Music to Their Ears

When Antonio Rodriguez, general partner of Matrix Partners, took his first meeting with music startup The Echo Nest, he fell in love with the entrepreneurs and the technology. It was everything else that he disliked.

“If they were in the financial space or retail space, I would have been way more interested. But the music industry? I didn’t want to touch that with a 10-foot pole,” he says.

Why such animosity to music? Maybe it’s because investors in music startups have a long history of singing the blues. From the ill-fated investment by Hummer Winblad Venture Partners in music file-sharing service Napster to dozens of other flameouts, including SnoCap, LiquidAudio, Imeem, Spiralfrog, Burn Lounge and Project Playlist, the music industry has shattered the rock-and-roll dreams of many VCs.

The primary culprit, of course, has been the record labels, who are typically more interested in suing music startups than working with them.

When they haven’t been suing them, they’ve been raking them over the coals with one-sided licensing deals.

“The history of digital music startups has been nothing but one giant redistribution exercise where you take money from the VCs and you redistribute it to the dying labels,” Rodriguez says.

What possessed him to change his tune and invest in The Echo Nest? Two reasons. The company promised it would never touch a licensing deal with a label, and also that it would never be a direct-to-consumer service.

So far, Rodriguez has been pleased with the deal. The Echo Nest—which also counts Commonwealth Capital Ventures, Argos Management and three co-founders of MIT Media Lab as investors—is currently selling music analytic services to a number of companies, including MTV, as well as to some of the large record labels. One Echo Nest service analyzes everything from blogs, tweets, Facebook posts and digital downloads to determine how bands are trending. The Somerville, Mass.-based company, which has raised more than $8 million in two rounds, has also developed a Pandora-like music recommendation engine that it is bringing to market.

“We have the ability to launch a thousand Pandoras with this offering,” Rodriguez says. “The goal is to build a huge business by productizing the discovery and consumption of music and selling it in a white box to other media companies.”

Music is Cool

Despite a checkered past, music startups are once again in vogue with VCs. Last year, The Echo Nest raised a $7 million round from Matrix Partners and Commonwealth.

Other recently funded startups include:

SoundCloud, a German-based provider of an audio distribution network, secured $10 million from Index Ventures and Union Square Ventures in December.

RootMusic, a San Francisco-based creator of the BandPage application for Facebook, raised a $2.3 million in January from Mohr Davidow Ventures and individual investor Larry Marcus, a managing director of Walden Venture Capital who also sits on the boards of music tech companies Pandora and SoundHound.

TuneUp Media, a San Francisco-based developer of a plug-in for iTunes, raised an additional $2 million in Series C funding, bringing the total for the round to $6.3 million, from previous investor IDG Ventures.

Jelli, a San Mateo, Calif.-based startup that combines terrestrial radio and the Internet, raised a $7 million round of funding from Battery Ventures and First Round Capital, bringing its total capitalization to more than $9 million.

In addition to more music-related tech startups entering the scene and raising capital, the music industry is poised to provide liquidity for the venture backers. Last month, Oakland, Calif.-based Pandora Media, which has raised about $65 million from Walden, Crosslink Capital, Greylock Partners, Labrador Ventures, The Hearst Corp., Granite Global Ventures and others, filed in January to raise $100 million in its public offering. The company, which grew out of the Music Genome Project to identify types of music, is growing rapidly, according to its filing, as revenue for the nine months ended in October rose to $90.1 million, compared to $31.4 million for the entire year before.

The reason for the recent surge in deals is partly traced back to the Apple effect. From iPods to iPhones to iPads to scores of other mobile devices, music is more accessible than ever before. It is with consumers everywhere they go, and that is inspiring a lot of entrepreneurs to build interesting companies in the space.

What’s more, music holds a prominent place in the consumer consciousness.

“Most people love music and are passionate about it to one degree or another,” Marcus says. “So as a passion center, there is natural desire for consumers to spend time in and around things related to music.”

VCs hope it’s a desire to not only spend time on music, but also money. Savvy investors, however, understand there is no real opportunity in the selling of music. From a distribution standpoint, major players, such as iTunes and Amazon, have that market cornered.

