FORTUNE — Since Spotify’s launch in Sweden three years ago, the music streaming service has become an industry darling by popularizing the “all-you-can-listen” business model. But it hasn’t always been smooth sailing for the startup. Securing licensing deals with the big four U.S. record labels for a stateside launch took longer than expected and, just last month, some 200 smaller UK labels yanked their content.
Now that Spotify is attracting millions of new users the question is, what will its profitability look like?
Earlier this week, MP3.com founder Michael Robertson argued Spotify and services like it are destined to be in the red forever. Why? He claimed that one-sided economics where all of the deal-making power is wielded by the record labels doom their businesses. If a service like Spotify doesn’t play ball with one of the increasingly more powerful labels, its ability to offer content suffers. If it does, they can get stuck with onerous terms such as a deal structure where the service coughs up money for whatever ends up generating the most cash: revenue per subscriber, per track played or simply a percentage of the company’s overall sales.
So are companies like Spotify, Rdio, Mog, and Rhapsody really stuck in a no-win situation? Not necessarily. Gartner analyst Michael Maguire believes it’s possible to level the relationship somewhat. “I think services can start striking better terms over time, but what they’re going to have to show is the ability to grow their audiences and maintain them,” he says.
Meanwhile, the services themselves argue it’s too early to call it a losing battle. “The music industry is constantly evolving and it’s not new to hear skepticism around new content distribution models,” Rdio COO Carter Adamson told Fortune. “It would be naïve to assume mainstream adoption will happen overnight, but what we have seen is that labels are invested in this model because of our innovation, great user interface, API and cross platform capabilities.”
Key to success will be upping brand visibility. All four of the companies mentioned recently inked partnerships with Facebook, which temporarily resulted in a brouhaha over what the social network calls “frictionless sharing.” Users who choose to do so now have their listening habits broadcast on the social network. It was a controversial move that paid off for Spotify nabbing it 7 million new registered users. (Spotify did not respond to requests for a comment for this story.)
Any question about how big eventual profits might be hasn’t dampened competition. Spotify recently announced it would be compatible with apps from third-parties much like Apple’s (AAPL) App Store and Google’s (GOOG) Android Market. MOG is betting on efforts like MOG Fusion, a program aimed at getting its service in consumer electronics and cars. Rhapsody announced a partnership with Metro PCS (PCS), where wireless users can get unlimited music alongside unlimited voice, text and web.
The larger and more popular a service becomes, the more leverage it will have. With 10 million global users, just 2.5 million of which pay, Spotify may have to kowtow to labels now, but what happens if it actually hits those reported internal projections of 50 million U.S. users within the first year of stateside operation?
Much in the same way Apple had to overcome criticism and prove itself when it first opened up physical retail shops, Maguire believes when a music service has substantial growth and retention numbers behind it — and therefore clout — labels will become more flexible at the bargaining table. Maguire says that should happen sooner rather than later, as many of the services’ deals with labels will likely be up for renegotiation starting mid-2012 through 2013.
If a service like Spotify accomplishes that, the question won’t be whether it can be profitable, but when.
