Democratised finance in music
Introduction
As funding at the top end of the music industries continues to concentrate into proven heritage rights, so there is developing a trend to explore alternative options, for new creators or fans that simply want a piece of the action.
Crowdfunding, democratisation of investment, could provide competition to traditional mechanisms of securing capital. Advancement of capital represents a key pillar on which institutions within the music industries continue to pin their business, yet as with each set of services, development of technology is increasing competition.
Crypto seems tailor made for this. Programmable money that has no barrier to access and no global boundaries. With tools and systems in place, any creator, anywhere, could build a community that could support and grow their career without any need for a record label.
However, the finance industry is tightly regulated, and thus it is important to understand what the rules of engagement are when gaming out how this could evolve going forwards. If 2017 taught anyone anything then you don't want to build something that the SEC decide is a security, or even looks like a security.
The last 10-15 years has seen growing activity in crowdfunding, and regulatory support as the internet has evolved. The new paradigm of token sales, NFT mints, and social currencies represent the latest development in this space, though many of the fundamentals remain consistent.
Historic context in music
One of the earliest experiments in fractionalising ownership of music rights came through David Bowie in 1997. So called "Bowie Bonds" allowed investors to pay for the right to future royalties on copyright. The initiative had mixed success, due in large part to macro forces changing the market structure on which these rights were generating income, i.e., the internet started to change consumption of music. Bowie Bonds had fallen from A3 to Baa3 (one above "junk") rating by 2004.
However, conceptually, the strategy of opening up investment to people that want to follow in to proven high value rights laid the foundation for much of the development we are now seeing in bringing external money into the music industries. It's been 24 years since Bowie Bonds were launched but streaming now represents a more consistent generator of value over time than CDs ever did.
Alongside the boom of "crowdfunding" on the internet, the first real example of "Fan funded music", emerged in 2000. Marillion, off the back of a US tour backed by dedicated fans, pre-sold an album to pay for recording costs after being dropped by its Major label. A novel concept at the time.
Websites started to pick up in 2008-10, as detailed in the Music Business Journal, to offer crowdfunding of art as a service, in-line with the trend that as the internet progressed from web 1 to web 2 and innovators experimented around the opportunities that a social orientated internet could bring. The focus was usually around pre-buying physical products, made possible by an industry that was on the whole still pre-streaming.
Indeed, Amazon entered in to partnership with one of the flagship platforms of the time, as noted in the Music Business Journal article in 2009:
"Amazon.com Inc. (Public, NASDAQ:AMZN) has recently become an active player in the game. Last year, a deal with Sellaband.com, in which Amazon agreed to be the official online retail store for Sellaband’s launched projects, lead to a $5 million venture capital investment from the European firm Prime Technology Ventures to help Sellaband.com expand in the United States. This is a clear sign that this business model has inspired some confidence in the marketplace."
However, Sellaband had filed for bankruptcy by 2010. Which is unfortunately commonplace for platforms that have tried to offer crowdfunding services to artists. Two of the three platforms detailed by the Music Business Journal in the link above (Sellaband and Slicethepie) have since gone under or pivoted.
In recent years, music crowdfunding has continued to grow, though usually through more generalised sites such as Kickstarter, Indiegogo, or GoFundMe; one of the most prominent music-based platform, Pledgemusic, went into administration in 2019.
Crowdfunding vs. investment in rights
Arguably, the reason why democratised funding has not significantly impacted the music industries to date is because it came at the same time as consumption moved away from products and towards services. A crowdfund targeted around pre-buying a product is less impactful when people aren't typically buying the product itself.
And so, it is natural to see an evolution in what is being made available for investment. When products aren't on the table, then artists look to sell access to their revenue stream, for an advanced payment up front, bringing outside investors and the public more in-line with record labels and publishers.
However, there are key differences between crowdfunding a product to be made in the future and offering fans the opportunity to invest in an artist’s rights and future royalties, especially when considering the regulatory environment in which you are operating. An artist is essentially offering equity in their career, with the promise of revenues as a dividend; an investment contract. Guidelines for this activity exist in the form of Securities requirements.