Plus, music sales continue to decline, with the overall music market shrinking 9% in 2010. Even digital music sales are starting to plateau, with some industry analysts predicting the market will peak at $5 billion this year before beginning its inevitable decline.

If they were in the financial space or retail space, I would have been way more interested. But the music industry? I didn’t want to touch that with a 10-foot pole.”

Antonio RodriguezGeneral PartnerMatrix Partners

Instead, the real opportunity is in advertising, app sales, premium subscriptions and the selling of virtual goods around music, Marcus says.

“What does a drop in music sales suggest?” Marcus asks. “I think it validates why going after music sales as a primary line of business is not a good idea. Music sales alone are a pretty bad proxy for the kinds of music opportunities I’m looking for.”

So far, Marcus has invested in three music startups—Pandora, SoundHound and RootMusic—but in a way, none of these are actually music companies, he says. Pandora is more of a media company, making the bulk of its money from advertising.

SoundHound, a service that can quickly identify songs it hears and provide the full lyrics, is more of a search company, making money through advertising and premium app sales. It is currently the number one music application on the iPhone App Store.

RootMusic, which allows bands to connect with fans via its Facebook application, is more of a social networking company. The company, which currently has about 14 million users, could potentially make money by allowing bands to sell virtual goods, tickets and other merchandise over its platform.

David Feinleib, the partner at Mohr Davidow who led the RootMusic investment, agrees that music in and of itself does not make a great venture investment.

“Just doing a music play for the sake of music would not have been as interesting,” Feinleib says. “I liked RootMusic because it was a marketing platform for bands to connect with fans. If it was just a pure music play, that would have been a bit too scary.”

Sean Parker, co-founder of Napster and the tech person who struck fear in the recording industry, has also returned to his music roots. As a managing partner at Founders Fund, Parker has invested in London-based Spotify, a digital music service with access to millions of songs. The company operates in Europe, but is in the process of signing licensing deals with the labels that it hopes will allow it to operate soon in the United States.

“What I’m trying to do with Spotify is finish what I started with Napster,” Parker said at an industry conference last year. “The distribution model for music remains broken, and I’ve dedicated the rest of my career to fix what I broke.”

Parker, who helped spawn illegal downloads with the peer-to-peer file sharing service Napster, notes that up to 10 trillion songs are currently illegally downloaded every year, compared to just 4 billion legal downloads. He argues that streaming radio services such as Spotify are the ultimate answer, and that “this is something the music industry has been afraid to do but I think they are about to take the plunge.”

Spotify (which has raised some $70 million from Creandum Advisor AB, Northzone Ventures AS and Wellington Partners GmbH, according to Thomson Reuters, publisher of VCJ) in January signed a deal with Sony Music, a step toward ultimately bringing the service to the United States.

But most of the major labels do not like the company’s free streaming services, and are not about to sign a deal until the company until it proves it can upgrade enough users to the roughly $16-a-month premium subscription fee.

“I can tell you there is not a big rush to do a Spotify deal,” one music industry source recently told Rolling Stone. “I guarantee if they do [launch], it probably won’t be with much of the music in the U.S.”

It is contentious situations like these that make Satya Patel glad he doesn’t have to deal with the record labels. Patel, a partner at Battery Ventures, is an investor in Jelli, a company that provides programming for some 30 radio stations in major U.S. markets.

Jelli allows its listeners to control what gets played on the air through its online voting system. Listeners can vote on songs in real-time by downloading Jelli’s iPhone app. The system also lets user rocket a song to the top of the playlist, or bomb it off the air.

“The Jelli model is set up in such a way that the company doesn’t have to deal with the labels, which have been a huge pain to the online music business” Patel says.

The company licenses its technology to the radio stations, which in turn are responsible for both the royalty structures and customer acquisition strategies.

“Jelli looks more like a software business from a margin perspective,” he adds.

Jelli, and the many other music companies in the market, are no doubt cool companies. But the biggest knock against music startups has been that they simply can’t generate venture-scale returns. Critics have long complained that even the coolest companies in the space couldn’t command much more than $20 million or $30 million in an acquisition. Apple, for instance, in late 2009 paid about $15 million to snap up VC-backed LaLa, a streaming site known for its 10-cent downloads, simply to kill it and integrate the technology into iTunes.

