Music-Industry Foes Join Hands to Accept Royalties

By CIOinsight  |  Posted 11-05-2005

Music-Industry Foes Join Hands to Accept Royalties

A cursory glance is enough to see that Joe DeTullio's office is not the domain of a high-powered CIO. Tucked away in a midtown Manhattan high-rise, the space is constricted, dark and unfinished. A power drill, some loose screws and a measuring tape are strewn across the surface of a cramped conference table that has been shoehorned into the corner. "The view is a little different," DeTullio says, as he gazes out the window at a solid wall of buildings.

If DeTullio sounds less than thrilled about his new digs, it might be because only this past summer the 46-year-old was executive vice president and CIO of Universal Music Group—the biggest music label in the world, and part of the $26 billion Vivendi Universal SA media conglomerate—where he oversaw a staff of 750. Then, on June 27, DeTullio became the CEO of Royalty Services LP, a software start-up with no revenues, no product and just two employees other than himself. "I'm now the CEO, CIO and the lead salesperson," he says.

It is not unusual for a CIO to think about striking it rich at a successful software start-up. And DeTullio is certainly not the first to try. But the circumstances that led to DeTullio's departure from Universal, and his arrival at Royalty Services—a company that hopes to provide royalty processing services for the music industry—are unique. Royalty Services is a joint venture between Universal Music and one of its biggest competitors in the music business, Warner Music Group. Together the two companies represent 42 percent of the global recorded-music market. Under ordinary circumstances, they compete fiercely against each other and against the other two major labels—Sony BMG Music Entertainment and EMI Group—to sign and promote successful recording artists in the face of shrinking music sales.

So what led to this most unlikely of unions? "We went out," DeTullio says, referring to himself and Tsvi Gal, CIO of Warner Music. "We went out to lunch."

Four years and a reported $30 million in seed money later, Royalty Services is busy developing a next-generation royalty processing platform designed to handle the fantastic complexity born of the steadily increasing number of ways that people can buy music. Warner and Universal partnered with Lightspeed Venture Partners (a venture capital firm) and Exigen Group (a transactional software developer) to create the new company, something the joint-venture partners are calling a "business-process utility."

The hope of all the stakeholders is that Royalty Services will grow well beyond its two guaranteed customers, Universal and Warner. They expect the company will eventually become the music industry's standard royalty platform, selling its services to Sony BMG, EMI and to the dozens of independent labels, as well. There is even talk of one day serving other industries that process complex royalty agreements, such as book publishing, film and television. But the service's debut is more than a year away, and its success is far from guaranteed. So for now, the story of Royalty Services is about how a simple lunch meeting between competitors can turn a vexing business process into a potential revenue opportunity. And why CIOs across a broad swath of industries should think about doing the same.

ZIFFPAGE TITLEA Tale of Two

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A Tale of Two CIOs

DeTullio was hired as CIO of Universal Music in the fall of 2001, just one month before Tsvi Gal took the top tech spot at Warner Music. Neither of them had any experience in the music business—DeTullio was CIO at Seagram's Spirits and Wine Group, and Gal was president of AT&T's ATT.COM. But both were given the same marching orders: Do something about digital piracy, and fix our aging royalty processing systems.

As it turned out, Apple Computer Inc.'s iTunes and a handful of other legal, though less-used, subscription services had just begun to address the first problem, but that, in turn, has only exacerbated the second. In the first half of 2005, digital music sales were estimated at $790 million, or 6 percent, of the global music market—more than triple the same period in 2004, according to IFPI, a recording industry trade group.

The uptick in online sales has added to an already dizzying maze of complexity for music companies trying to track sales of everything from CDs to single-song downloads to ring tones. Every sale, no matter how small, needs to be run through a unique set of rules based on the record label's contracts with the artist, producer and writer, as well as with any union, or other interested party, before royalties can be paid—which typically occurs on a quarterly or semiannual basis. "It's a huge transactional nightmare," says Warner's Gal. "The number of contracts is in the thousands, and each one is different. And there is no off-the-shelf software that can scale to what we're talking about. This is tens of millions of transactions a month."

Further complicating matters is the music industry's push to move single-song pricing to a variable model, rather than the flat fee—usually 99 cents a song—that Apple and other music services charge. "Not all songs are created equal," said Edgar Bronfman Jr., CEO of Warner Music Group, and the most outspoken advocate of variable pricing, at an investor's conference in New York City. "We want, and will insist upon having, variable pricing." Demand-driven pricing, possibly even auction-style pricing, for digital songs would add a mind-blowing layer of IT complexity to an already overwhelmed industry.

