Securitizing music royalties and selling them to fans was first trialed back in 1997 by David Bowie with the Bowie Bond. In recent years, as streaming has solidified into a strong business model for the music industry, this concept has made a comeback with companies like Hipgnosis Song Fund raising over $1 billion to purchase music catalogs and listing shares in their company on the London Stock Exchange. Their investment has had a $138.4 million return in 2021 alone, so it’s a seemingly lucrative strategy, albeit an expensive one.
But since it’s 2021, the year of the NFT, it was only a matter of time before a startup would come along with a plan to disintermediate the music biz using NFTs. Enter 3LAU, the artist DJ who can arguably be credited for popularizing music NFTs with his highly successful $11 million drop back in March. His startup, Royal, is a music marketplace that lets fans buy an ownership stake in songs as NFTs from which they earn royalties. On the surface, this pitch sounds like an exciting opportunity for fans to participate in the success of independent artists. However, when you dig into the economics of the music industry, the numbers just don’t add up. Because the royalties a song can realistically generate are relatively small and song royalties don’t scale with the market value of NFTs, fans should not buy a music NFT with the hope of earning substantial income from the royalties alone.
A Small Piece of a Small Pie Equals a Small Portion
While music has an uncanny ability to move our hearts, minds and culture, it doesn’t have the same ability when it comes to removing cash from our wallets. Streaming has become the most dominant way recorded music is consumed: 61% of 2020’s $23.1B revenue was from streaming. Sounds like a lot! However, when compared to the revenue earned by a company synonymous with the delivery of digital music, namely Apple, the music industry generated a pittance as Apple made $274.3B or $22.9B a month in 2020. Yup, that’s right; the entire recorded music biz only grossed $0.2 billion more than Apple made in a month.
The truth of the matter is that of the 8 million plus artists on Spotify, only 317,690 made more than $1K on their ENTIRE catalogs in 2020 according to Spotify’s own Loud & Clear website. Not a lot of money to share at that level. On the other end of the spectrum, 870 artists grossed more than $1M on theirs. The earnings range is too ambiguous with this group, so let’s examine the next earning tier of 1,820 artists who grossed between $500K and $1M also on their entire catalogs.
If each of those 1,820 artists made the maximum of $1M on their catalog, then 100K music fans (the current number of Royal users) could each receive $9K in rev share if every single song on all 1,820 catalogs were NFTs with an associated 50% royalty split. (1,820 x $1M = $1.82B ÷ 100K = $18,200 x 50% = $9K) How much would you have to pay to buy entire catalogs of 1,820 artists? As seen in the Hipgnosis Song Fund example, it’s an expensive proposition. At a conservative 10 songs per artists and a floor price of $1K per NFT, each fan would need to pay $18.2M to get $9K in royalties — a return of 0.05%. But what if you owned a piece of the most streamed song in history? Would that offer a better return and make you a millionaire? Let’s find out.
Owning a Piece of History
The most streamed song on Spotify is “Shape of You” by Ed Sheeran with 2.97 billion plays to date. At the current rate of ~$0.004 per stream, “Shape of You” should have generated around $11.88 million from Spotify. For fun, let’s say that Sheeran minted a series of 100K NFTs prior to the song’s January 6, 2017 release, which he sold for $100 a pop, netting Sheeran a cool $10 million before the song was even released. Nice!
So if you had bought a “Shape of You” NFT when they were first minted, what would you have gotten for your $100? You’d be eligible to receive a 1/100,000 slice of the future royalties “Shape of You” generates. Now let’s break it down. Sheeran is signed to Atlantic Records, a label under Warner Music Group, which means that at best he’d receive a 30% share of the royalties from the track with the label collecting the other 70%. Of that 30%, let’s say Sheeran throws caution to the wind and puts the rights to all his royalties from “Shape of You” into the NFTs. At today’s streaming count that would equate to ~$3.56 million, a little more than 1/3 of what the fans initially paid for it. That would mean each NFT holder would collect $35.6 over the course of 4 years of ownership.
