On April 16, three men — a retired bankruptcy judge from Alabama, a former litigator with expertise in transportation industry economics and a career attorney for the Copyright Office — made a decision that has profound implications for the future of webcasting, and for the music and Internet industries in general.

These three judges on the recently empaneled Copyright Royalty Board decided to raise webcasting royalty rates drastically, to levels proposed by SoundExchange, a digital music collecting society presided over by record labels and musicians unions. Specifically, the board’s ruling denied webcasters’ requests for a stay and a rehearing, effectively closing the door on further deliberation over the royalty rates and requiring that webcasters begin paying the new rates by May 15 of this year, due retroactively from the beginning of 2006.

Supporters of this decision argue that these new, higher royalty rates will ensure that musicians are paid fairly for their work as the music industry shifts its focus from traditional media to the Internet. Currently, record labels and recording artists don’t receive any royalties at all from terrestrial radio, which is required to pay only composers and publishers. However, detractors argue that the new rates are ruinously high and will lead to bankruptcy for the vast majority of webcasters, eliminating a resource that entertains more than 70 million Americans and financially supports tens of thousands of recording artists.

In order to learn more about the webcasting business, and the potential effects of this ruling, we spoke with Tim Westergren, the founder of popular Internet radio provider Pandora and one of the most vocal proponents for lower webcasting royalty rates.

Aram Sinnreich: What, exactly, is Pandora, and how does it work?

Tim Westergren: Pandora offers personalized radio over the Internet. The secret to our product is the music genome project, which is this enormous collection of songs that have been musicologically analyzed, each along close to 400 musical attributes, by a team of 50 trained musicians. We use this musical DNA to connect songs and create playlists.

We launched the radio service in November 2005, and in the past year and a half we’ve accumulated close to 6.5 million registered listeners.

Sinnreich: What’s Pandora’s business model? How do you make money?

Westergren: It’s advertising-supported. Our primary costs are licensing and streaming, and the core personnel. But a business like ours scales, so the whole thing is, build a large listener base, and then you start to get the advantages of scale. We sell visual advertising right now, and we recently experimented with audio ads. But we haven’t made any decision about whether that’s something we would pursue long-term.

I can’t tell you too much about our financials, but we’re not profitable right now, and [until the CRB ruling] we were looking at a year or two from now being able to turn a profit. It’s a relatively small-margin business, and it’s all about getting a big audience.

Sinnreich: What are the new webcasting rates, and how do they affect your bottom line?

Westergren: As a webcaster, we pay a performance royalty for every song that we stream. It’s a royalty that’s not paid by terrestrial broadcasters, and is paid at a much lower rate by satellite broadcasters. Until this ruling, the rate that we paid was 1.17 cents per listener-hour, which equates to about 0.076 cents per song streamed to each listener.

The new rates, which are retroactive to the beginning of 2006, are immediately higher than that. They go from 0.076 to 0.08 cents per song, and then they go up incrementally over the subsequent five years. And by the end, they’re at 0.19 cents per song. That’s close to a tripling.

Economically, these new rates will represent 70-80 percent of gross revenues for folks like us, as opposed to only about 25 percent today. So they make the business completely uneconomic. There’s nobody that can deliver an advertising-supported webcast at those levels, because advertisers won’t allow us to raise rates high enough to cover it.

When you consider that satellite radio providers pay between 5 and 7.5 percent of gross revenues for the same thing, it seems especially unreasonable.

Sinnreich: As of May 15, you’re going to owe higher royalties retroactively to January 2006, due in one lump sum. How big is that check going to be?

Westergren: I can’t tell you specifically, but the near-term impact is many millions of dollars.

Sinnreich: What do you think the impact of these new rates will be on the Internet radio industry as a whole?

Westergren: If these new rates really stick, it’ll stop. No legitimate webcaster can afford to stream. There may be a few large terrestrial stations that keep their streams going online as a loss leader, but the whole business and ecosystem around Net radio is really going to be wiped out.

On the other hand, there are 70 million Americans currently listening to radio over the Internet. If you suddenly turn it off, the demand doesn’t go away. More Web radio will start sprouting up from countries where royalties aren’t strictly enforced, and people will start tuning in to them.

Sinnreich: The RIAA and SoundExchange argue that higher rates are necessary in order to adequately compensate recording artists as CD sales and other traditional music channels continue to lose customers to the Internet. What’s your take on this?

Westergren: I’m a musician myself, and I’m a huge fan of paying artists for their work. Our position is that we’re happy to pay it, but it has to make sense for the business. You’re right — CD sales are really dropping dramatically, and there’s a fair bit of panic going on. But that’s coupled with a serious misperception about the economics of online radio. SoundExchange and the RIAA say that since Internet radio’s getting bigger, a bigger piece of the webcasting pie needs to go to artists. In reality, revenue might grow, but that doesn’t mean it’s going to become much more profitable. You can’t squeeze blood from a turnip.

