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The Funding Gap

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This week, MOG, the music blog network, announced this past Thursday that they had secured $5 million dollars (U.S.) in new financing from Menlo Ventures and others, giving them a total raise of $12 million dollars. This is great news for MOG’s founder, David Hyman, and even better news for digital music start-ups around the world.

In early July, online music streaming service Pandora announced a $35 million dollar raise. Greylock Partners led the investment round, joining existing investors Crosslink Capital, Walden Venture Capital and others. This sent shockwaves throughout the investment community and triggered new hope among aspiring digital music moguls. Over the past year, it has become increasingly difficult for new digital music entities to raise the funds necessary to take a new venture to market. The truth is that as the ideas are getting better, the cash is getting scarcer.

Ron Conway is the legendary angel investor who has provided early funding for Napster, Snocap, iMeem, Twitter, Digg, Kyte and others. Paraphrasing his comments, he stated last year that he would no longer invest in any company that relied on the rationality of a music industry executive. He was reacting to the ever-increasing licensing costs that surround and engulf any music-related venture, the numbers are completely spiraling out of control.

Here’s a recent example: My firm, TAG Strategic was retained by a U.S. start-up last December to help them present their innovative model to the label and publishing communities. After over seven months of meetings and negotiations, the general sentiment was as follows (again paraphrased!), “we really like what you’re presenting, but the model could be extremely disruptive. We now are comfortable with iTunes’ 80% market share and wouldn’t want to do anything to upset them. We would, however, feel a lot better about getting into business with you if you’d consider a $1 million + guarantee.”

So, do the math: Four major labels at $1 million each, plus four major publishers at $1 million each, plus $1 million for the indie labels via Merlin, and another $1 million for indie publishers; $10 million in music licensing start-up costs. This means that this new venture would need to raise a first-round of at least $12 million, just to get out of the gate. While this is an extreme example, it is not unique. Rumors swirl around the licensing advances paid by Nokia, Spotify and Omnifone to bring their innovative offerings to market. While I believe that they were all significant, I really hope that they were not as large as the street estimates.

As I’ve stated before, both here and in other venues, it’s critical that the deals being struck now are win-win endeavors. The digital music companies that have debuted over the past eighteen months will provide meaningful revenues to the music industry, even more significant than the dollars currently being generated by iTunes. This won’t happen if the start-up licensing costs exceed the revenue potential. This past week, iLike was acquired by MySpace for an estimated $20 million, a company that had received an estimated $35 million in VC funding. This exit sent a chill throughout the investment community. In short, an investment of X provided a return of roughly .6X. That is not a sustainable path for funding.

The music industry needs the support and the funds that the VC’s can offer, venture capital is more important than ever. Labels don’t have the liquidity necessary to back the required innovation that will take the business squarely into the 21st century. It is time to work together, share the risk and share in the rewards. It’s not an unreasonable approach, it’s smart business.

(Note: the author has worked with Napster, iMeem, MOG and Pandora)

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