In this tokenized royalties setup, it’s important to think about the royalties as a sort of yield or interest you’d receive on top of the value of the NFT itself. In that context, an 8% annual yield over 4 years sounds pretty good. Now you could say, NFT royalties are supposed to get rid of the record label so only allocating 30% doesn’t make sense, and NFT owners really should get an even larger share. Good point. Let’s say, Sheeran got permission to release “Shape of You” independently and went ahead and put 100% of the royalties on-chain. Then under this new deal, how much would each NFT owner make? The NFT yield would be considerably higher at 21.5%, netting holders $118 on an initial $100 investment, resulting in a total of $218 at the end of 4 years. Now of course, songs are played on multiple streaming services including Apple Music, Tidal, YouTube and Pandora. However, not all streaming services perform the same way. For example, “Shape of You” only has 628.29 million streams on Pandora compared to the 2.98 billion on Spotify. In addition, songs also generate royalties from other sources like public performance rights and sync licensing, for example. But for arguments sake, tripling the total earnings of “Shape of You” to account for the royalties from multiple sources, results in a total of $618. Not bad!
Ok, you’re not likely to become a millionaire when you own 1/100,000 of one song, but you’d still be making a solid return on your initial investment and own a piece of music history to boot. This unfortunately is where the good news ends because realistically it is probably the most you could earn from the partial ownership of royalties from a single song, even the most popular song ever released. At the end of the day, the only way to make money in the streaming model is to do so at scale, i.e., you need to invest a lot to make a little.
The Greater Fool Theory
Thus far in our deep dive, we’ve focused on the royalties generated by an individual song. But NFTs themselves have unique value as well and are often priced separately from the associated royalties. In some cases, the price of the NFT could be many times higher than its royalties, as evidenced by the “Worst Case” NFTs that are trading at 650x above the song’s current royalties. This value disparity is a classic example of a concept in finance called the Greater Fool Theory. The theory posits that one “fool” may buy an overpriced asset, the price of which is not justified by the underlying projected earnings or price-to-earnings ratio (P/E), with the intention of selling it to a “greater fool,” who in turn sells that asset to a “greater fool,” and so on and so forth. This cycle continues until there is a market correction, at which point the “greatest fool” is left holding the bag.
Many buyers #HODL to their NFTs if they are collectors or just want to support the NFT creator. But for those wanting to trade NFTs with the express purpose of earning passive income from the underlying royalties of a music NFT, the Greater Fool Theory’s vicious cycle may diminish the appeal because of its increased risk. Perhaps the biggest downside is not that prices may decrease, but that the underlying royalties of the music NFT will grow at a completely different rate than the price of the NFT itself. This means that no matter how much you buy an NFT for, it will have little to no effect on how much revenue the song will generate in royalties. Let’s take a look at an example.
Say you invest $100 into ETH2 on an exchange that offers a 5% APY (annual percentage yield). After 1 year, your principle + yield would equal $105, after 2 years you’d have $110.25, after 3 you’d have $115.76 and after 4 years you’d have $121.55. Now let’s compare that to your $100 investment in the 30% royalty share “Shape of You” NFT we proposed earlier. Over the same 4 year period you would have made $35.60 instead of $21.55. Sounds pretty decent! But hold on a sec; it’s not actually that great.
You see, the return on a 5% APY is proportional to the amount of money you invest. Therefore, if you had invested $1K instead of $100, your return would also have been 10x higher at $215.50. But the royalties you receive from a song is not based on the dollar value of your initial investment, rather they are determined by the number of streams and the payout policies of multiple third parties. Regardless of how much you pay for the NFT (assuming the same scarcity), you will not make 1 penny more in royalties. Whether you pay a $100 or $1,000 for the “Shape of You” NFTs, you’d still only receive $35.60 in royalties. Your 4 year grand total would be $1,035.60 (3.56%) compared to $1,215.51 (21.55%) from the $1K ETH investment.
The only way to scale the royalty earnings per NFT is to reduce the total supply so that each NFT owner can receive a larger slice of the royalty pie. But when you decrease the supply of NFTs, you must also increase the price proportionately in order for the artist to make the same dollar amount from the initial sale. So what does this mean? Simply put, there is a disconnect in economic value between the price of NFTs and the passive income due to each NFT owner. Furthermore, while prices of the NFTs may increase on secondary sales, the yield/return of the royalties will grow at a completely different rate, assuming people are still streaming the song. If everyone stopped streaming that song, you’d receive $0 in royalties regardless of how much you paid for the NFT. Finally, in order to see the largest yield/royalty return on a music NFT, you’d have to be one of the first buyers, as songs tend to decline in popularity after 4 to 5 years. However, that 5% return on a yield account will still be 5%, (as long as the offer remains the same) regardless of when you invest since the opportunity to benefit is not limited to the initial buyers or lessened for later investors.
