May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

1/20

f HllVlrd lI!l11in= ScIKiDI I liMO Entelltlnmlm 'CB9911- tompatillvll

StrBtBD~

I CB9B

r ® 11m M~GI!lw-.HIU Comp~i~. 2D05

HARVARD/BUSINESS/SCHOOL

9-701-003

RIlV, SIII'TJ!MBI!R ll. 20aa

JAN W. RIVkIN GIIIUUT MEIER

BMG Entertainment

Forly flOOlS above Times Square, Strauss Z~lnkk and Kevin Conroy mat in ZeWck;s comer office.

As presidmt and CEO of BMG Entertainment, one of the world's leading record companies, Zelnick faced a tough set of decisions about how to organize and operate tha company. He knew he could count on Conroy, senior vice president of worldwide marketing and new technology, for a clear opinion,

The discussion came in August 1999 as the global music indusby faced a period, of potentially tumultuous change. Two of the six companies that dominated the industry had merged a year earlier, and at least one other was rumored to be looking for a buyer. Customer test~s and buying habits were in flux. The Internet brought the promfse+-or specter-iliat consumers would buy much of their music online rttthe:r than purchase jt Jrom s-to:ref:ront retailers, Soon; customers might download music rather than buy prerecorded compact discs or cassette tapes. With this change, the traditional chain linking artists through record companies and retailers to COnsumers might take on an ~ntire1y new form. Certain indusby' analysts and parlicpoIInts even predicted-some g1"fulI~ that the new technology would spell the end oJ the major record companies. Chuck 0 of the rap group Pubilc Enemy took an extreme position:

Soon you'll see a marketplace with 500,000 independent labeJs.......the majors can co-opt all they want, but it's not go.ing to stop the average pwson from getting into the game. Today i1 major label makes a CD for as littJe as SO cents, then sells it wholesale for $] 0.50 so retailers can charge $l4-tllat's highway robbery .... The true revenge will come when the major labels start dropping their prices. 1 can see the public saying.. "01(.1 could go to th~ store and pick up the album J want for $5, but I can get it on the Net for •.. $3."]

Among major music companies, BMG had been one of the :most eager to embrace the new technology, despite the threats it might pose. Conroy and Zelnick had steered BMG toward online OPPOttunities as early as 1995. BMG was the first major :record company to create a set ol branded websites tailored to particular genus of music in order to attract music fans. It was also the first to U5e downloading technology to promote the sale of conventional, prerecorded CDs and cassettes.z Via an innovative agreement with Ar.netka Online. consumers who played the CDs of certain BMG artists on their computers Were linked automatically to relevant websiti!S.

Changing technology created a new .set of ~; digital customers" for BMG= online retailers such as CDNow, which shipped CDs and tapes to consumers; storefront retailers such as Tower Records that

Gen-lt Me.ter. MilA 2.000, f'tap~n!d this r:D!Ie under tile supervIsIon of I'tofessot l~n W. Rivkin. HIJ.5 (D5C:I ~re developat:! solely IlIi the tt~b for class disc~jOtl. ~ ~re not Intended 10 sttllt ~ tndots~mQnI!;, &OUIt'l!~ of prim~ry data. Ot mustralloll!;l of effective Or illdikllvl! m~lIggcmCl\t.

CDP)lrlSht II!! ~oo »~i(!liP1t pnd Fallows of Harvard Co)les~ To otd~r ~op.ij!$ Qor 'VqIli51 permission la t~f'to(hll:~ IIlplcrlais. ~1I1-800-S4S--75(!.:;, wrll~ HoIVotV, 1I11Sinm School Publ~hlng. Bl!5lon. Mi\. 0216-3. Ot go to hUp:/ /www.hbap.horvard.edu. No part of this publication may bv reproduced. staM In B relrlevol 'Yslem. wed in a ,spleadshttl. Of tl';)l'ISmlltro In 011)1' fotttL at by ~!'1y m~PJ1_J~lrarue, tnlXil~II!('lI.), photocopying. neordrng. Or Illherwl~w;thO\lt the ptrmiuicn of Mar'V~rd BUSlnI!S8Seh~t.

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

·8 II!IIMlrd 1I~1~es.s 5etlool / liMO f!IIBrtalnmcnl

Casaa- Cgmpalhj~1I

Str.l~

IIV Tho M~GIWI-II~I Comp8nles,2DOIi

IIMG )!l1i1!rlainment

were establishing online operationsj websites that enabled consumers to download music directly from the webj and individual ccnsumers who were visiting BMC's music webslte~- Z@lnick now had to decide how to organize BMG to serve its digital customers. One option was to give the existing distribution organization respo.nsibility for the new class of customers. Alternatively, BMG could set

, \lp a 'separate division to handle digital distribution. Th@ mandate of the digital organization was also at stake. How IOYll1 would 'BMG remam to its traditional customers, storefront retailers? How eagerly would it pursue other retaile:rs Of consumers themselves? ,Regardless of its structun and mandate, the digital Ol"ganization would soon fac:e difficult choices about technology. A number of companies such as Microsoft Liquid Audio, and IBM were developing technologies to support the dow:nJoading of music (Wet the Internet, Should I1MG continue to forge nonexdusive partnerships. with a wid!! range of technology vendors, or was it time to foeus on a smaller number of exclusive telationships? Zelnick and Conroy knew that others in the industry would watch BMG's moves carefully.

Development of the Global Music Industrye

Befote the advent of the- phonograph, music was disseminated by means of printed sheet music.

Sbeet musk was published much aa books were: Publishing companies bought '!he works of composers and lyricists, printed the works, and sold them through retail concession stands and licensed agents. Composers and lyricists often tried to bypass publishing companies and go directly to ihe consumers by playing their mulrlc in piano bars and public places, or if they were able to afford it~ having their music Sung by professional singers in evening dance halls and :r~taurants. As . publishing companies forged relationship' with retail outlets and developed mail-order lists, however, composers and lyricists increasingly relied on publishers. By the late nineteenth century, the musk .. publishing business was centralized in New York City, particularly in an area of lower Manhattan called Tin Pan Alley. The first popular song to sell 1 million copi@s, "After the Ball" (1892). spar.ked rapid growth in the industry. Composers and lyricist9 were hired to tum out simpJel meJ1lorable, emotionally appealing songs for a mass market.

Sound-recording devices were invented jn )877 by Thomas Edison in the United States and Chatles eros: in France. Edison's cylinder-based tlllking machine was fi:r$t sold to thl!- public in 1889. Edison SOOn faced competition from Al~ander G~ham Bell's American Graphophone Company and Columbia, a maker of coin-operated music cylinders. In 1901, the VictOr Talkmg Machine Company launched disc, reco:rdings. Victor's discs, invent@(] by Emil Berliner~ quickly displaced cylinders. Edison continued to produce his fragile, lower-capacity cylinders unti11913, when he introd'dced his very own "Edison Dilimond Discs." Edison discs required a different player, ustd different material, and ran at a diffe:rent ipeed than Berliner discs. Although Edison discs provided better sound quality than Berliner discs, consumers and most popular artists had already switclled to Be.rliner discs and remained with them.

The early oligopoly Protected by patents, Edison, Colu:mb1al and Victor, maintalned en oligopoly in the recording market fo:r many years. Through alliances and partnetships with smaller companies, the trio extended their reach around the globe. FOr instanc~ the newly established Gramophone Company became Vidor's European representative. Edison, Columbia, and Vjctor initiDlly produced and distribut!!d records in order to convince consumers to buy phonograph machines. By the 1920s, however, the companies focused on records, not machines, as their primary products. Sheet music shrank to account for about 15% of mU5ic-publi,hing revenues, and recording royalties became the major revenue stream of the music business. The music publishers of Tin Pan Alley continued to manage the copyrights of composers and lyricists. Record companies took on the

2

2/20

J

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

3/20

HIlYard IhmilleSS Sc:"tlDl. 11MB EnI'r1ailllllHn'

ClIStIS'- CMlpBtirivlI

Slral~g)l

CaSH

® lila MG6teW-Hill Companies. 2006

BMG Enlertainment

job of finding talented performers to make records as well as the tasks of manufacturing; mal'keting,

and distributing recordings. .

The U.s. music industry saw significant. growth until 1923, when broadcast !"!Idlo, iii new technology, posed a serious threat. As consumers purchased radios, record sales declined dramatically for a couple of years. Columbia, (or instance, came perilously close to bankruptcy. The electric microphone and ampJifier, new technologies developed alongside the radio, made it possjb)c to record musk with much greater fidelity. Record companies initially refused to promote electrical recording because their warehouses were full of old acoustic dlscs, Soon, however, they adopted the new technology. The higher quality associated with electricaJ recordings and a widespread economic boom brought strong growth to the industry during the late 1920s.