But that kind of thinking might soon be confined to the oldies bin. Some investors argue that big exits in the music space are right around the corner. They argue, for instance, that’s its only a matter of time before social networking giant Facebook starts getting serious about music, most likely through an acquisition.

What’s more, music startups are likely poised to see a resurgence now that Pandora is filed to raise $100 million in its IPO. If that turns out successful, expect to see more VCs tuning in to the music space.

Beating the Drum, Literally, for Music

It validates why going after music sales as a primary line of business is not a good idea. Music sales alone are a pretty bad proxy for the kinds of music opportunities I’m looking for.”

Larry MarcusManaging DirectorWaldenVC

When Ryan McIntyre became a venture capitalist in 2000, he forbade himself from making a music investment.

McIntyre, a passionate music fan and lead guitarist for a band called Soul Patch, worried that his love for music could potentially cloud his judgment.

For the majority of his venture career, he listened to his own advice. But he finally broke down when a startup called TopSpin Media came along in 2008.

“By that time, the digital music landscape had settled down and it was easier to predict where the industry might go,” says McIntyre, a managing director at the Foundry Group.

It also helped that, as a musician who had released his own albums, McIntyre could relate to the Topspin service. The Santa Monica, Calif.-based company, which has raised an undisclosed amount of funding from Foundry and Redpoint Ventures, provides a platform and analytical tools that allow artists to build their brands, distribute their music, connect with fans and sell merchandise. To date, more than 1,000 bands are on the Topspin platform, including such major acts as The Beastie Boys, Linkin Park and Eminem.

But here’s the question: Does being a musician make you a better VC?

McIntyre says that’s a stretch, but he admits that many of things he’s learned while playing in a band—such as responding to non-verbal communication, collaborating tightly with a group, and making real time decisions while engaged in a heated jam session—absolutely translate to his work as VC.

Larry Marcus, a managing director at Walden Venture Capital and an avid drummer, is a bit more philosophical. In his mind, entrepreneurs are the lead singers and songwriters, while VCs are the backup musicians.

“My role as a VC and a drummer is to be supportive and help lay down a good foundation,” he says. “But in both cases, I understand that I’m not the front man and I’m not playing my own songs. In that sense, being a drummer does give me a better appreciation for my role as a VC.”

In contrast to McIntyre, Marcus believes his love for music can guide how he invests. For instance, he was an early investor in Pandora at a time when many other VCs dismissed the company, which previously based its service on a subscription-based service, as inconsequential, with little hope of turning a profit.

“If I didn’t have a passion for music, I probably would not have taken that first meeting with Pandora or believed that consumers would care about the Music Genome Project [Pandora’s patented system for figuring out the preferences of music listeners],” Marcus says.

For David Feinleib, a classically trained violinist who played in youth orchestras, investing in a promising startup is like witnessing a virtuoso performance.

“Hearing a great musician is a transformative experience,” says Feinleib, a partner at Mohr Davidow Ventures and an investor in RootMusic “And working with great entrepreneurs is just as inspiring. They pull you into their groove and have the power to blow you away.”

VCs Who Play

The VC community has quite a number of talented players, especially when it comes to music. Here’s a sample of some known VCs who also like to jam.

Dave Andonian

, managing partner at Dace Ventures, plays guitar in a Boston-based band called French Lick. The band includes, on drums, Boston Celtics owner and CEO, Wyc Grousbeck, a onetime partner at Highland Capital Partners.

David Feinleib, partner at Mohr Davidow Partners, plays the violin.

Raj Kapoor (vocals), managing director at Mayfield Fund, and Tim Chang (bass), partner at Norwest Venture Partners, perform regularly in a Silicon Valley band called Coverflow. The band also includes two Facebook employees—Prashant Fuloria (guitar) and Ethan Beard (guitar)—and Philip Kaplan (drums) from Blippy.

Joe Kraus—partner at Google Ventures and onetime founder of Excite.com—plays the drums.

Larry Marcus, managing director at Walden Venture Capital, plays the drums and is an investor in Pandora, SoundHound and RootMusic.

Foundry Group Managing Directors Ryan McIntyre (guitar) and Jason Mendelson (drums) play together in a band called Soul Patch.