Some context on Securities
IANAL, so I'll keep this brief. Basically, the determining factor on whether something is a security or not boils down to how it fairs against the "Howey Test":
The Howey Test refers to SEC v. W.J. Howey Co., which reached the Supreme Court in 1946...in doing so, the Supreme Court established four criteria to determine whether an investment contract exists. An investment contract is:
An investment of money
In a common enterprise
With the expectation of profit
To be derived from the efforts of others
It's pretty much a safety blanket that the financial authorities throw down to protect everyday people, i.e. not "accredited investors", from being hoodwinked into giving over their life savings to schemes that haven't proven themselves to be sound to the regulatory body.
The Howey Test was infamous during the 2017 ICO crypto boom where projects tried to work around restrictions while the SEC formed its position on whether token sales should fall into this category of investment contracts. The SEC made its move in a test case against a project called Munchee, which set the foundation for future consideration. "If it looks like a duck, and quacks like a duck, it's a duck"; if you’re selling something that looks like an investment contract, but calling it something else, it’s still an investment contract. And ICO mania slowed as a result.
There have been attempts to work with regulators on the issuance of tokens. STOs (security token offerings) for example picked up from 2018 into 2019, but relative success of projects raising in this way was muted due to the additional cost and restrictions, and reduction in scope of potential investors.
The allure of tokens, and crypto in general, is that it enables anyone from anywhere to invest in something that they want to. Regulation, albeit well meaning, introduces restrictions ranging from KYC through to proof-of accredited investor, which counters this narrative and can serve at cross purpose. Coins that are deemed as assets rather than representing an investment contract do not fall under this definition, and so are free to be traded between users unencumbered by restrictions. However, calling a token an "asset" when it acts like a security will fail the duck test when placed under scrutiny.
NFTS and Securities
The rise of NFTs in 2021 has reopened a lot of thinking around what does and does not count as a Security. At its simplest level, an NFT represents a digital product, however, there is the potential to encode royalty payments for the original artist and future buyers, which is a different proposition in this context.
To this end, trading platform FTX recently announced that it believes that NFT sales that promise a royalty for buyers represent a security and would not be facilitating the sale of such projects.
Projects that aim to take this mechanic and apply it to music royalties likely face a challenge in a similar regard.
Regulation CF
One solution that is being explored currently in some areas is through using "Reg CF", part of the JOBS Act passed in the USA to provide equity crowdfunding opportunities for smaller companies, to enable wider investment in rights.
Regular CF has fairly strict requirements:
require all transactions under Regulation Crowdfunding to take place online through an SEC-registered intermediary, either a broker-dealer or a funding portal
permit a company to raise a maximum aggregate amount of $5 million through crowdfunding offerings in a 12-month period
limit the amount individual non-accredited investors can invest across all crowdfunding offerings in a 12-month period to $107k in total;
Investors with either an annual income or net worth lower than $107k may invest up to 5% of the lower amount per annum
Investors with both annual income and net worth higher than $107k may invest up to 10% of the lower amount per annum.
require disclosure of information in filings with the Commission and to investors and the intermediary facilitating the offering
Tl;dr it is still carries heavy restrictions for companies and investors that want to go this route. And has strict caps on the value of money that can be raised in this way.
Current approaches in Music
Private investing platform Republic launched a music vertical recently, through something it calls "S-NFTs", which utilise Reg CF to enable investment in an entity that owns the rights to a work.
"Security NFTs (S-NFTs) combine the ownership and transparency of NFTs with an innovative investing framework. The S-NFT makes it possible for fans to invest capital toward a new song or album and in return, share in the royalties.
Republic is one of the first crowdfunding platforms to offer this type of investment. Artists have sold NFT artwork that accompanies an album or song, but few have been able to figure out the mechanics of how to tie the returns from streaming distribution to the NFT.