In 1929, the Depression hit the recording industry at its peak, sparking consolidation. Edison went out of business, and the Radio Corporation of America (RCA), wbic;h had prospered as II result oJ radio's popularity, acquired Vidor. In 1931. rivals Columbia. Parlophone, and the Gntmop.hone Company merged to become IDectric and Musical Industries (EMl), based in England. The American opemtions of BM1 pa9lled mto the hands of CBS, another radio network. The companies that emerged from the consolidation-RCA/Victor, EMl, and CBS Records-Jed the music industry in the following decades. Indeed, they formed the core of three of the five major music companies that

dominated th~ industry in 1999. '

Industry Jeade.rs continued to experiment with new fonnats for distributing musfc, In 1948, CBS Records mtroduced a long-playing (LP), 33-1plD disc pressed from vinyl and an affordable phonograph that could also play older, 78-lJ'm shellac discs. one year later, RCA/Victor launched the 45-lpm single and a longer, ~xtended-play (EP) disc. Confused by the competing fonnllts~ customers bought neither, In a compromise, the two companies agreed to sell players for the 33-rpJl) and 45-rpm dfscs, and they discontinued the EP.

A few new, significant record companies-including Decca, Mercury, and Capitol--:foined RCA/Vidor~ EMI, and CBS Records during the 1930s and 19406. Despite the arrival 01 new competitors, the production, marketing. and distribution of music remained concentrated among a handful 01 finns. Between 1946 and 195,2,. the six largest companies produced 158 of the 163 records that adlieved "'gold record" status. and RCA/Victor and Decca ~resented 67% of Billpclflrd's Top Pop Records chart.

The impact of reek and ro1l The 1950s brought a host of new styles of music targeted at the newly affluent teenage market-most famously, rock and roll. Hundreds of record (ompanies were founded Within i!I few yea;t;'S. With an endless supply of young musicaJ talent, any start-up record company that Specialized in the right genre at the right moment and kept overhead and production costs low could make a profit on Ii single release that sold only a few thousand copies. Many of the new companies proved short-JIved, but a handful enjoyed lasting success. For example, the sons of the Turkish ambassador to the Unitad States used a $10,000 Joan from their dentist to found Atlantic Records. Older record companies such as :RCA/Victor and CBS Records long jgnored the opportunities posed by the teenage market and rock and roll. These-new genres originated far from Tin Pan Alley. with which the established record companies had long-standing relationships. Mo.reove:r, some nK;o,rd company executives felt that, by selling to teenagers, th~ would tis); the goodwill they had built up over the years with parents.

In 1955, RCA's country section paid $35,000 for the contract of a little-known rock-and-roll artist from Sun Records, a small company established in 1952. RCA's strong marketing organization placed the artiet, Elvi5 Presley, in prominent venues sud-! as the Ed SulHvan Show In 1956. Elvis earned his first gold records the same year. RCA's signing of Elvis along with Decca's ccntracts with

3

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

,CD IbMr~ tllIi;llbt Sobool 9P/1G El!le~;Qm8J11

I:Ises - CtmpetlrJve

SlraIllOY

® lhs McGIBw-Hill. Comp8nlas,2006

BMG Interio)nmenl

B.ill Haley and Buddy J-Iolly slgnaled the fulJ entry of the majot record companies Into the rock-androll market. Still, between 1955 and 1959, small independent record companies accounted for 101 of the 147 records that made it into the U.S. Top Ten chart. In 1962, the records of 42 different labels appeared on the Billboard album charts, and the slx largest corporations accounted for less than half of the 1JmbOtlrd albums,

With the advent of rock and roll and FM stereo broadcasting, radio and disc jockeys (DJs) became the paramount tools for record companies to promote their products, Especially durirlg the 19505 and 1960s, the number of new songs reltased each year grew to be far more than radio stations could feature. Record (;omparu"e9 actiyely encouraged DJs: to play their records, and rumors of Npayolalt- bribery-spread widely. Senior managers of record companies became, and indeed remained, concerned that Uley had no direct control over their most important promotional medium.

The dismbution system linking record cemperdes to consumers became more elaborate during the 19505 and 1960s. Earlier, record companies had signed exclusive deals with distributors to deliver records to retailers. With ihe advent of rock and roll, the Introduetion of jukeboxes, and the growth jn lelail outlets, a layer of subdistributors that carried products from all reeord companies developed. :Rad<. jobbers began 10 buy records hom distributors and manege shelves, Of racks, in leased locations or departments. 'Ihe largest retail chains built warehouses of their own. In 1955, CBS Records' Columbia division launched the first record club, allowing consumlD'S to purchase records directly frOJn the record company by mail.

Reco.nsoHdaUon With developments in the distribution network and promotional channels, small, independent record companies increasingly sold out to major companies or reached agtUmmts undeJ." which major companies distributed l'GCoxds on their behalf. Jt became common during the 1960s for music corporations to operate multiple "labels"""---5e)'arate divisions with distinct operations and images. sharing certain overhead, manufacturing.. and ws.m"butjon activitit?S. 'wbm within a cotpOtation were :managed Jarg~y as sl!parnte organizations in order to preserve creative talents and distinct images. By 1972, although the top five lIIbds accounted for only 31.4% oj the marls, the top five corpomtfons distnbuted 58.2",1) of indusny output. The distinctive musical styles of the 197Os-disco, glam rl)tk, punk rock,. new wave, reggae. and funk-were pioneered by indefJendenl labels and musicians far hom the mainstream but were quickly adopted by the roajOJ' music co,rporatiOJls.

Jndustry revenue declined in the late 1970s and ,early 1980s but rev.ived in the :mid~1980s. The debut of Music TelevisiOJ'l (MTV) in 1981 and the introduction of the dIgitally ltCorded compact disc (CD) in 1983 sparked a surge of consumer interest mmu$ic. The CD had an especially Jarge impact on Industry revenue, as owners of LPs and tapes replaced thefr e:.ntirt' colltctions with the- nnv format.

Mergers and acquisitions, which had played II role in the musk industry since the Depression, accelerated during the 1980s and 199Os. By 1999, nearly 85% of the global market for recorded music rested in the hands of five corporations-the "majOIS": BMG Ent~.r1ainment, EMI. Sony Music Entertainment. Wa:rner Music Group, and Universal Musk Group. Exhibit 1 describes each of the majors.

Organization of the Music Industry in 1999

Businessmen, they drink my wine,

- Bob Dylan, "All Along the Watchtower/ 1968

4

4/20

I I j

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

5/20

Harvard Business S~ImDJ BMG' J:.,Mnment

ealD

® l11a M~GFlIw-HIJJ tDmpa~ieB. 2006

511111111'

lIMG Enl~riainment

In 1999, the maj01: record companies stood at the center of a complicated industry. Composers, lyricists, and performing. artists provided the raw ~X'tistic input for the business. Music-publishing companies mediated between composers and Jyricists. on one hand and record companies on the other. Retailers and distributors delivered products from record companies to consumers. Radio and musk television stations provided the primary promotional channels for record companjes. Rights agencies saw to it that royalties were distributed properly. (See Figure A.) Exhjbit 2 shows the size and ,geographic: distribution of the global jndushy over time.

Figure A Music Industry Roles

Composers

Music pl,Jbli~hJn9 companies·

Lyricists

Consumers

Performing artists

Promotional channels (8.S •• md/o)

Rights agencies I

• Major raeord companies owned theIr own mUl;lc publishing and dlt;!rlbullon operations. Some milJors also hid ulllnteraslS, as descllbMl Inlhe text

Sou~: C~wrilb'S.

Composers and lyricists Composers created th@ SCOl"@ for a piece of music, w:hilc lyrlds,t& wrote the words for a composition. 1f not the same person.. the composer and Jyrlcist of a song shared the- copynght. During the time of sheet-music distrlJJution, composers and lyricists Were often contractors hired by publishing houH$, writing songs on demand. Over the years, they became more independent. ComposeJ'S 811d lyricists were compensated through advances Of one-time fees from music publishexs, from royalty pilyments that accrued when theh- musk was sold downstream, or by both means.

Performing artists Artists either performed their own compositions, in which (,aGe they were also compooenl and lyricists, ox- used repertoire created by others. A countless number of unknown artists pedonned live gigs and made demo recordings fnhopes of being signed-that is, taken under contmct-bya record company. Artists typically signed for five or more albums at a time. As a J:'esuJt~ artists tended to stay Wlth 8 single company for some tim'!.

