A New Music Model? Perhaps. But not for VCs.

Brad Stone has a nice article in today’s NYT about Polyphonic, a new model for funding music artists and bands. The venture is exciting, largely because of the people involved. Terry McBride, in my opinion, is probably the most innovative businessperson in the music business and has a track record to demonstrate it. In the article, Brad Stone quotes me as casting doubt on the appropriateness of this model for venture investors. To demonstrate why, we need to make a bunch of assumptions, but I will make those assumptions as reasonable as possible:

The Polyphonic model, according to the article, will take $20M and invest $300K chunks into bands. Let’s assume that is structured as an advance against a 50/50 split on all revenue the band produces (publishing, touring, merch, recorded music sales and other licensing.) After fees to operate the business (let’s say $2M over three years), on average, Polyphonic would make 20 investments (i.e., fund 20 bands) a year over three years, or 60 bands. This assumes Polyphonic does not provide any follow-on funding to the bands. That is, on $300K, the bands must pay themselves, pay for marketing activities, tour support, record an album, seek distribution, and generally fund their infrastructure. (While possible, this is thin.)

How much revenue can a band produce? Let’s break that down. Out of the 105,575 new releases in 2008, just 1,515 sold more than 1000 units. Polyphonic likely expects these 60 acts to perform as a portfolio. Some will bomb, some will do well, and a few will do really well. (VCs manage investments this way too.) Putting some numbers around that, let’s assume 10% sell meaningless amounts, 50% do okay (under 20,000 units), 35% sell well (45,000 units) and 5% do exceptionally well (more than 100K units). Let’s say one is a huge breakout and sells 1M units. And let’s assume a 1x multiple on the sales revenue for merch, publishing, touring and other income (ie, doubling).

As the chart below shows (at $7 royalty a record ($10 ASP – 30% retail margin) and assuming the band can double its recorded music revenues through touring, publishing, merch, etc.), the total to an entity like Polyphonic would be just under $27M on a $20M investment, or about a 35% cash on cash return. Might beat the S&P over three years, but probably not.

You can see where the sensitivities are: if the major breakout hit sells 2M units, the the take is more like $46M. If you assume no breakout hits, but all 60 acts sell 45,000 units, the return is about $28M. If you assume every band can triple its revenues beyond its recorded music sales, the you can produce about $46M on $20M, which is pretty decent.

The other challenge with this model is that the funder owns nothing more than a cash flow interest in the band. The article discusses that the artist still own their masters and all rights. I applaud that construct as I think that is the right new model with the right incentives. However, it means the multiple applied to a company like Polyphonic, which is building no long-term equity value, is less than that paid on a company building longer-term equity value. In other words, it is hard to sell a company like Polyphonic for a big multiple.

VC economics, however, look very different. If a VC took $20M into 10 deals at $2M each (let’s say each investment buys 25% of the company) and just one companies is sold for $200M, assuming all other deals fail (unlikely), the VC has produced $50M on $20M. If two companies are sold for $200M, the VC has produced $100M on $20M. (This analysis is greatly simplified just to illustrate the point.)

Let me be clear: I really like what Polyphonic is doing and am hugely supportive of their model and direction. I want alternative models like this to exist, I want artists to prosper, and I want artists to be in control of their own destiny, surrounded by smart people who understand how to market in the new digital world. I just don’t think these models can produce a venture return. There are plenty of other sources of capital for these models, and I am excited to see them get funded and take off. Hats off to Terry McBride and the team at Polyphonic.