Spotify: Building Product to Improve Unit Economics

Using your product roadmap to improve ARPU, Gross Margin, and Churn

2021 was about growth at all costs. 2022 is about “capital efficiency” and improving your “unit economics”. So what does that mean? 

Let’s use the example of a product most of us use every day — Spotify. 

Spotify could focus all their revenue growth efforts as a team on Sales & Marketing. Attract more users and convert a fixed percentage of them to Premium Subscribers. This would increase revenue, but wouldn’t increase the profitability of each listener.

Instead, alongside marketing to drive user growth, Spotify uses its product roadmap to improve the profitability of each Spotify listener. The team makes product decisions through the lens of growing the Lifetime Value of each listener (LTV), thereby improving the unit economics of the business. By earning more from each listener, Spotify isn’t as reliant on listener growth to achieve profit growth. If they’re able to keep the cost to acquire each listener (CAC) stable while increasing LTV, Spotify should become increasingly profitable over time. 

For a quick refresh, Spotify’s business model looks like this:

Spotify attracts free users and delivers a delightful listening experience. Over time, Spotify earns revenue from those users through advertising to free users, converting a proportion to paid subscriptions, and in the future allowing users to buy one-off items like audiobooks.

Spotify’s goal is to maximise the amount a listener pays over their lifetime as a customer. A listener’s “Lifetime Value” (LTV) is made up of the revenue you earn from the listener (avg revenue per user, ARPU), the gross margin you apply to that revenue (the % of revenue remaining after the cost of delivering the product) and the churn rate (what % of users stop using their product over the period).

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Spotify hosted an Investor Day in April 2022 to share how they approach building product features to optimise each of the elements of Lifetime Value. 

“If we do X today, what can we expect to be the profit X will bring to the business and its creators in the future?”

Spotify is a classic example of how small product improvements compound over time to build a stronger business. Here, we’ll dig into the three main components of LTV  — ARPU, Gross Margin and Churn — to show how Spotify’s product decisions help improve the profitability of their customer base. 

If you’re a founder, consider how you can focus your product roadmap on features that improve one of these core three elements of Lifetime Value. 

ARPU

Businesses can grow revenue in two ways — by getting new customers, or by charging existing customers more. 

While Spotify is always looking to grow the number of Monthly Active Users (MAUs), this will slow over time as Spotify’s market share grows. So Spotify needs to find ways to charge existing users more to increase ARPU, whether those are free listeners who are monetised through advertising, premium subscribers, or those paying for one-off purchases. 

Advertising: Earn more revenue from free listeners by improving Podcast Ads

Businesses pay Spotify to advertise to their listeners, so even those consumers who never pay out of pocket generate revenue for Spotify.

While the core music advertising business continues to grow, the real opportunity to increase advertising’s contribution to ARPU is by expanding into new areas of advertising.

Until Spotify entered the market, podcast advertising was in the dark ages. The podcast industry measured audience, reach, and impact about as well as you would for a full-page ad in a magazine. Advertisers could measure total downloads, but had no precise data on how many people actually listened to the episode, let alone reached or acted on the ad.

The podcast advertising market was small before Spotify entered the market in 2018 ($480m revenue), but Spotify bet that with better tools they could grow the size of the market and take a meaningful market share. 

Spotify focused their product roadmap on developing a better advertising product, allowing advertisers to target specific demographics and interests, measure impressions, and understand the effectiveness of their ads.

And it’s working. In 2022, the podcast advertising market is expected to reach $2.1bn annual revenue and Spotify is already seeing the impact on ARPU — advertisers who buy both podcast and music ads spend 4x as much as those just focused on music.

Premium Subscribers: Charge more once you add value to the bundle

Spotify converts 44% of total listeners to premium subscriptions, charging an average of €4.54 per listener per month. Until recently, premium ARPU was a problem for Spotify. From 2015-2021, Spotify’s ARPU for premium subscribers declined 38% as it added incentives like Family Plans, which help acquire listeners while they’re young and build the habit of opening Spotify every day, but the bundled price means each listener pays a lower price on average. Spotify also expanded into developing markets at cheaper price points to account for the lower average earnings in those markets. 