Once signed. an artist enjoyed a degree of creative and economic freedom that depended largely 011 hi, or her popularity. Record companies could largely dictate the creative moves of newcomers like Britney Spears. Superstars like 'Whitney Houston, in contrast, had extensive LTl!lItive heedo.m_ When connects lapsed, established artists sometimes switched record companies in search of better c:ontractual ar.rangements Or more creative latitude.

Artists earned income primarily from royalty fees paid by record companies for the saJe of their recordings. Concerts and merchandise provided additional income. A cadre of persona] and business managers, assistants, agents, and lawyers typicalJy accompanied fI successful artist. The artist paid this entourage out of hjs or her royalty Income. Artists differed dramatically in how successful they were and how long their successes endured.

5

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

g 4

I' •• , ... ,"

--

• I Ihtrvartl IItwNle= School I BMG ~nlen~lnlll.nI c.s-Compelitln

Sitateg,

I @lha MtGfllw"HIIi CDIllpanles. 20GIi

7014103

BMG lnteriainmcnl

'.

Music publishers Musk publishers purchased the partial or total rights to pieces of music from composers and lyricists·. The pubHshing houses then promoted the music Vigorously through II variety of channels. Key to. success was striking the proper balance between selling the same piece tlirough multiple channels and regulating content tightly so as not to cheapen the COil tent. This balance often raised tensions between the artists and the businesspeople who ran the pubJishlng houses. Over time, each of the :majors had acquired or created a publishing arm to' be part of its operations.

Record companies Record companies were widely considered the centra) players in the music industry. In addition to the five majors, .... lndies," or independe.nlsl·played this pivoklll role. liech record company took performing artlsts under contract, purchased musical rights from publishing houses, managed the recording process, manufactured CDs and cassettes, distributed CDs and cassettes to retailers and other channels, and promoted its products aggressively. During this pl'OCess, the company paid for all ~ts. associated with launching new ,musk. In return, it received the wholesale price of the CD or cas9f!tte, less the royalty fees paid to the artists and the publiaher and other costs aS50dated with each sale.

"&ealdng" new arlists--that )s, bringing them to commercial succ~r,d mflml$ing fuei.life cycles were :keys to it record company's profitability. Having promjnent artists ¥Jlder contract not only brought greater sales directly but also helped a record company gain precious retail shelf space for lesser mown acts. Promising new artists tended to be ilttr~cted to record cO!l'Ipanil!S that had the best illt~1:S under contract and showed a strong history of successful management. Sometimes the demands of premier artists could undermine the profitllbility of a record company tor that &petific act. Consequently, product mllnagern had to DfiJance the benefits of an artist'l;! big neme with the cost of holding the !!:rtist under contract. In an eJfoo to escape his contract with Warner Musk, the wen .. known artist Prince hied var.ious tactics, including changing his name to +, an uJl}'ronoum:eable sy:mbol, and claiming tha.t his old contract did not apply to The Artist Formerly Known as Prince. During subsequent disputes, he appeared in public: w.ith the word "s)ave" insaibed Oil his cheek to reflect his relationship with Wamer Music. Warner released hi:m from his l!ontrad in 1995. The Artist's next 1I1bunlS were distribuhiI by his own label and promoted primarily 'ria the Internet, ThO'ugh sales volumes w~e Iow, The Artist claimed that his net proceeds were higher than they had been with Wamet. In 1999,:he returned to a major record company, ~gning with BMG's Arista label.

The major record companies shared a basic organizational ,tructure (Exhibit 9). With the exception of EMJ, elicit was part of a larger dwersified corpoiation. Withln the record company :itself was a central manufacturing division that made and packaged cassette tapes, a central distdbutio;n $)'ste.m that delivered CDs and cassettes 10 Ntilil outlets and jndepttndent distributors, a musicpuhtishins operation that managed copyrights, and a number of distinct "labels." Several of the majors also had retail interests. lIMG, Time Warner, and Sony operated record clubs. All thue had interests in online retailers, as did Univer~l. EMl had only recently dives~ed itself of retailer HMV.

HistoricaJly, the :majors had carried out manufacturing locally in orner to reduce transportation I;OSts and avoid duties and taxes during expOrl and import. With the development of economic freetn1de 2ones, the record companies consolidated their production plants. Sony.. for Instance, manufacnned products for the European market in !hit Neth~]ands. while Wamer produced in Germany. Worldwide, a major record company such as 'BMG might maintain 10 (1f more production facilities.

Each of a record company's labels operated li1tgely autonomously, with a separate p)'esident,. proJit and loss (P&L) responsibilitYI and brand identity based around S@flre and artist roster. UsuDny, there were four fundions under each label: artist and repertoire (A&R}, marketing.. business affairs, and accounting. A&:R was responsible for finding new artists and developing new .repertoire.

6

6/20

f I
i
~
,
1
·1
J
I .1
.J
-:
!
I May-11-2009 0133 PM PricewaterhouseCoopers LLP 646-471-7055

7/20

HBl'Vllrd Blaii_ Sl:hcHll SMIl' llntwt.ljnm~1If

tlSet- Compelltillt

StJ':lt~9V

~ThcM,GI1I\V"HIll CompBnle:, 2006

BMG Enll1l'tllJnmenl

701-003

It also found songs for artists who did not write their own. Marketing, usually the largest function of a label, handled sales, promotion, advl!!rtising, publicity, and artist relations. Business affairs dealt with legal issues such as artist negotiations, producer agreements, and licensing arrangements. This function also finalized foreign licensJng and dlstribution deals:' Accounting played a crucial role because of the numbers of parties involved in each recording project. The accounting department handled the order-to-cash cycle, financial and managerial reporting. and the payment of royalties. Historically, most labels were split between U.S. and .international Operations, w.ith the four functions sometimes duplicated in the two regions or even Jn specific countries.

Independent distributors Although major record companies often diitributed thelf product directly to large retailers using their own, trucks and resources, a handful of distribution companies remained independent of the majors in 1999. For example, Koch Jntematlonal distributed indies' p.roducts to retailers. Indies, however, increasingly struck distribution agreements with the distribution arms of the major record- companies. BMG, for instance, distributed on behalf of the independent labels Beyond, Logic, Milan, Razor & Tie, Restless, V2, Wind~Up, and Jive. Although Independent distnbutols were often regional, some distributors had national reach, supported mainly through cross-regional alliances and mergers.!! •

Retaj) (hannels In 1999, musk Was sold to consumers through brick-and-mortar storefronts, record dubs, mail order, and increasingly, online retailers. ExhibJt" shows the breakdown of sales in the United States by type of retail outlet. Intematlonal chains such as Tower Records. HMV, and Blockbuster and natio;nal chains such as WOM in Germany and fnac in France played leading roles in the distribution of music. 'The number of small independent retailers had declined IiIIpidly during the 19BOs and 1990s as invesbnents in stores and retail technology grew. 'Ihe largest eight chains in the United States a('counted for 17.5% of all retail sales in 1982 and 57.8% in 1992. Over the same period, total retail sales Increesed by 55%. while the number of stonllocatio.ns declined by 15%.6 The :number 01 products offered at retail had grown even more rapidly than the size of the average store, leading to a shortage of retail shelf spaC(!.

Under "cooperative advertising" arrangements, record companies paid for part of the advertising efforts of retailers. ln return, :retailers agreed not to advertise prices below certain levels, Antitrust authorities we;re rut.rently rev:iewing these arrangements. Despite such practices, retail price wars were common in the mid-l990s.'

Consumers The activities of an of these businesses and artists were directed at individual consumers, Consumers had widely diff~rent tastes in music, and the range of g@nl'e5 had broadened Over the yeal'$. Genres Hom classical music to hard-core rap enjoyed loyal audiences. Exhibits 5 and 'show the popularity of genres and shifts in buyer demographics during the 1990s.

Promotion . Consumers were likely to buy music they heard on the radio or saw on music t@leviiion stations. In a typical week, record companies released 135 singles and 96 ~Jbum$, each averaging 10 trach, whi1e most popular radio statio.ns added only three to foul' new songs to their playlists.8 Consequently, record companies aggressively lobbied radio and musk television stations to get th~ir :new :releases an-ecL Tales of illesal incentives were legendary. Allegedly~ record companies had paid for DJs' vacation rentals and listed DJs as royalty-receiving co-composers of songs, for instance."

