Music & Money: Will They Ever Learn to Dance?

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Music soothes the soul and livens the spirit, but can it ever produce outsized investment returns?

In the current era, investors on all levels have mostly been frustrated with music-related investments, despite the presence of ground-shaking disruptions.

And flimsy business models are keeping serious investors away from pure-play music startups.  That frustration also extends to bigger companies like Warner Music Group and EMI Group, both considered highly unattractive and risky bets.

In a discussion Thursday at the SanFran MusicTech Summit, venture capitalists acknowledged the incredible sexiness of the space, though they also recognized a treacherous path towards success.  “The bar is a bit higher on music investments, and there tends to be an oversupply of ideas and entrepreneurs in the space,” said Toni Schneider of True Ventures.  “There is still that prize out there of figuring it all out, though it is risky and a lot of money has been lost.  So people are very, very gun-shy.”

Not only that, but successful growth frequently involves complicated and risky legal pitfalls.  In fact, the less-than-legal route is now becoming a viable and recognized strategy.  “The standard playbook in digital music is to infringe like crazy, get to scale, and gain some leverage against labels,” explained Tim Chang, a principal at Norwest Venture Partners.  “Once you get their attention, they come knocking with a lawsuit, which is basically foreplay to a licensing deal.  At that point, you go raise venture money and try to pay off the labels, and convince them to convert some of that infringement suit penalty into strategic equity.”

That sounds like a workout, and a rocky ride for entrepreneurs to stomach.  But venture capitalists are really only interested in companies that can deliver serious multiples – and a massive pot of gold at the end of the rainbow.  Just last month, Paul Santinelli of North Bridge Venture Partners noted that investors are generally disinterested in anything yielding less than three times the initial investment.

But the panel of investors in San Francisco outlined an even tougher bar.  “We have a very specific metric,” explained Stewart Alsop, a partner at Alsop Louie Partners.  “We want to believe that every company we invest in can pay off our fund.”

And that produces some extremely massive revenue demands.  For example, on a $75 million fund, a 30 percent share of a company carries the expectation of a $250 million return.  “It just gives us a way to discipline our thinking,” Alsop explained while recognizing the nosebleed figures involved.

The rationale comes from the massive miss rate associated with early-stage companies.  “Historically, startups have a mortality rate of 75 percent,” Chang said, while noting that the typical return window is between 7-10 years.  “Our job is to take the risk, but also manage the risk, and it only gets harder as the fund gets bigger.”

In fact, VCs oftentimes dissuade healthy startups from accepting otherwise lucrative buyout offers, simply because the overhead expectations are so aggressive.  And that structure may not make sense for certain startups, especially given the availability of angel funding, or even self-financing options.

And what about financing for creative projects, including labels and bands?  Investors are normally disinterested in smaller projects, simply because the multiples and payouts are so soft.  But Alsop pointed to an investor type that finances projects like movies, as well as a class of wealthy angel investor that dabbles in music projects, restaurants, and wineries.  “If you want to have a small fortune by investing in music, you start with a large fortune,” Alsop joked.

Report by publisher Paul Resnikoff in San Francisco.