Revenue On Tap

When the major record labels slapped the popular Chinese Internet portal Baidu with a copyright infringement lawsuit in 2005, it seemed like the original Napster all over again.

All the elements were there—consumers getting free music from a wildly popular Web destination from which record labels weren't getting paid a dime. Just ask Kazaa, eDonkey and Grokster how that worked out for them.

My, how times have changed.

Following a November 2006 ruling in favor of Baidu, EMI broke ranks with the music industry—still appealing the decision—to strike a deal allowing the Chinese company to offer free streaming music from its site in return for a split of advertising revenue. Exact details of the deal, or a date for a live service, remain pending.

While pirate sites have, in the past, offered record labels a cut of their ad revenue as an olive branch, they were generally rebuffed and sued into oblivion. EMI's change of heart symbolizes a newfound spirit of cooperation among music labels now more open to—or, some say, desperate for—alternative business models as the digital age evolves.

When the industry sued the original Napster and others of its file-trading ilk out of business, it banked on the emerging "legitimate" digital-music retailers to ease the sting of declining CD sales. But with digital revenue still unable to recoup the industry's financial losses, advertising could emerge as a key link in closing that gap.

"We're using ad funding to turn a completely pirated environment into a profitable environment," EMI head of worldwide digital music Barney Wragg says. "That's opening up a bowl of possibilities, which has huge potential growth for us. This is not small potatoes."

In fact, record labels are on pace to begin collecting advertising revenue from a host of online sources, not just those with questionable legal status.

Ad-supported free music services such as Qtrax and Spiralfrog are in the works. The Ruckus digital music service designed for university networks switched in January from a monthly paid subscription model to an advertising model. Meanwhile, subscription services like Napster and Rhapsody have added an ad-funded free music tier to their offerings, and music recommendation site Pandora began testing in-stream audio ads this month.

Music videos are attracting ad revenue as well. AOL, MSN and Yahoo have been sharing advertising revenue with labels for the use of their music videos for more than a year. Just this month, Google got into the game as well, striking a deal with Sony BMG and Warner Music Group to syndicate music videos to online services participating in the search giant's new AdSense video advertising initiative. And YouTube is slowly building its ad business.

Even wireless operators have started taking cautious steps into mobile advertising to support more media services.

Labels are betting on advertising revenue "in a big way," according to one major-label source—putting in place account management, consumer marketing and advertising sales departments dedicated to Internet advertising in preparation for a "substantial" revenue stream. Label executives speaking on background say Internet-based advertising revenue could match that of their existing synch-publishing revenue, an average of about 15% of the total pie.

By all accounts, the time is ripe to get in on the Internet ad boom. According to the Interactive Advertising Bureau, Internet ad revenue reached an all-time high of $4.2 billion for the third quarter of 2006—the most recent measured period. That is a 33% increase over the third quarter of 2005 and a 2% increase over last year's second quarter.

This growth is expected to continue throughout the year and beyond until the rate of Internet ad spending catches up to the rate of Internet traffic. And while more traditional forms of advertising will remain more expensive, Internet ad costs will rise once advertisers can more granularly target specific user groups online.

Supporters say music services are in a good position to compete for these advertising dollars given their ability to identify specific demographic groups that advertisers wish to reach.

Advertisers feel certain assumptions can be made about the respective fans of Jay-Z, Rascal Flatts or Madonna—regardless of whether they're downloading their music from Qtrax or watching their videos on YouTube—and hope to use these services to better target their audiences.

"The holy grail for advertisers is the ability to pinpoint certain demographics and deliver their products to them," says Andrew Nibley, chairman/CEO of Marsteller, the advertising, interactive and promotions arm of Burson-Marsteller, and newly named chairman of the Qtrax advisory board. "The more specific you can make the advertising to the lifestyle of the person going to that service, the better. They're actually zeroing in on somebody who's likely to buy their product."

Additionally, advertising models allow record labels to monetize existing user behaviors, rather than try to "re-educate" them or convert them to paid services. For instance, while Apple is celebrating the fact that it has sold 2 billion songs on iTunes since its inception, almost 15 billion songs were downloaded from free file-sharing networks collectively last year alone, according to data from BigChampagne.

Services like Qtrax, Ruckus and Spiralfrog aim to compete directly in this space, which labels hope will woo younger fans with more time than money.

"We don't consider ourselves to be in competition with existing paid services," Spiralfrog founder Joseph Mohen says. "We're targeting the guy on LimeWire every day who's not paying a damn thing."

Meanwhile, YouTube boasts more than 40 million users and streams 100 million videos a day. Labels are concerned that much of the content on YouTube is either copyrighted work—such as music videos—or user-created content that incorporates their copyrighted material, such as lip-synched videos or music video re-enactments.

Rather than trying to force users to pay themselves for the use of their work, or suing YouTube directly, labels have turned to ad-revenue sharing as a middle-ground solution.

Given the prevalence of advertising throughout the Internet, particularly on peer-to-peer music services, few feel it will put off music fans.

"Not only do people not particularly mind advertising in this context, but they may not even have a preference of ads versus no ads," BigChampagne CEO Eric Garland says. "Some of the most popular P2P communities have been heavily advertised."

However, there are deep concerns that ad-supported music services won't be able to attract enough advertising dollars to cover the expensive music-licensing fees and other operational expenses inherent in any digital music service today.

"You'd have to be extraordinarily well-funded, because you're paying the labels regardless of whether or not somebody's listening," says a music industry source, who asked not to be identified. "The economics don't work out so well. For one of these services to really work, it would have to become a phenomenon."

Like today's subscription-service providers, the ad-supported players are trying to convince labels to accept a percentage of their overall revenue as payment, rather than a fixed minimum monthly payment and price-per-user fee.

"The past is fixed cents, the future is percentages," Spiralfrog's Mohen says. "Retrofitting legacy pricing models into [digital retail services] will prevent the birth of new sources of revenue for them. Those that accept that will be much more successful much faster."

But perhaps the primary obstacle is digital rights management. While music acquired from ad-based music services is free, it still won't work with the popular iPod—a limitation that has stunted the growth of every music service save iTunes.

Yet any opportunity for Internet-advertising revenue remains high on labels' to-do lists during this year of transition and experimentation. According to EMI's Wragg, it's a win for all concerned.

"The consumers are getting the media that they want, the advertisers are getting real measurable value for their money and ads, and the record companies are able to profit from it and pass it through to the artists," he says. "So I think this has really got some legs."