The “Worst Case” Scenario
So how’s it going on Royal? The platform launched with a single song by 3LAU himself, which offers a 50% royalty split generated by the track “Worst Case.” Originally airdropped to the winners of the Royal early access contest for free, the 333 “Worst Case” NFTs have a current floor price on OpenSea of 3.7 ETH or $14,800. That’s pretty impressive as it translates into a total market value of just under $5 million! With such a high valuation the song must be slayin on Spotify, right? Well it turns out that “Worst Case” has 1.9 million streams, equal to $7.7k USD at Spotify’s going rate of ~$0.004 per stream. Now of course, over the next few years those streams will grow.
Before continuing, it’s important to remember that the Royal NFTs or Limited Digital Assets (LDAs) as the company refers to them, have two separate elements, i.e. the NFT itself and the associated royalties each NFT owner is entitled to receive. This is an important distinction to make because it is unlikely the royalties generated by a song would ever come close to the market value of the NFT, and here’s why.
Currently, the “Worst Case” NFTs are trading at 650x the current value of their underlying royalties. In order for “Worst Case” to generate $5 million in streaming royalties for NFT owners, it would need to have 2.5 billion streams on Spotify to generate at least $10 million in royalties, 50% of which would go to NFT holders.
Note: This is an extreme over simplification of how royalties are paid out. The number of rights holders on a song can range from solo artists who, write, produce, perform and distribute their own music, to bands signed to major record labels that have multiple members, songwriters, producers, managers, agents, etc., who are all entitled to a cut of the royalties. This means that the share of royalties available to be tokenized by an artist may only be around 5–10% of what the song generates when all is said and done. But I digress.
But why is it important that the royalties should ever generate as much revenue as the price per NFT? This is an important nuance for potential buyers to understand because it means that the only way for a buyer to recoup their investment is to sell the NFT itself. As explored in the previous section, this can be a great proposition for a while until there is an inevitable market correction and someone is left holding the bag. The bottom line is that royalties you might earn from holding a music NFT such as “Worst Case” have little to no chance of offsetting your initial investment or netting buyers with substantial passive income. Royalties themselves do not scale with the market price of the associated NFT — they scale with streams and streams just don’t make big money. In the instance of “Worst Case” the only way it could generate enough royalties to match the market value of the NFT is for it to generate nearly as many streams as “Shape of You” by Ed Sheeran with 2.97 billion streams which translates to $11.8 million in royalties.
What this boils down to is that “Worst Case” would need to accumulate the same number of streams as the most popular song in history for NFT holders just to make back the amount of money they paid for the NFT to begin with. While “Worst Case” hits hard, I don’t see it up there with the likes of “Shape of You” anytime soon. Besides, only eight songs have ever received more than 2 billion streams on Spotify from artists like Post Malone, Drake, and The Weeknd. So why is there such a disparity between the royalties generated and the trading value of the NFTs, and why might that not be ideal for NFT holders? The truth is that while there is a high level of interest in the idea of owning the rights to a song’s royalties through an NFT, the economics of the music streaming economy just don’t return equal value.
Should You Even Buy Music NFTs?
The intent of this deep dive is to shine a light on the disconnect between the economics of tokenizing royalties and the promise of how much revenue can actually be generated by an individual song using today’s streaming metrics. The music streaming TAM (total available market) is too small to create meaningful passive income streams for fans at scale, and tokenizing those royalties is not a sustainable way for artists to supplement or increase their income. In that case, are NFT streaming royalties the future of the music biz? With the model of securitizing fractional amounts of royalties? No.
The NFT and Web 3.0 movement is underpinned by the concept of utilizing new technologies to create economic value through supercharged network effects and the accountability of blockchain technology, independent of Web 2.0 standards. If these same songs themselves were traded as unique products, the pricing would be extravagant but completely valid as the value of the NFT is simply determined by market demand. When an underlying asset is attached to an NFT, whether a piece of land, a car, or a revenue stream, it is important that investors understand exactly what’s being purchased and what rights, assets, or income streams, owning that NFT entitles them to.
If the goal is to buy an asset that generates meaningful passive income and earn royalties like artists do, this is not an effective model as there are too many parties with whom the relatively small amount of income must be split. However, if the idea is to simply trade on cultural value or clout of the brand of an artist/creator, and use the NFT itself to generate a return on the secondary market, then what’s the benefit of tokenizing the royalties to begin with?