Introduction
Despite being a global sensation today, Spotify had to overcome a number of obstacles and challenges to secure its initial funding. From being turned down by every VC in Europe, to increasing their valuation by 20% at the 11th hour, read on to find out how Spotify raised their venture capital.
Background
Founded in 2006 by Daniel Ek and Martin Lorentzon, Spotify faced intense competition and a mountain of legal challenges. Record labels who tried their best to resist the transition from selling high-margin physical records to very low-margin streaming commissions.
Despite these existential challenges, the founders were determined to build a successful business and, as you will discover that secured funding through a combination of persistence and creative dealmaking, but it certainly wasn’t easy!
Spotify's Seed Round
When trying to raise the seed round for Spotify, Daniel and Martin had rejection after rejection. However, they continued looking for investors. In fact, they kept looking until they realised that they had run out of investors to approach!
We were turned down by every single US and European VC fund.
For some actual context, Martin has been quoted as saying that they received over 50 rejections from venture capital funds before finally securing investment from Li Ka-shing’s Horizons Ventures and Swedish investment firm Northzone.
Here is a minute clip of Martin talking about how easy he thought raising money for Spotify would be:
At the time of the seed round, Spotify had 50,000 users and generated around $50,000 in monthly advertising revenue. While these numbers looked strong and Spotify had clearly built a superior product to the illegal streaming sites, investors struggled to get comfortable with the risk that Spotify wouldn’t be able to attain streaming licenses from large music labels.
Creandum, the VC fund that ended up financing Spotify’s Series A round, shared:
We ended up following the company for a good 18 months before the fund finally invested. Those were 18 months followed by ups and downs in the relationship, but also plenty of back and forths in negotiations. Ultimately, as it became very clear how the relationships with the rights holders would look, we were able to pull the trigger and actually invest.
Spotify's Series A
Here are three interesting and lesser know facts about Spotify’s Series A round:
- Custom outreach
When conducting investor outreach, Martin sent highly individualized emails to their potential investors and even offered to meet with them in person whenever possible. This approach helped Martin create a personal connection with his potential investors, which made it easier to convey his vision for Spotify and excite them. Martin would tell prospective investors: “We’re not selling a product. We’re selling a feeling. We’re trying to create a connection with people.”
By taking the time to build relationships with investors, the founders were able to secure investments from individuals who were passionate about their vision for the future of music streaming.
2. Currency Swap
During the negotiations for the Series A funding round, Spotify’s co-founder Martin Lorentzon switched the valuation currency from Swedish krona to U.S. dollars at the last minute. Whilst on the face of it, this might not appear to be very significant. However, it resulted in a 20% higher valuation for Spotify. It was a gutsy move, and something very rarely seen in the industry.
Changing deal terms at the last minute is not good practice. Normally if any party tried to re-negotiate deal terms at the 11th hour, it would be a VC fund, not the startup, as investors have more leverage the less runway you have. This can tempt some malicious funds to force founders into accepting worse valuations. Ensure that you conduct due diligence on the VC partner you approach to ensure that they value their reputation and wouldn’t risk blowing it up to secure better deal terms.
Martin Lorentzon made a judgement call that his investors were so excited by the growth potential of Spotify, that a last-minute change like this would not be enough to make them pull out of the deal. Luckily for Martin and Daniel, he was right.
It does bear remembering that you are looking to partner with your investors for many years. So getting off on the wrong foot, by making similar changes to your term sheet might be detrimental to the long-term relationship. I know several VC funds that would see this type of behaviour as a major breach of trust and they would definitely think twice about investing in the team.
3. Veto Voting Rights
An interesting deal term was added to the Series A term sheet. It gave investors the power to block future fundraising rounds if they were not happy with the terms. This clause gave the early Spotify investors an unusual amount of control over the company’s fundraising efforts and demonstrates that they had reservations about the company’s ability to raise future capital.
Thankfully for Martin and Daniel, Spotify was able to generate enough momentum to raise additional capital at acceptable terms for their early investors. However, had Martin and Daniel struggled to raise their Series B round, the early Spotify investors would have been able to veto any unfavourable deals. This clause gives a VC some power to mitigate their equity dilution.
That said, if they veto every funding offer, Spotify would simply run out of cash. So their values are somewhat aligned with Martin and Daniel. In reality, this clause might have enabled the VCs to protect their equity in a down round, forcing Daniel and Martin to dilute their personal shareholdings to accommodate the new investors.
Spotify's investment memo by Creandum
This screenshot shows the inner thoughts of investors at Creandum back in 2007 when they were debating whether or not to invest in Spotify.
This slide was used to pitch Spotify to the rest of the team. There are a couple of things I think are worth noting:
- Storytelling
Look at how effectively the idea for Spotify is explained. Only one sentence was necessary. This level of clarity is something all founders need to replicate in their pitch decks - The importance of your team
Creandum put bio’s of the Spotify team at the top of their list of things to consider when investing in startups. This is particularly true for investors at the early stages. They put a lot of importance on a team’s experience, and ability to stick together through adversity. The fact that both Martin and Daniel were serial startup founders gave investors confidence that this team could overcome a lot of the challenges they were facing. - Weaknesses
This was a risky investment! VC funds exist to make bets on promising startups. Don’t be deterred from fundraising if you think your idea is risky.
As the memo states, there are ways an investor can de-risk their investment. Creandum state that their investment will be staggered in “tranches”. This means that if Creandum agrees to invest £3m in Spotify, they don’t invest all this money at once. Instead, the investment could be split into three separate £1m investments. Every additional £1m will be unlocked once Spotify hits certain milestones such as, once they ‘hit 100k users’ or once ‘deal terms are agreed with music labels’.
This staggered investing strategy allows Creandum to de-risk the investment, as they would be able to walk away from future investment commitments if Spotify doesn’t hit its pre-agreed milestones. Hence, they could potentially only be risking £1m of capital in this hypothetical scenario if Spotify failed to reach the milestones required to unlock its secondary tranche of financing.
Lessons Learned from Spotify’s fundraising journey
One of the key lessons from Spotify’s fundraising journey is the importance of persistence and resilience in the face of rejection. Even the founders of Spotify faced 50+ rejections from VC funds.
When you are a founder and you exhaust what seems like all your potential investing options, it can feel quite scary. This is the time to dig deep and breathe. Persistence is required and many successful startup founders of the past also struggled to raise financing.
Another lesson is the value of finding the right investors who believe in the company’s vision and are willing to take a chance on a startup with potential. Spotify’s investors were drawn to the company’s innovative business model and the potential for disruption in the music industry. This allowed for a healthy dynamic between the founders and their investors. The investors knew they were taking a huge risk, but they were betting that Martin and Daniel were the right team to break through and capture some of the $50bn in advertising budget that was being spent on music and radio advertising.
Eventually Spotify was able to grow large enough to list on the New York Stock Exchange. This values the company at $29.5bn in 2018.
Conclusion
The Seed and Series A fundraising rounds at Spotify were critical to it becoming a global music streaming giant. The funding Martin and Daniel were able to secure enabled them to build a world class team who broke through the regulatory and technical challenges they faced.
The lessons learned from Spotify’s fundraising journey, including the importance of persistence, finding the right investors, and the potential impact of deal terms on future fundraising rounds, are valuable for any startup looking to raise funds and build a successful business.
If you are interested in learning more about Spotify and Daniel Ek, I’d suggest watching the Netflix series “The Playlist”. This is also a great video by Forbes made in 2012 on Daniel:
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