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COLUMN-Has Europe's hottest site got what it takes? Eric Auchard

-- Eric Auchard is a Reuters columnist. The opinions expressed are his own --

LONDON, Aug 5 (Reuters) - Spotify is enjoying a fairy-tale success as Europe’s hottest Internet start-up this year, thanks to music industry support and rapid adoption by avid listeners. The trouble is that the young company appears to have no special technology or business model that will help it compete in an online market where many consumers expect music to be free.

The company, founded by two Swedes, combines some of the best features of other music discovery sites with the aim of taking on no less a rival than Apple Inc AAPL.O and its iTunes media store. It has certainly caught on -- despite being on the market for only 10 months, the advertising-supported service has attracted 2 million users in the UK, Sweden and other European countries.

Unlike iTunes, which sells songs or videos by the download, Spotify is one of the many services that offer consumers streaming access over the Web to a more or less unlimited library of songs. In Britain, Spotify has rocketed to become the 10th most visited music site, up from 27th a few weeks ago, according to Web measurement firm Hitwise.

It still ranks behind sites like BBC Radio 1,, the pioneering music discovery site, and a newer rival, the ad-supported site, which is backed by musician Peter Gabriel. Spotify also has competition from social network sites like MySpace and Nokia’s Comes with Music service on phones, among many others.

Spotify is reportedly close to securing new investment from high-profile investors including Hong Kong billionaire Li Ka-shing's charitable foundation. The Li foundation, along with venture capital firm Wellington Partners and others are apparently looking to invest up to $50 million, which would value it at $250 million. Spotify declines to comment. But analysts think one of the four big record labels may also be looking at a stake. (See

The problem with getting close to any one label is that Spotify is dependent on having all the labels on its side in order to offer listeners a wide music selection. Napster learned this lesson earlier this decade when Bertelsmann’s former music label, now part of Sony, bought it, leading other big labels to shun it. On the other hand, the closer Spotify gets to the labels, the more generous the revenue split may be.

So is such a rich valuation justified? Spotify’s business model combines a free, advertising supported service designed to appeal to newcomers and a 9.95 pound per month premium subscription offering. While company executives say its long-term business model involves selling subscriptions, the company has emphasized the advertising-funded side of the service in order to fuel its early-stage growth.

The company won’t say how many subscribers it has, but analysts believe no more than 2-3 percent are paying members so far. Meanwhile, in order to win over users, it has kept advertising to a minimum, running ads alongside only one in every four songs. This comes nowhere close to covering the costs of bandwidth and royalty fees it must pay music publishers every time it serves up a song.

Another problem is keeping those fans listening. Many users say they rely on Spotify to discover new music, but then turn to iTunes or to purchase it.

A key factor to its growth has been the success Spotify has had courting the media and other music industry trend-spotters. The UK press breathlessly chronicles the company's every move in the same way it does for Google, Facebook or Twitter. Compare the buzz it has attracted to other music sites at

Then again, Spotify knows how to create controversy and milk the attention it generates. It recently said it was looking to offer its service via the iPhone, in competition to Apple’s own iTunes. The move is likely to be rejected by Apple, which has rebuffed similar programs that compete with its services.

The online music world is littered with trendy start-ups that enjoyed similarly spectacular growth only to find it difficult or impossible to evolve a second or third act, as industry conditions rapidly change. SpiralFrog was one such player with strong music label backing just two years ago when it launched its ad-based music download site. The site closed its doors earlier this year.

It is likely to be several years before business models based on advertising or subscription services can produce anywhere close to the revenue now generated by music downloads, where just 10 songs at 99 cents apiece bring in as much revenue as Spotify’s premium-priced offering. Apple’s iTunes, which dominates the market with roughly 75 percent of online music sales, takes an estimated cut of as much as 30 percent on each song, infuriating the labels, and some artists.

Spotify will only get so far by playing David to Apple’s Goliath. Europe’s latest Web hero still has to prove it has the flexibility to adapt its business strategy and expand to face many more challengers.

-- At the time of publication Eric Auchard did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns, Reuters’ customers can click on [AUCHARD/] --

Editing by David Evans