Rights agencies Many composers, Jyricists, perfonning artists, and ml1sic-pubJishing houses Wilre paid in the fonn of royalties: payments tied to the tlctual use of music, Accordingly, a set oj rights agencies arose around the world. to monitor the use of music. Performing-rights agencies surveyed radio stations, television broadcasts, live concerts, and many other venues in order to keep tabs on the pcu-fonnance of copyrighted music. Mechanical-rights agencies supervised the use of

7

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055 ~

CD I 111m"' BlI8i~ SthDol I liMO J;n'~rtl!lrnIHID'. . I'.asI!III~ClIIIIJIBliljll.

Sln:ibll1

I CIs,

I .(0 lOB McGrew-Hili Colllpnnies, lOO5

BMG Entertainment

music in the production of COs, cassette tapes, and other mechanical formats. These agencies deUvered reports and p~ymentg to member composers, lyricists, artists, and publishers. With few exceptions, one periol'l)'ling-rights and one mechanical-rights agency operated in each country, either .separately or together. Examples mduded ASCAP IBMl arid the Harry Fox Agency in the United States, GBIv:lA In Gennany, and ~S/MCPS in the United Kingdom.

Industry economics The flow of money within the musk industry was as complicated as the set of adors. Exhibit 'J lays out the way in which revenue from an a'Vetage CD was divided among various players. The average figures, however, mask imporlant variation from one album to another_ Some recordtngs were far mote successful than others. A hit album could sell more thAn 10 million CopjiS, while a flop might sell only a few thousand. It was extremely difficult for music industry executives to predict which albums would be hits before investing heavily in. development and promotion. This was e~pecial]y true of albums by new artist!. Accordingly, making Il :reco:rding was a ~y venture. Many labels stated that less than 20% of the recording~ they released recouped their costs. .

A system of "recoupable costs" affected who bote the costs of an album's failure and who enjoyed the fruits of success. Durin~ the production and marketing of n record, some of the costs incurred by the record companies were classified as recoupable hom the artist's loyalties. These costs were deducted before any payments were made to the artist. For a typical recording, a record company might spend $300,000 up front in productiOl"l and marketing costs. Of this, $200,000 might be c:Jassified as recoupable. If the artist's royalty rote were $2 per unit sold, then the artist would receive :nothing until 100,000 units had been sold. Thereafter, he or she WOuld earn $2 per unit. Thjs arrange.me:nt put the burden of a failed recording QJ1 the record company but also made it possjble for the company to earn a p;rofit before the artist received any payment.

BMG Entertainment

BMG Entertainment was .!II subsidiary of Bertelsmenn AG, II Garman media conglomerate_ The 'World's fourth-largest media company, Bertelsmann had interests in book publishing and clubsi music labels and record clubs; ptoiessional mfonnation; magazines and newspapers; telev.i!ion, film, ~nd rodio; print and medla Slervices; and OtIline services and multimedia. The COl'poration was privately owned by the BertelsmaM Poundatien, the Mohn family, and the Zeit Foundation. Exhibit 8 shows the composition of Bertelsmann's 1998-1999 revenue of 26 billion Deutsche marks (DM).

BMG Elltertainment was managed autonomously from its headquarters in New York City. In 1999, it was a $4.6 billion music and entertainment company with more than 200 record labels and operatlons in 53 countries. Its revenue was derived from North America (51 %), Europe (32%), Latin America (9%), and Asia-Pacific (8%).10 Amons its worldwide superstars were Christina AsuiJera, Carlos Santana, Whitney Houston, Sarah McLachla~ Puff Daddy, Dave Matthews, and a long list of other gold and platinum arti~ts. BMG distributed five of 1999's 10 best-selling albums.

Strauss Zelnick took the helm of BMG in July 1998 after leading BMG's North American operations lot three and a hall years. Prior to joining 'BMG .. Zelnick had worked in a series of film, televis.ion, 'Video, and multimedia coxnpanies: including 20'~ Century Fox and Columbia Pictures. 'When he arrived at BMG North America in 1995, he found a dfvision that had diversified, largely unsuccessfully, into businesses such as video distnbution and apparel licensing. All but three of 25 units within the division were 10$ing money. Zelnick rapidly withdrew from loss-making positio.ns, cut the costs of operations, and refocused the division on musk. BMG'$ North American music market share soon began logrow.11 In the eyes of roany observers, Zelnick typified a new type of

8

8/20

I r

"

.

'!

.,

I

'J

I;

.I(

.'

.

"

~'!.

i

'/

.;.

,i

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

9/20

I

L

I Harvard lIuslnw khDIII I BMG Eotarllltnmem Gnes - (;lHIIpmilln

Slnttegy

I ~ 111. M~GlBw-lIIn Comp~nfes. 2008

lO

:SMG Enll!rlllinmeni

music executive. Traditionally, individuals had risen in record companies based on their creative talents and track record of breaking new artists. In contrast, Zelnick was best known for his strong business ba ckground and, his focus on efficiency and profitablHty. Zelnick held MBA and Jaw degrees from Harvard .

. Much of :BMG's business activ.ity took place within its more than 200 labels, 'Which included Arlsta Records, Ario1a, RCA Records, the Wjndhar.n Hi1I Group, Buddha Records, and 'BMG Classics. Manufaduring, distribution,. rnu.!llc-publishing, and some sales and marketing actiVities were centralized and coordinated across the labels.

Manufacturing Led by CEO Uwe Swiente1; the Stores!! Media division of BMG manufactured compact discs .. cassettes, and related packaging. Facilities in Argentina, Brazi~ Germany; Ho.ng Kong, Ireland, Mexico, South Africa, Spain, and the United States produced more than 2.5 million CDs each day. A technoJogy group withlri the division. establlsh@d in 1994, tracked thedilvelopment of new-media products and served as a contact point within BMG for technology questions.

Distribution BMG Disbibution, led by Pete Jones, Jay at the center of the music-markedng process, linking BMG's labels to brick-and-mortar retailers. Distribution personnel called on major :retailers, promoted BMG~s latest products, negotiated prices and terms, took orders, ovenJ8W shipments .. visited tetail sites to assist with product placement, and handled O'edit and collectio.n. The division not only served BMG'1l own labels but also dishibuted on behalf of a number of independent labels.

Music publishing BMG's lnusic-pubJishing di v ision, under Nick Firth,. controlled the copyrights to mare than 700,000 songs. Through some 150 acquisitions, it had accumulated the catalogs of div8'1R artists such as the Beach Boys, B.B. King, Bany Manilow, and Santana. The djyisio.n's primary role was to acquire rights to songs and administer those rights. It also sought to generate royalties from its copyrights by placing its songs in films (e.g., The Runway Bride and 'The Malrix), tc]msion (e.g ... Friends and Bufty lile VttrrTpin: Sl«yu), and advertiSing campaigns (e.g ... Cadbwy and MeTcedes).

Sales Millions of consumers enrolled in one of BMG~s musk clubs, th~ largest collectio.n of musk dubs in th~ world. Oub members ordered a set of introductory CDs or cassettes at a very low price. SubstquUlt1y,!hey rewived a S€-lected album each month.. whim they could decline to purchase, as well as a catalog of other avaiJabJe albums. BMG Special Products developed specialty albums to assist companies such as. Avon, Coca-Cola, AT&T, and Shel1 Oil in their marketing efforts.

Marketing At :BMG and other major record companies, marketing had traditional1y been managed entirdy within .individual labels. BMG's labels continued to be responsible for day-to-day marketing activities and the promotion of individual artists. Rec~ntJy, however, BMG had placed Kevin Conroy in charge of corporate marketing. In this new role .. Conroy coo.rdinated the marketing activities of ~p1I:I"~te labels and establish~ strategic alliances and partnerships with other companies (e.g., Visa, AT&T). As the Internet became a promotional tool that spanned label boundaries, Conroy increasingly led BMG"s approach to digital distribution, e-commeree, new-music formats, and other emerging technologies. BMG's approach to the IntemeHs described in greater detail below.

The Other Majors

The five major record companies represented different artists and operated under diverse labels (Exhibit 1). In many ways, however, they resembled one another closely. An were organized in the same fashion. All operated around the globe and wert large enough to do so effectively. All had

9

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

.. e lial'llllrd BIII!I_ Sl!haol BM(: IiIll.rlai_1

Cases - Comlltliti~.