When you invest in music offerings through Republic, you are typically buying the music rights through special membership units of an LLC that owns the rights to a song, album, or equivalent. The membership interest may be represented by a non-fungible token (an NFT) which is a representation of that ownership and the vehicle in which returns are distributed."
Similar to Republic, though non-crypto, SongVest seems to be targeting democratised financing of rights by leaning on Reg CF; defining the investment opportunity upfront and getting approval from the SEC, before making this available to investors.
"Registered users can start bidding in these live VIP Auctions without any commitment to purchase, at a minimum price of $20, and make non-binding reservations to hold their SongShares. In a VIP Auction, fans set the final price per royalty share unit, before the offering goes to the SEC for qualification, which means that if collectively the bidders determine they will pay $22/share for royalties, then SongVest would submit to the SEC an offering for $22 per royalty share. Fans with successful bids at the end of the VIP Auction will receive the first notice and opportunity to purchase during a VIP Sale held after SEC qualification has been granted. SongVest tells MBW that it takes 10 days to get the SEC qualification. After the VIP Sale period, any remaining SongShares are made available for sale to the public."
3LAU's Royal seems to be taking a slightly different approach, at least for now, with no mention of the SEC or Reg CF in its public material to date, except for a note that:
"While the ICO boom of 2017 led to plenty of founders receiving SEC letters alleging securities fraud, entrepreneurs in this wave seem to be working a little harder to avoid that outcome. Blau says that the startup’s team is working closely with legal counsel to ensure the startup is staying fully compliant."
It remains to be seen whether this will hold or not. If the definition of NFTs, that represent the right to royalties, but are digital assets, survives legal scrutiny then Royal could end up being the trailblazing platform for the next phase of crowdfunding the creation and propagation of music. If it is forced to fall in line with other platforms such as Republic and SongVest then it remains to be seen if the benefit of raising money this way outweighs the cost and effort involved.
As of now, Royal has airdropped 333 LTAs (Limited Digital Assets) to represent “assignment of sound recording royalties” as part of a competition. The implication, with no specific public commitment, is that this will develop into a mechanism for investment into royalties.
So, what does this mean?
The journey that the crypto space has been on serves as an educational tale for the music industry as it explores the potential for democratised finance. Naturally it makes sense that companies and advisors with experience over time in crypto will be at the bleeding edge of development of new initiatives.
Furthermore, the open access and global nature of crypto means that it is almost tailor-made for this type of platform that grants access to democratised finance.
However, with every regulation that is required comes restrictions that go against the grain of crypto and increases the cost vs. benefit of this as an option.
The fundamentals of democratised finance as a legitimate alternative to typical industry funding options have yet to be proven at scale in the music industry, with many failed attempts over the years. Lower transaction costs and greater access to capital and users through crypto could shift this balance, but it'll all come down to the decisions made by regulatory bodies.
There is a lot of momentum in this space, and investment from leading VCs to back it up. It is unlikely that things will slow down until greater clarity is handed down by the SEC, in the form of a test case if required.
Whats next?
Until there is intervention, experimentation will continue in the coming months. Royal has set out a direction of travel which will be determined by the risk tolerance of the team involved. Regardless, there is significant activity and support for innovation in this space and it is highly probably that further attempts will be made to open up funding for future royalties to a wider set of investors.
Leaning on historical context, it's likely that projects that are built on similar fundamentals that have been attempted in the past will end up struggling to gain mass adoption.
In purely financial terms, the investment case for royalties generated by smaller artists feels in conflict to current narratives around the level of pay-out from DSPs. Institutional finance is currently very actively building positions in the elite heritage category, which arguably provides an opening for new ideas to finance the rest of the market. But what that looks like, we'll have to see.
The key is in active experimentation, but there are significant risks when innovating around a market as regulated as investment contracts.
All these initiatives require awareness of the connection between paying for music and the well-being (or survival) of musicians at a scale that seems impossible to me, outside small communities of devoted fans.