Sinnreich: So you don’t think they’re malicious so much as misinformed.

Westergren: They’re definitely misinformed. But there’s another piece of the story. Half of the money we pay to SoundExchange each month goes to the labels, and half goes directly to the artists. If these new rates do stick, then the only way webcasters will stay alive is to start striking direct licensing deals, at lower rates, with the major record labels. If those deals are struck, then all of that money goes directly to the label, and goes under the umbrella of traditional record deals, where only a very small percent ends up going to artists.

Sinnreich: So you believe that one of the strategic reasons the RIAA has for supporting these higher rates is so labels can offer a competitive lower rate directly to webcasters, which would mean more income overall for labels and less income for artists?

Westergren: That’s exactly right.

Sinnreich: That sounds pretty nefarious.

Westergren: It’s business. These are businesses that are struggling, and they’re trying to maximize revenue.

Sinnreich: Have you seen any evidence of labels making direct deals with webcasters?

Westergren: SoundExchange just announced that they’re happy to let the RIAA deal directly with webcasters. Labels, throughout this process, have also been soliciting deals on the side. And they’ve already signed some — [popular webcaster] Last.fm signed a couple.

Sinnreich: Some have argued that the labels might also negotiate lower rates in exchange for promotional concessions from webcasters — the kind of thing that’s sometimes referred to as “payola” in terrestrial broadcasting. Would Pandora consider such an arrangement?

Westergren: Pandora has never, ever taken money to play music, and we never will. Labels have certainly offered, and I don’t think that’s nefarious — it’s the same as buying a billboard, or an end-cap [a type of display] in a record store. I think that is undoubtedly part of the motivation for direct licensing deals, and I wouldn’t be surprised if there were a promotional element to many of those deals. And that’s just business.

The problem is that listeners lose out. What’s being killed here is this channel that’s a wellspring of discovery and deep catalog and music-centric programming. And to my mind, it’s the future of music, and the only hope for it. And if it gets bottled up and stuck in these kinds of deals, it’s going to wind up being more of the same of what you already have.

Sinnreich: How deep is your catalog, and how much comes from the major labels?

Westergren: We have close to 600,000 songs now, and half the music we stream is independent of major label affiliation. And 70 percent of the songs we play come from albums whose Amazon music sales rank is 10,000 or lower. It’s indie, indie stuff.

Sinnreich: Some people would argue that if the market won’t support webcasting, it’s no great loss. If Pandora’s going to go out of business, who cares? This is an age of booming consumer access to a broad range of content. There’s digital terrestrial radio, mobile music services, satellite radio — why do consumers need Internet radio on top of that?

Westergren: That’s a fair question. The only answer to that is to look at how consumers respond. We’ve grown like a weed, and the only reason that’s happened, considering that we don’t advertise the service, is because there’s a need for what we’re offering. And I think that it’s going to grow faster and faster. And if you want to shut off these kinds of services, sure you can force people to be happy with what they have, but that doesn’t mean there’s not an appetite for a lot more.

Sinnreich: What’s Pandora going to do if the new rates stick?

Westergren: There’s a pretty good chance we’ll just turn it off, and give the money back to our investors.

Sinnreich: Fortunately for you, there are still some options on the table. You were involved in the recent launch of SaveNetRadio.org. Tell me a little bit about it.

Westergren: It’s a coalition led by webcasters — us, AOL, Yahoo, Live365, RealNetworks and a huge slew of smaller sites — and it includes many musicians and listeners as well. Its intention is to collectively solve the problem, and to marshal our respective audiences, directing that energy into congressional pressure to get a bill passed that will create parity between Internet radio and satellite radio.

We launched it on April 16, and had a quarter-million people sign the petition and contact their congresspeople in the first three days. And it’s continuing to grow. Pandora listeners are very energized.

I think musicians really need to pay attention to this, and not be passive, and get smart and get active. This is a watershed moment. There’s this budding vibrant online radio phenomenon that’s got massive energy and enthusiasm, and is growing in leaps and bounds. And it’s a new voice for the newly empowered creative class. Musicians are now able through technology to produce this huge volume of really good music. There’s no room for it in broadcast radio, but there is in this new medium. And it’s under threat right now, in a big way.

Related links:

CNET’s coverage of the April 16 ruling.

Another CNET news blog about NPR and other webcasters fighting the proposed fee hike.

The Recording Industry Association of America home site.

NPR’s story on the case includes links to the Copyright Royalty Board, SoundExchange and others.

Pandora’s main page.

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