Slrat&IIY

cD! '!'hI! M~GfBW .. 11II1 Companies, 21106

701-003

JMG Enttrt:linmenl

labels thftt covered the full spectrum of musical genres. All pe:l'fonned the same basic functions, though with different.degrees of efficilmCY. Artists chose among the majors largely on the basis of characteristics of particular labels, not corporations. Personal relationships between label managers and artists were especially important in aMracdng and retaining artists,

Univexsal Music Group, the world's largest music company, emerged from Seagram's acquisition of Universal Studios in 1995 a:nd Sea.gram's purchase of PolyGram in 1998- ,Industry OOseJViIl"S believed that the merger had been difficult. Beyond music, Seagram participated ;in the produdio,n and dfsbibut;ion of spirits and wine, film and television production, the operatiDn of theme parks~ and specialty mall retailing.

Sony Music Rntl!rtO!linment was part of Sony, the Japan@s@ @Iltmainml!1lt and electronics giant.

Sony produced not only music but also hardware to play music, such as the Walkrmm. Other divisions made video games, films, television programs, computers, wireless te1ephWles, semiconductors, and magnetic media, The corporatlon prided itself on its cutt.ing-edge technology.

Wamer Music Group Was a member of Time Wamar, a U.S. media conglomerate. 'The cOrpO:rate perent operated a set of cable channels including CNN and HBQ, publlshe.;l magazines and books, produced feature fibns and teJevbion programs, and provided cable television connections to more than 12 million homes. With its cable systero, one of the most tec:hnologicaUy advanced in the United States, TIme Wamer was providing high-speed lntemet access to roughly 300,000 hOl,lseholds and W8S experimenting with services such as video on demand, high-definition televisiDn, and interactive televislon.

Among the majom, only the U.K.-based :mvu was not part of a diversified corporation. EMl's current lineup of artists was aJ'guably weaker than that of its rivals; the company had fewer CUJ:l'eJlt g1ob~] superstarS than other labels. Nonetheless, lIM1 had iI strong history wHh bands like the :Bea:tles, and m...tJ's music:-publishing division was the largest music publisher jn the worJd. lts catalog included some of the indnsUy's most valuable copyrights, including songs by the Beatles, the Rolling Stones, Pink Floy~ and Fnmk Sinatra. ·In 1999, many observers felt that liM! was Joo.lOn8 lot a buyer.

The financial results and market shares of the five major record companies are shown in &hibits !II and ]0, respectively.

The Internet

Music was one of the categot.i~'of:~~f\'r4I~ndiSl':inMt'ilHea€d by skyrocketing use of the Internet in the late 1990s. The lntemet a,ccP\liltw for O.3%,oh)l m~sia.:sales in 1997 and l.l% jn 1998, and it was forecast to account for 10% by 2005_12 Music was maYketed ~nd sold over the Internet in several ways. Through sites such as CDNow and Amezon.com, consumers could purchase conventiMal, physical CDs and cassettes and have them shipped to their homes. Downloaded music was a more radical departure from convention: new technology allowed surfers to transfer fill!S I:ontaining music dkectly (WeI" the lntemet to their computers. Thousands of sites posted megal, pirated copies of songs. Supported by new software and hardware, a growing number of sites offered legal digital

downloads. ,r:~ . ;.', ,., .• ,., , "'

,

, .

.: o:l

- • • • ~ I r

,.t.

10

10(20

I

I

I

j

.

I

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

HaMid IhlS!ntst; SChg1l1 . 8MG i'nt~rl9inmBnl

Casr:s- Co",p~I!I!VD

StrJIto}y

CHI!

(p 1110 MtGf1IW'"1H1l Companies, 2009

Online Sale of Physical Products

A number of Intemet retailers offered consumers a. comprehensive selection of prerecorded CDs and cassettes. CDNow WQS typical ohhi., new type of ;retailer.lS, In late 1999, CDNow boasted a selection of 390/000 COs, casseHes, and related items. Visitors to its site could browse the selection by genre; search for favorite artists, albums, or songs; listen to music samples; and read countless articles related to musk. Once shipping eharges were included, CD and cassette prices lit CDNow were comparable to those posted by st01ef.rOflt retailers.s

CDNow held virtually no inventory and relied on Valley Media, it musk distnoutor, to ship products to customers. Valley Media also handled the 10/0-2% of merchandise that customers returned to CDNow. A third-party credit card processor mllnllged CDNow's blUing operations. The company focused its ow.n internal efforts on the development of its website and aggressive marketing to consumers. lts 1999 marketing expenses were anticipated to approach $90 million. Analysts expected CDNow to Jose more than $]10 million in 1999 on sales W $150 million.

Downloaded Music

Technology 01 downloading 'Thousands of websltes gave surfers' th~ nppommity to download copies of songs Or albums directly over the Internet. The downloading of music involved software and hardware beyond 1'1 computer, an Internet browser, and an Internet connection. ThefirSt element of additional software was a compression protocol-baskally, a standard for :reducing the computer file that contained a song to a s.i2e that could be downloaded quickly. MP3 was t1H:most common protocol. A typical MP3lile containing a three-minute song could be downloaded by a computer with a 56K modem in seven minutes or by a computer with a cable modem in less ~n one minute.

A second element of software, a playerl opened the compressed Jjle and played the downloaded song. lntlm'll!t users could download the most popular pJayers-including ReI!l]ukebox,. Winomp .. Liquid Player. and Microsoft's Media Player-to their computers for free.

To playa downloaded song someplace other than on one's computer, a user needed additional hardware, Computers were lnCl'asingly equipped with CD drives that could write files to a compact disc,. not simply n!'ad from a diSC'. For about $200, Diamond Media offered a Wulkmlln-sized gadget that could store up to one hour of downloaded music, typically in an MP3 fonnat. Sony's MmlOZY Stick stored up to two hours of music on 8: device smaller than a stick of chewing gum. One could plug the stick into a computer, dow;nlood music. then move the stick to a portQble plaYiIT. The Memory Stick and associated player retailed for roughly $500. Empeg's Empeg Player, an MP3 plilyer for ears th2lt could store up to 70 hours of mUSiC, retailed for about $200.14

&cause lVlP3 files could be copied repeatedly, many record companies associated MP3 with illegal musk piracy. "MP3" was the term mast commonly submitted to Internet aearclt engines, and most of the 150,000 MP3-fonnatted songs on the Internet circulated without any compensation to the artist or copyright holder)!! Forrester Research estimated at the beginning of 1999 that over 3 million infringing MP3 files were being downloaded every day.16

A number of companies vied to provide Qoftware that would make downloading el'lsy and piroq difficult. Liquid Audio, fot instance, marketed a completesystem to companies that wanted to sell downloadable songs. Consumers who registered with Liquid Audio received a free "passport" in

~ Shipping ch~rges wlilre typically $2.95 tOt on" CD and $3.9~ {or IwO Ot thtee CD:!i.

11

o

11/20

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

o l Hlmnillusillcss S~"~~I I BMIi' ~n"r1lIrnmtl'll (lll!l~ - ClIIl1petltl",

·SIIitIQW

I CJ Iha M,Gr.lw"Hili Comp~nles, 2005

BMG Enlm1~inmtnl

exchange for personal contact information and credit card details, Passport holders could then go to any site using Liquid "Audic'e system, purchase a sortg. download it (in MP3 format or an alternative), and play it on their computers, Liquid Audio managed the billing of the customer. Songs downloaded via the Liquid Audio ·system were remastered using proprietary technology. Such "Liquid trarks." could be copjl!d only once digitally to a CD. Copies carried a .... digital watermark" that would allow authorities to trace any illegal copy back to the original purchaser. Competing systems, OJ' components of such systems, wel'e offered by technology giants such as IBM and Microsoft and new ventures such as lntertrust and Reciprocal.

lndu.,try groups were also working to l!Ilable downloading without piracy, Most prominently, the leading music trade associations, record companies, and technology companies launched the Secure l)jgital Music Initiative (8DMI) in December 1998. Involving dozens of comp8Jliea, SDMJ aimed to set open fechnology standards that woUld ease digital distribution while protediJlg copyrights. The organization intended to have a full set of standards in place by March 31, 2000P

Downloading entrepreneurs A host of new ventures sought to tap the opportunities posed by music downloads. MP3.com, perhaps the best known of the start-ups, aimed to' create a meeting ground for consumQ.tS and :musicians_ls The company helped artists set up web pages OIl jts site at no charge. Each page included free, downloadable samples of music posted by 1he arllst. If II consumer liked the samples, he or she could use a credit card to purchase the artist's entire album. Once an order was placed. MP3.coJJ\ arranged for an outside contractOl' to manufacture a CD and ship it to the customer. Artists set their own album prices within a tange of $5.99 and $14.99. MP3,com and the artist shared the proceeds I}f each sale, net of :manufacturing costa, 50/50.