So Spotify needed to counter this trend. One measure of a company’s long-term defensibility is whether it can raise prices and retain customers. Spotify demonstrated pricing power by raising prices for premium subscriptions in late 2021 and seeing no impact on churn, helping raise overall ARPU 6% y-o-y and increase Lifetime Value. 

A La Carte Purchases: Add new revenue channels with new products

Outside of premium subscriptions and advertising, Spotify is looking for new ways to increase revenue from listeners.

One example is adding paywalls for podcast creators who want to charge their fans subscriptions for their content. In 2021, Spotify rolled out a paid subscription platform for podcasters, unlocking the ability to put either a whole show, or select episodes, behind a paywall. Podcast Subscriptions have already unlocked a meaningful revenue model for many creators who’ve enabled it. Because of the tight connection between creators and their fans, the on-platform average subscriber retention rate since launch is 90%. Spotify is offering this for free today, but plans to charge a 5% fee from 2023.

Another example is the acquisition of audiobook platform Findaway, which closed in June 2022.  Once Findaway is integrated into the Spotify platform, listeners will be able to buy audiobooks within Spotify, giving Spotify access to a $4.2bn market growing at a 26% CAGR. I know I won’t be logging into Audible, a product that hasn’t improved in over a decade, once I can get my audiobooks in Spotify.

Gross Margin

Gross Margin matters because the higher the gross margin the easier it is to become profitable as a business.

The best software companies have >80% gross margin because it costs so little to deliver the service to customers. Bits are much cheaper to create and move than atoms, and cloud computing is often the largest contributor to Cost of Goods Sold for software companies. 

However, Spotify has to pay a royalty to record labels every time a song is played on their platform (for more on how streaming royalties work, this is a fun article), which significantly impacts the gross margin of the business (25.3% today). 

Spotify gets a lot of criticism from Wall St analysts for its failure to expand Gross Margin since its IPO, particularly as its investment in developing original podcast content continues to drive overall gross margin lower. 

So what is Spotify building to improve its Gross Margin?

1. Marketplace

Marketplace allows artists to pay Spotify to promote their new music to either users who listen to them already or have similar tastes to their current listeners.

This is a prime example of R&D investment driving profit. Three years since launch, Marketplace is expanding the Music segment’s Gross Margin by contributing €160m in gross profit, an 8x increase in four years.

2. Podcasts

On Spotify’s estimates, podcasting can be a 40-50% Gross Margin business within 3-5 years (vs 28% for Music).

While investing in Original and Exclusive (O&E) content has a negative impact on gross margin today, Spotify believes that future revenue from O&E content and advertising will help increase the gross margin of the overall business and improve LTV.

This is beginning to play out; listeners who engage with both music and podcasts have a higher lifetime value than those who only engage with music because they are less likely to churn and have higher exposure to ads.

3. Audiobooks

Early indicators suggest Spotify’s bet on Podcasts is working, so they want to expand further into higher-margin audio. Spotify’s acquisition of Findaway represents a way to enter and take market share in the $4.2bn audiobook market which operates at 40% gross margin, earning more and higher quality revenue from existing MAUs. 

Churn

By reducing churn, you earn gross margin dollars from listeners for longer. So making the product as engaging as possible for as long as possible has a considerable impact on future profitability.

The increasing accuracy of Spotify’s personalisation in first music and now podcasts is a perfect example of how investment in R&D — in this case, Machine Learning — can impact a company’s trajectory. When you ask listeners what they most admire about Spotify, more than 81% cite its personalisation.

Podcasts also increase engagement. In 2018, less than 7% of listeners on Spotify listened to podcasts monthly. Today it’s 30% of listeners. Users who listen to both podcasts and music listen twice as much as listeners who only listen to music.

Spotify’s R&D investment in both personalisation and podcasts has decreased subscriber churn 30% over the last 4 years. 

Decades over Quarters

By prioritising its product roadmap through the lens of long-term unit economics, Spotify builds a stronger and more profitable long-term business. 

For founders wondering how to apply this to their business — consider not only how to grow through new customers, but also how to make your existing customers more profitable. Improving your unit economics has the added benefit of increasing the valuation multiple investors are willing to pay for your business, meaning that not only does revenue grow, but the overall valuation grows even faster.

1. For simplicity, and to make this useful for early-stage founders, I haven’t included NPV but Spotify do also NPV future customer gross margin for their cost of capital.