Up, Up and Away: Is The Spotify Balloon a Cautionary Tale?

Already we see leaks to the tech press that Spotify is pushing off a U.S. IPO to next year while it pursues a "path to profitability". Now that's a new one--the company has previously told investors a growth story like many other startups. But unlike most other startups, Spotify now has a $1,000,000,000 convertible loan from private equity companies staring it in the face--along with what will no doubt turn out to be credit card interest rates when the total cost of the money is calculated (interest plus discounts on Spotify's anticipated public stock). We have to ask, where does the path to profitability lead?

Is Spotify leaking this IPO information, and if so, why now? Was any serious person outside of Spotify banker Goldman Sachs refreshing their news feed in anticipation of a Spotify IPO announcement any time soon? My bet is that it is mostly, if not entirely, to get out ahead of an anticipated breakdown in their negotiations with major labels and to try to put some chum in the water about the beastly record companies, greedy artists and nasty songwriters. You know--the people who make Spotify's only product.

In the meantime--one question about Spotify's growth strategy is how will they be able to afford their interest payments on that billion-dollar debt--5% plus another 2.5% every six months that Spotify doesn't IPO (capped at 10%). The clock is ticking toward the one-year anniversary of that loan with its first interest reset.

Of course we can't know the exact terms as the debt is private and the devil is in the details--but we can guess that it is at least possible that the terms of the bonds do not require interest or installment payments be paid monthly. We can speculate that it's possible that the bonds allow rolling all installments of interest and principal into a balloon payment at the ultimate maturity date of the loan. A balloon means no loan payments for now, but a relatively big nut to be paid pre-IPO (which will itself be carried as an obligation that will be at least something of a drag on Spotify's pre-money valuation even if the interest is capitalized).

That balloon payment--if there is one--will itself likely also be subject to the 20% discount on Spotify's IPO share price that is another feature of the loan. Bondholders reportedly get special treatment in return for their risk--they evidently get to buy the IPO stock cheaper and sell it sooner than any Spotify insider or employee.

That may mean that Spotify's bondholders might be able to elect to convert any balloon payment of accrued interest into shares as well as the loan principal. A balloon payment would save Spotify from having to make installment payments on the bonds in the short run but shove more shares out the door in the long run IPO scenario. (A convertible loan is a special type of security that allows the bond holder to buy shares of a class of a company's stock in lieu of repayment, in Spotify's case, probably common stock.)

And let's be clear--these private equity companies weren't born yesterday. In order for over a billion dollars of Spotify stock to have value to them, the bondholders have to convert some (and eventually all) of the bonds to shares and sell those shares to somebody in the retail market. An IPO gives them more potential buyers.

A billion dollars of Spotify stock hitting the public market all at once will tend to drive down the share price. Getting that much stock sold requires some forethought and probably means selling in tranches.

This is why the bondholders will probably want a post IPO follow-on stock offering or two or three that will allow them to get out the door with their cash and a nice premium (sometimes called "demand registration rights" if the follow on is initiated by bondholders or "piggy back" rights for bondholders to participate in a registration initiated by Spotify or another investor with demand registration rights).

Remember--"IPO" is "initial public offering," not the only public offering. (See, for example, Pandora.) It's also why they got a short "lock up" period that restricts how much stock they can sell in the IPO and after the IPO--which inevitably will be before the employees, and possibly the labels, get to sell their shares.

Markets know this potentially dilutive overhang of shares is out there because they weren't born yesterday, either. That billion dollar overhang will tend to depress the present value of shares of Spotify stock based on technical analysis alone as the stock will tend to price-in the future dilutive effects of the total number of convertable shares hitting the market. This is just math--at best, high school algebra.

It certainly appears that the bondholders are going to make bank on this deal--or with the right "events of default," they may have the right to take over the company and then make bank.

This should all be a cautionary tale about taking stock for a one-time pop in revenue in exchange for an absurdly low royalty rate with an unsustainable future return. A royalty rate that then becomes the benchmark for everyone who doesn't get the stock. This is why I for one would rather have the money and let them keep the stock.

How about that "path to profitability"? Spotify is now getting a bit long in the tooth to be ignoring how to convince investors that the company will eventually make money, or why the world's dominant streaming services is not profitable given otherwise decent numbers according to Motley Fool:

Despite the influx of competition last year from big names like Apple and Tidal, Spotify managed to accelerate its revenue growth in 2015. Revenue grew 80% to reach 1.95 billion euros for the year. That's up from 45% growth in 2014, when it recorded 1.08 billion euros in revenue.

So why can't Spotify make money? Because the company's overpaid executives made the costly decision to bet on growth and stand up operations in dozens of countries to achieve market dominance but losses as far as the eye can see? Or because they pay out so much of their revenue to the beastly artists and songwriters? You know--the beastly artists and songwriters whose labels drive traffic to Spotify at no charge and make Spotify's only product?

Either way, it looks like we're in for another year of Spotify in our lives. And Apple keeps quietly adding paying subscribers to Apple Music perhaps in anticipation of shutting down the iTunes Music Store when streaming cannibalization passes them by on the path to profitability.