MP3.com prmr.ided artists a set of computer tools thilt made it 'very I!flSY for them to set up w~b pages lind load samples. The compa.ny also gave artists daily information on the numbers of visltors to their pages~ nutnbers of downloads, and rankings within genre, The website guided consumers to amsts by genre and by online popl.lltlrlty. As of late 1999, MP3.com's site contained more than 160.000 songs from more than 31,000 artists. The most popular musicians, however, were absent from the site, in part because the majOr music companies did not allow participation.

MP3,£om was fl)unded in Matm 1998 by Michael Robertson, formerly the CEO of a company involving digital photogrilp~y. In 1999, MP3.com was projected to Jose mote than $40 mi1Jion on sales of apptoximately $20 million. More than 90% of its revenue came from advertisements placed on its site, CD sa:les accounted for the rest of its :revenue. In the first f~ months after its July 1m ,initial public offering.. jts :marke~ ~pitalization fluctuated h£1ween $1.5 billion and $7 billion,

As of late: 1999, !Music.com, i!I SCCOl'ld start-np, hod secured exclusive rights to sell digital downloads from 140 jndep~dl5lt record lebelsY:' These indie labels repr~ted 1,500 artists with over 300,000 SQJIgs. of which 27,000 were already available fot downloading from EMus1c.com's :;;ite. COIlSUmer$ paid $0.99 to download .11 song or $8.99 for an entire album. Half of the proceeds. net of administrative COSt6, were paid to the label. The labels cunentJy under conttact represented 12%- 15% of the indie market. EMusic.com'g. management team hoped to increase this share to 40%. The company had recently inked agreem@Jlts to offer its downloadable music lib:tary through Yahoof and America Online. It had also acquired the lntemet Underground Music Archive, which hosted the home pages of 5,000 artists,

EMusic.com was founded in June 1998 by Robert KOM, an entertamment attorney, and Gene:

Hoffman, It developer of privacy software. In the year ended June 30, 1999, EMusic.c:om lost $18 million on revenues of $92,.300. In late 1999, its market capitalization Was roughly $500 million.

12

12(20

,

I I

,

j

.;

May-11-2009 0133 PM PrlCEwatErhousECoopErs LLP 646-471-7055

Ha"",", Busi"ess School 8MB FIIIMII;1IIII8111

I:!tses -l:ompillll1YD

1lI1111i11r

It> The M~G/aw-HIII CCIIlPvnles, 2006'

BMG BnlGrlolnmt1li

. Li5tcn.com aimed to be the comprehenslve directory of legal, downloadable music.2o Although wsten.com did .not sen musk itself, its online directQry classified music Into 600 genres and subgenres and led Internet users to hundreds of sites that did sell music. The company directed userS only to sites it believed to be selling music legally. Its team of editors wrote independent reviews of artists' work and pointed usem to favored artists. Its site also featured guides that helped users learn how to download music.

Founded in December 1998 by Rob Reid,.11 former venture capitalist, and Iaunched on the web in June 1999, Listen.com soon struck a wide array of alliances. In June 1999, it announced partnerships with leading online ml.lsiC-:selJing sites such as EMUslC.rom to set their artists into Llsten.com's directory as soon as possible. Soon aftenva.t'dsl seven leading independent labeJs agreed to work with Listm.com to increase their artists' Internet exposure. By then, Listen.com had signed deals to syndicate its music directory through the porla]s,of ExciteGHome, Snap, and HotBot. The comptlny was alJegedly in investment discussions with all five of the major record companies.

Napster, founded by 19-year-oJd Shawn Fanning, enabled Internet users to tap one another's music: collectiotls. &ch user of Napster's free software indicated which of the Mf3 files on his or .her computer hard drive were available to others. Napster maintained a list of the userQ cun-etltly online and the titles those users were making available, A user could search the Jist for a song, then downJoad th~ desired file directly from another user's )~ard drive, Copyright holders received no payments for such downloads.

Ram1er Reaction

TraditioJ1al brlck-and·mortar retaiJers saw both the online sale of prerecorded music and the downloading of music over the Internet 8S serious threats. By the end of 1998, 70% of the members of the National Association of Recording Merchandisers (NARM). the trad~ association of U.S. :mtWic re!ailers, had established some web presence. Another 15% expected to do SO in 1999. Retailers used ihejr sites primarily to pIDl"fIote music tuld provide customers with infonnation. Many sold. prerewrded CDs and cassettes through their sites. Of those that did, most aJlowed customers to mum unwanted CDs and cassettes purchased online to traditional storefronts. One-third offered so,me ability to download music, and another qUflrler expected to add downloading OIpabJUtif!S during ]999.21

The websites of major retail cllltins such as Virgin,. HMV, and Tower Records w@,re similar in dJamcter. Tower~ for instance, went online in 1996 but relaunched its site in the middle of 1999 with new features that matched those of CONow and Amaeon.eom. Through its site, Tower sold new, used, and out-of-print COs. It offered music reviews, columns, and a function that Jet shoppers know what other customers were buying. The site also included a catalog of downloadable Liquid Audio 8Qngs.22 Many industry" experts were skeptkal of Tower's online prospects. Ana]y$t~ pointed to the lower margins associated with Tower's online sales and the hefty expenses it was incurring related to e-commerce.:!3

While developing their own websites, traditional retailers asked the major record companies for assurances that the majors would continue- to support storefront ~tailing- At the same time, retailers were «msidering a fuJJ range of options. Simon Wright, managing director of Virgin's retailing group, commented, "At the moment, the view in Virgin is that the terms being offered by thl? record companies would not justify further investment in music. Ultimately we could pullout of music a1together."211 Pamela Horovit~, president of NARM, took a more combative stance: "II the record companies want to start marginalizing the retailers, then retailers will start looking to become labels themselves and signing up bands thernseJves."2li

13

13/20

o

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

. 0 [";rn,d iI..,,',_ Scltool I PMli Enl.l1alnmelll CISe'S- tlDropmtiw.

StnlluDV

I (I) '!no McGfBW-Hili l:omrmnlu,2OO6

, "

70],003

BMG J!nlllli:iinment

The Majors' Actions.

As entrepreneurs pursued the opporl'l:Ulities posed by the Internet and traditional retailers coped with the technology's potential threats, the major record companies responded with a fluny of jnitiative5, deals, and alHanc:ss that reached a fever pitch in 1999.

'BMG Entertainment BMG launched its first online efforts in 1995, soon after Zelnick's arrival.

Though Zelnick was focused at the time on stemming losses in numerous units, Com-oy convinCti!'d him to invest $) million pet year in the nascent World Wide Web. With the funds, BMG set up a series of websitn dedicated to particular genres of m~sic: Peeps.com for hip"hop and rhythm and blues, Bugjuice.com for alternative, TwangThis.com for country, Connect2music.com for adult contemporary, Rockuniverse.com fOT rock, and SO on. The sites linked fans to exclusive infm;mation 8hout BMG 8rtist&~ inteJ'\'"iews with the artists, live broadcasts, chat rooms, and promotional downloads. By p)ilcing the s.ites· web addresses on albums and other media, BMG attrncted hundreds of thousands of unique visitors to the sites without a distinct Ildverlising ounpllign.26

Initially, the sites were not designed to sell music to consumers. Rather, they focused on promotion. Peeps, for in&tanc8, began to publici:ze pop sensation Britney Spears eight months before her first album was released. The slte gathered the names of 100,000 potentia] fans, 800/1) of whom later bought the album.2T The CDs of certain BMG artists included the software of America Online (AOL), the online smrice provider. When played in a computer, the CDs would enable consumers to sign up for AOl.. service. Customers who signed up would then be directed to BMG's websites.211 BMG hoped to develop the genre ~te5 as disthlct br;mds thllt cou]d stand on their own- The goal, Conroy explilined. W~~ both to "O'eate a djgital connection between our artists and their fans" and to "test the conventional wjsdom that consumer bxanding jsn't relevant in the muslc business.»29

Universal Mu!>ic artists were added to the sites in April 1999 after BMG and Unive1S81 annW>1~ed a new venture, Getmusic.com. Getmusic not only se.rved as lUI umbrella for the genre sit@s but also :included an online store comparable to CDNow or Amazon.com. The store's selection included albums by ell the lIlajor labels, but BMG and UniversaJ artists were featured most prominently. Links on the &eme sit" directed surfers who wllnted to buy an album to the Getmusic store. Prices jn the .store ~ often 20% higher than at CONow or Amazon.com.so

