenues.
  • Even though the company primarily makes money via its paid subscription members, it also has an ad-supported service.
  • The ad-supported free service played a key role as an additional revenue stream in 2021, as it drove more than 12.5% of its sales and a critical sales funnel that drove 60% of added premium members in 2019.
  • Even though Spotify made over nine billion euros in revenues, the company reported a net loss of €34 million in 2021. Spotify’s business model is still evolving, and it might well emphasize more and more on its ad-supported service to grow its revenues.
  • An interesting aspect is that even though Spotify is driven by AI, one of the most popular features – that drives most of the content hours on the platform – is the user-generated playlists that represented about 36% of monthly content hours back in 2017! (When Spotify still reported these numbers).

Read: Who Owns Spotify, Spotify CompetitorsHow Does Spotify Pay Artists? 

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