MarketWatch First Take: The Spotify IPO filing includes a giant warning sign


Streaming music service Spotify Technology Inc.’s initial public offering included a warning that should send a shiver down the spine of any investor who remembers the dot-com boom.

Spotify filed with the Securities and Exchange Commission for a rare direct listing Wednesday, offering more than 200 pages of information on the music-streaming service. In the paperwork, the company says it “identified a material weakness in our internal control over financial reporting relating to inadequate financial statement preparation and review procedures” for the past three calendar years.

During the dot-com boom of the late 1990s, the so-called Section 404 warning was pretty standard for many small companies filing to go public in that pre-Sarbanes Oxley world. Most of those warnings were because the companies were so small and young that they did not have proper financial accounting systems in place.

That is not the case with Spotify, which is almost a decade old and reported 4.1 billion euros (about $4.9 billion) in revenue for 2017. The problem with Spotify’s internal controls appear to largely stem from the difficulties in paying royalties to artists, the biggest expense for streaming-music companies like Spotify and Pandora Media Inc. P, +1.15%  , and its own internal accounting procedures.

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“We have in the past and may in the future identify material weaknesses in our internal controls relating to our royalty payments,” Spotify’s filing said. “For example, for the year ended December 31, 2015, we identified a material weakness in our internal control over financial reporting related to the accounting for rights holders’ liabilities.”

Spotify said it could either underpay or overpay royalties due to record labels, music publishers and other copyright owners. Underpayment could result in lawsuits, disputes and unexpected amounts due, while overpayments may be difficult to reclaim.

Jay Ritter, an IPO expert and the Cordell Eminent Scholar at the University of Florida, warned that most internal-control warnings like Spotify’s are “just boilerplate legalese,” noting that Spotify has 42 pages of risk factors while Apple Inc.’s AAPL, -0.15%    entire prospectus was just 47 pages and had no risk factors in 1980.

“It is difficult to find things that are worth paying attention to because it is diluted with too much legalese,” he said in an email.

Barrett Daniels, chief executive of NextStep Advisory, a startup consulting firm, said that he, too, is normally not too concerned with internal-controls warnings, but this one stands out.

“Usually they are pretty vanilla,” Daniels said. “And this one is not, it is pretty unique.”

It is not unique among music-streaming services, as Pandora had a similar warning in its S1 when it went public in 2011, though it did not get into such specifics. Because of this, it seems this warning is a giant blinking sign in Spotify’s listing that may as well say “the digital music business is really tough.”

Royalty payments to artists and record labels are the biggest costs, which continue to grow as its users grow or listen more, and often lead to disputes or renegotiations. In 2017, expenses for rights holders grew by 27% year-over-year, and the company has paid a total of more than 8 billion euros (about $9.7 billion) in royalties since its founding in 2008, and has had significant operating losses due to its content costs and royalty expenses.

Read more about Pandora’s woes with ever increasing royalty costs

This is also a big reason why Pandora has never been profitable, even as it has taken a different approach by relying more on advertising than subscriptions. It is possible that no company could make this type of business profitable, and that is a warning that any potential investor should note.