BMG had experimented with downloaded music since November 1997, when it became the first of the majors to use downloads far promotional purposes.~ It did not sell downloaded music routmely, however. In June 1999, BMG announced that it would begin selling music directly over the lntWlet by late in the year. It did not make public which artists and works it would sen.. what technology jt would use, or what prices it would charge.n At the same time, along With the other majors, it began 8 trial in San Oiego to sell music OYLer the lnternet using lime Warner's cable seJVice and IBM teclmo]ogy.SS

BMG took an active role in jndustry initiatives such as SDMl. Through a large number' of ;relatively small arrangements and partnetships with companies such as Microsoft, Uquid Audio, Real Networks, AT&T, and lBM, it :maintained Nlationships with all of th~ players involved in setting the technological standards for downloadable music. Senior executives tried to stay very much in the center of the industry's "deal flow" related to the Internet. As a result, they hlld hundreds of due-diligence files on potential deals. Zelnick explained some of the rules he used in sorting through opportunities: "Don't sen yOUt copyrights or license them m<dusively, Don't make long-term deals that you can't change. Once you've followed those rules, be willing to take risks end try things out. If God forbid you're wrong, you. still own your copyrights. N 34

14

14(20

I '

I :

I .~

,

I .

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

15/20

HarwrllllllSllIeSS Schonl SMO ElllertalnmBnI

Cases - CompBijllv~

S*~I99'

® lhD M~~I'OW-Hill [;ompalli~a, 2006

lIMG Iinltrtiinffii!"I

Sony Musk Entertainment Like :6MG, Sony Musk Entertainment was among the first and most eagel' of the majors to embrace new technology for music distribution, Its Columbia House subsidiary, jointly owned with Wamer Music, launched Total H, an online store se1Hng conventional CDs and I;IISSl!ttes, in mid~199a. In JUly 1999, Sony and Warner announced plans to aequire CDNow and merge it into Columbia House.3.'i

The company also pursued digital downloads. In May 1999, Sony publki%8d plans to sell singles directly over the Internet using compression and copyrighf-protectiOfl teclmclogy from Microsoft. Fred Ehrlich, Sony's genetal manager fot new teC::hnology and business development, said that download prices would be comparable to those of singles put~ased in retail stor!!S_36

A t nearly thl! same time, fill! company announced that it would help a start-up linn install "digital kiosks" in retail stores, At the kiosks, shoppers' could select among 4,000 albums, roughly half of Sony's catalog. The Idosk would then download the album via a proprietary computer system. imprint the album on a CD. and print liner notes and pad::aging within 10-15 mlnutes. The kiQE;)c, said Danny Yarbrough, chairman of Sony Musk Distribution, I'offers the retailer the ability to offe:; tit1eB they wouldn't be able to physically carry ~ ... I-a:/ An initial test of the kiosk was expected in the fall of 1999.

Sony Music's corporate parent had broader interests in nl!W-n'lllSic teclmology. lis consumer electronics division hoped to establish its Memory Stick as the leading portable device for downloaded music, The musk division's initial hesitation to make Us music available for downloading-because it feared piracy-had allegedly created a serious rift in the corporation. Sony COlpOration was the first to propose specific copyrlght-protection methods for approval by SDMt88

Uni\'el5aJ Music Group Through Getmusic. its venture with BMG, Universal sold conventional CDs and cassettes and promoted Us artists online. Universal also took part in SDMt ]n early May 1999, however, while SDM1 was still hashing out standards for digital downloads, Umvel"Sa1 ~ounced that it would soon distribute music online using technology developed in COJ'ljundion with II. Silicon Yaney start-.up. In doing so, it became the first of the majors to commit itse1f to digital downloads, Industry observers felt that Universal had "broken ranks" with the other majom. :tar.ry KenswiJ, he-ad of electronic commerce at Universal, offered a different jnteIpretation. Universal's efforts, he said, would "run in pOiIra)]eJ" with SDM] and be flexlbJc enoughto comply l.vith the standards that 2VentuaJly emerged.39 Soon afterwards, Sony and :aMG announced slmilar plans for music downloads,

Wamer Music Group Through its stake in ColOJnbia House, Warner MusiC participated in Total E and the pending merger with CDNow. It IIlso took part in industry forums such BS SDMl and the San Diego downloading trial. In 1999, the company offered promotlonal digital downloads featuring some two doeen artists, and it was conducting market research to assess the impact of the promotions-

Overall, however, Wi!lrner'8 migration toward the Intemet had been slow, In part due to its rorporate parent Time Warner. Since 1994, Time Warner had rnampioned a corporate-Wide lntemet initiative dubbed "Pathfinder," An ambitious effort to combine all of Time Warner's publishin~ film,. cabl@, and ml.liic interest~ jn o.ne portal, Pathfinder c:ollllpscd under the weight of corporate bureaucracy and conflicts of interest. By 1999, Time Warner was scrambling to catch up in the online arena.to

EMI Among the majors, EM] had been the last to announce plans for online acDvity. In June 1999, it reached lin agreement with muslcmaker.com, a start-up company that made customized CDs and sold songs over the Internet. For five years,only musicmaker.com would be allowed to use EMJ

15

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

"Iron! 11115111§li St:IHIDI Cases - CDInpIItitM Stra!egy

·IIMO fnlRrlslJlmllnl

~ Ill. McGraw-Hili Companies. 2005

7O'l-003

BMG Entertainment

bhibit2 Si.z@' and Geographic: Distribution of the Global Music Industry
't
1991 1992 1993 1994 1995 1996 1997 1998 1999
Retail value of sales 27.8 29.5 31.2 36.1 39.7 39.8 S8.6 38.7 38.5
(US$bn)
Units sold (bn) 2.8 2.9 3.0 3.9 9.4 :3.6 3.6 3.6 3.6
Percent of re1ail value of sales
~ I North Amerfca 30A 32.6 34.0· 35.2 ,32.9 33.1
, 33A 36.6 39,4
Europe ag.7 37.8 85.0 33.3 34.8 34.5 S3.8 38.6 33.B
Asia 20.4 21.S 22.6 23.3 24.5 22.9 22.6 20.3 19.2
~ ; I latin America 4.2 4.2 4.7 4.8 4.3 5.4 6.6 6.1 5.8
Rest of wOIld 5.3 3.7 .3.6 '3A 3.6 4.1 4.0 3A 1.9 Source: Inll!flllltil;lfllll F~tj01l of the Phcmtlglllphk l~. ~ R«",dmg 1rIdusiry in Numbers. NOIe: Unl" Include CDs, ca_ltllS, lind LPs.

:~

ExhibIt 3 Organbational Structure of a Major Record Company

Record ~omPlny

Diverse other businesses

J8pertoiYil

18

16(20

I

•

, .

,.

i·

I

/'. 'i

"

Ii

. ,

, I

j

I

L

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

CD J N:mlanl b&ill8!l3 School JIIMO Enlenllnment !:Mts- tmIjItII'IIM

Shlellr

I m Tha McGmw-Hili CampenleJ, 2008

lIMG inlc::rt:.inment

songs in customized CDs,41 In return, EMl received II 50% stake in the venture, Soon aftetWanis, EMI announced that it would use Liquid Audio's technology to encode Jts songs for future digital deUvery.42

. ~

Orgznizing for Digital Distribution

Amidst the moves of competitors, customers, and dep:reneurs, Zelnick and Comoy co~idered 1)ow to organize BMG to serve the emerging set of .... digitat customers. II Su~ customers wo~)d want to purchase bytes hom BMG but might not buy a physi~ produd such as a GO or iI C'a~tte. It Wu:I unclear who these customers would be. They JJU~t be online merchants, traditional :fet;Iilers, consumers; or altogether new intennediaries, for instance.

One option was to set up II separate d~on within :BMG to serve the new customers exclusively.

Accwrling to :recent rumors, Univen:al was pursuing this path: A dj"tina organization 'Would de.:!kate itself to making music available through computers, kiosks, TV set-top boxes, and portable devices.f.!I Skeptics felt that Universal was doing this primarily to create a division that it could later

ipin ofl in an JPO. '

Another option was to give BMG;s current distnbution organization ,-eSpMsiblHty for digital customers. For yeats, the distribution division had successfully managed accounts, generated orden, . overseen co]1ectioos, reported sales, and delivered p.hysical products. Pete Jones, the head of the organization,.. had little experience with digital te('hnology. but then no one in the company llad such e>t:perlence. By al1 accounts, Jones was one of the few people in a contentious industry who was uniformly austed and liked by retaileJ5 and artists.

However jt WaS structured, the digital organi2ation would soon need to choose a posture 10ward technology partners, To date, BMG had maintained relationships with the hdl 8J'l'By of C!ompanies-such as Liquid Audio, Microsoft, and IB.M~involyed in setting the standards and clearinghouse :methani:sms len downloaded musk. It was.undeer whether BMC should condnue to play the field in thi$ manner or place a firm bet by backing one partner.

Zelnick and Conroy knlffl that iheir decisions would be highly visible in the close-knit Il'JUSic community. Competitors and customers alike wOlild view the choices as signals of BMG's longertam intenti0IJ5. As Zelnidt spoke, Conroy glanced at a painting across the offfce. In big bold letters, the painting carried a slogan: HAMan of Vision. N

. I

16

17(20

.. j !

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

,CD I tlarverd B~I_ Sobwl I SMO E"lIhrlDlnllHlnl 1:asaI- tOlllpelllfn

5lI'ate!I.

I ex.

I ~ The Mcllt.lw-HIII Companies. 2005

BMG Enterhlinmmt

Exhibit 6 Demographics of Music Purchasers in the United States (% of purchases)
1990 1991 1992 1993 . 1994 1995 1998 1997 1998
Gender
j:~male 45.6 45.9 47.4 49.3 47.3 47.0 49.1 51.4 51.3
Male 54.4 54.1 52.6 50.7 52.7 53.0 50.9 48.5 48.7
Age ~
10---14 7.6 8.2 8.6 \ 8.6 7.9. 8.0 7.9 B.9 9.1
15-19 18.$ 18.1 18.2 I 16.7 16.~ 17.1 17.2 16.8 15.8
20-24 16.5 17.8 16.1 15.1 15.4 16.3 15.0 13.8 12.2
25-29 14.8 14.5 19.8 . 13.2 12:6 12.3 12.5 11.7 11.4.
I
30-34 13.2 12.5 12.2 11;9 11.B '2.1 11A 11.0 l1A
35-39 10_2 9.B 10.9 . 11.1 1'1.5 10.8 11.1 11.6 12.8
40-44 7.9 6.7 7.4 8.5 7.9 7.5 9.1 B.B 8.3
45+ 11.8 12.6 12.9 14,,8 16A 18.1 16.1 18.5 18_1
'.
Source: NaHMal AssodlltlJJJl of Jlecordins MItTChflJ'ld~~!l9f IIItId l~ ~ulll SUn'':'),''
NOle: Tolals may 111;)1 !1M up 10 100% clue 10 Hdon'l know Inl;) _iii-" Jm~. P=IDg~ ntncd dolillt 5111'=1, )'lOt ~NIII
sold.
&hibit7 Average Revenue and Cost of a Compact Disc: Sold at a Retail Outlet Notoes

Retailer ecOnomics

Retail price $t6.98

Wholesale prfce (COGS) 10.75

GI'OGS marein 6.2:3

Staff cost 1.36

DlsllIbIfdon cost 1.3B

_A,--"ent~~(!n~a..;;;sh;.;.;OPP~in;;.:g~ma=II) ....;2~.55=-_ As low as $1.53 for a free-standing store

Operating profit 0.97

Rec:ord company ec:onomies WhoI8Hie price

Cooperatlve advertising Manufacturing of GD Manufacturing of CD booklet· DlstrlbuHon and sales Mariceting and promotion

Artist and repertoire

Royalty paynwnt to performIng artist Royalty payment to composer and lyricist OVerhead Md mailing

$10.75 0.86 0.60 0.15 1.40 2.15 1.08 1.25.1 0.70 1.94

As high ss $2.15 for Independents

AdVertising, video C;lips. PR, tour promotIon, etc. Includes productIon ~udio costs

15% of whol!lsale- price mInus 3% recoupment 7¢ per song x 10 songs

Operating profit

0.59

Soilf(e: "Jg"Biz PoisM (or Renewed Pri~& Wars7" BiIlbolrtd,JllnwlI'Y 8, 2000.

20

18(20

f

May-11-2009 0133 PM PriCEwatErhousECoopErs LLP 646-471-7055

I

L

lI~m", BlISh,_ S~rrool 8MG f;menllnmnl

CaK-COIIIpelltM

Slmtegy

It) ThQ M~GrBw-1j1l1 Compnnlu.200ij

. 5MG EnlerlBi.llmmt

H"hibit 8 Compositio.n of BertelmnaM Revenue, 1998-1999

By b~silless s~ent;

By g~ographic sewtnl;

United States G~rn;any , .Fiest of Eul'Opl., IRest of world

34.7% 28.1% -29.8%

7.6%

BOOks

eMs Entertainment Print and media

Maga%fnes ilnd newspapers Professional information MultimedIa

30.8% . 30.1% 14.0% 19.9% 3A% 1.8%

Soll~; Berilismann public documb'll$.

"

Exhibit' F"mlinclaJ Results of Major Record c,\panj@S/ FY 1999 ./

SMS Sony Mu.sic Unlv,8r$al WamerMusrc
Ent.rI:IIinment EMI Erltorl~inment Music: GrouE! G1Dul!
Ravenue ($ mm) 4,300 3,598 .... _, .. ,r 6,338 3,751 ' 3,834
Assets ($ mm) NA 2.950 6'.298 16.392 7.483
Oparatlng income 1$ mm) 177 367 320 -439 179
Return 01) sates 4.1% 10_2% 5.1% -11.7% 4.7%
Return on assets NA 12.4% 5.1% -:?7% 2A%
Source: Company 1I1lf1U111 repor!.!:, ~wrile.r ~lcuJlltJons. Nolw.

For BMG, Sony, Ul1lver:ild .. lind Wamet • .resuUs lire lor mUlli~ bu&inesg !ll!gm!ll'lt only. BeL'llU!Ut corpotalicms dlffl!J' In how they t_£y revenue, l't'VMtle IOlab shown here lire nol rl!jiabJe for CIIlcul:lling ffiilrkel sh~res; see llxhlbU :10 lor mlldi~ wre infonn~tfWl. BMG rav~rlUl! fJiUre differs slightly from ffgure SIItOn in IIr.oCI 1I1.'(1I1J$II f~1 yODI' is dlfktetal from I;IIlezldllr yellr. UnivErljBl!l5Sel IIgute is inflaled by ~I pUI'~hBSe!l. UnJvers:t1 DpeliltinS In.oonc ligure mcludes $313 milli(ln restructuring cliart,l!.

21

19(20

01'.33 PM PriCEwatErhousECoopErs LLP 646-471-7055 May-11-2009

20/20

CD I tI~rnrtl BusrlNSS Scltoal I OMS I;ntelUlnmenl Casts - CempelIDVt

Stm~!I~

I taJe

/ @ The M~GIBw-Hilr CDmpMies. 2005

IxMbitlO Music lndustty Market Shares (%. U.S. only)
. '
I !
1991 16'2 1993 ,1994' 1996 1006 1997 1998 19S9
Total albllmsa
BMG 92 10.7 12.0 12.9 12.4 13.5 14.5 14.2 17.3
EMJ 13..4 11.6 11.8 11.2 \ 9.8 7.9 11.9 12.3 9.3
Sony 16.5 17.2 17.S 15.3 \ 13.9 14.9 12.8 16.6 16.9
Univemalb 25.0 24,8 22.8 23.6 '123.2 23.9 25.4 24.3 26.6
I ,
Wamer 26.5 24.0 21.7 21.1 ./ :21.8 m.B 19.9 18.2 15.8
Others 9.S 11.7 14.6 115.9 i '19.1 19.6 1B.1 14.3 15.3
\
Current albumsa 13.6
BMG ...,... 16.5 17.8 16.8 20..8
EM' - aa 7.2 12.3 12.5. 8.2
Sony 13.4 14~ 11.9 17.3 17_8
Unill&ra.atb - - 22.6 23~3 25.6 23.9 25.5
Warner 22.0 20.6 1B.6 17.5 14.0
0Iher$ 1R7 17.9 I 13.9 1t.9 13.7
Sourer. $Qu~lm.BMG.
8 "Cwteflt" albums e)(dude altos ~f old albums horn II company's 1;IIIIIIog. "Tolill" 1I1b~ Include 'both l'U!7VJl1 alt>wn.s "nd
mtaJos cales.
b lJJI!~) ligures inco1pCmle l"olyt;nlm sales. prior h;I- purcl'lase of POlygram. 22

: I . I

,.

> I

'\