Company Profile
Company
Royalty Services LP

Corporate Headquarters
New York City

Partners
Universal Music Group; Warner Music Group; Lightspeed Venture Partners; Exigen Group

CEO
Joe DeTullio

Market
Royalty processing for record companies and other royalty-based businesses

Employees
3

Revenues
$0

Though all four major labels are struggling with the same issue, the problem is most acute at Universal. When DeTullio came on board, in 2001, UMG had just scrapped a two-year, multimillion-dollar attempt to create a new royalty process in-house, with the help of an outside consultant. The company had nothing to show for it, and it cost DeTullio's predecessor his job. "The reason Joe came was to fill a vacancy created by that old program," says Nick Henny, vice chairman and CFO of UMG. "We needed someone to come up with a solution, not just a bunch of guys in a room dreaming something up. We told Joe to shift away from a proprietary solution and start thinking about an industry solution."

After DeTullio and Gal met and agreed that royalty processing was not a competitive differentiator—Gal likes to say that "no artist ever joined a major label because of its royalty system, but they have left because of it"—and that both companies were in desperate need of a fix, Gal started working the phones. He called the CIOs of other major labels and asked them the same two questions: Are you having the same problem we're having? Do you consider this to be a strategic advantage to your company? The calls confirmed his suspicion that everyone was, more or less, in the same boat.

The CIOs—DeTullio of UMG, Gal of Warner, Miles Braffett of BMG, Bud Howey of Sony, and EMI's director for the U.S., Peter Bakalor—finally met in the fall of 2002, each accompanied by a small army of lawyers, to discuss how they might work together. It turned out that Sony and EMI had slightly more updated systems in place than Universal and Warner, and so felt less urgency about replacing them. "We were looking at a ten-year horizon, Sony and EMI were thinking they could go longer," Henny recalls. The result: Sony and EMI chose to bow out.

Warner and Universal, with the blessings of their respective CFOs, decided to work on a new system together. And though they were now in a position to halve their development costs, both wanted to further reduce the costs and limit the risks of development. They floated an RFP and watched the offers pour in. Gal recalls that just about every major consultant and software firm on the planet submitted a proposal. "IBM, Deloitte, Capgemini, Wipro, you name it—everyone was invited," he says. "But we were looking for something different. We didn't have the exact details, but we knew that, in general, we were looking for a vendor that was willing to share in the risks and the rewards."

ZIFFPAGE TITLEJoining Forces

Joining Forces

It's not hard to understand DeTullio's need to spread the risk of a new royalty platform. He knew the cost of developing the system would be substantial—somewhere in the neighborhood of $35 million, he estimated. And DeTullio was fully aware of the fate of his predecessor, who had chosen to go it alone. "Universal put a lot of time and money into the thing and got nothing, and yet the third party they hired made a lot of money," DeTullio says. "I've been a consultant before, so I know that the trick these days is to convince the vendor to get a little more skin in the game."

Exigen, a San Francisco-based software and services firm best known for its back-office applications used by insurance and brokerage houses, came to the table with the most aggressive proposal. With the financial backing of Lightspeed Venture Partners, of Menlo Park, Calif.—which agreed to pony up enough to give them 50 percent of the resulting enterprise—Exigen proposed creating an entirely new company, to be called Royalty Services, with Universal and Warner each owning 25 percent. Exigen would provide the development and consulting expertise, but not own equity in the company. It was far more vendor involvement than DeTullio or Gal had expected. And it proved to be the winning proposal. "They took it to the next level," DeTullio says.

For Warner and Universal, the decision was easy. They stand to get a custom-built answer to their prayers, at a fraction of the cost of doing it themselves. If the system is going to cost $35 million no matter who builds it, then why not pay for only a quarter of that. "My motivation for doing this was simple," Henny says. "I wanted to get the best system at the lowest cost."

As for Lightspeed, the 50 percent equity stake in the new venture was born of a different motivation. As one of the lead investors in Exigen, Lightspeed believes that the market opportunity for this kind of "business-process utility" is enormous, and not just in the music business. Exigen, EDS Corp. and Sydney, Australia-based Westpac Banking Corp. have already created a similar BPU to address mortgage processing. A BPU, as defined by Exigen, is any software that reduces costs by aggregating common transactions across many companies in the same industry. "There is an existing market for royalty processing, and having two committed customers from Day One with a combined 42 percent market share doesn't hurt," says Ken Elefant, senior associate at Lightspeed. "But there is a plethora of industries in which you can set up these BPUs. Anything that's transaction-intensive creates an opportunity. But it requires collaboration between CIOs, and many layers of the organization must buy into it."

In the case of Warner and Universal, the process of "co-competition," went smoothly. But in other industries the adoption of these business-process collaborations has been slow. "It's a valuable way to take undifferentiated structural systems and achieve economies of scale," says Nick Carr, author of Does IT Matter? (Harvard Business School Press, 2004). "But there is considerable resistance. There is still some nervousness about giving up control."

Creating a new company makes the most sense when the process in question is specific to a particular industry. Broader processes that are the same no matter what industry is using them, such as payroll, have already been outsourced to business-process outsourcing giants such as ADP Inc., which can achieve greater savings through massive economies of scale. Other horizontal processes, such as customer service and accounting, are increasingly being sent offshore to take advantage of cheaper labor. The uniqueness of royalty processing to the music business, combined with the domination of the market by just four companies, made it ripe for this kind of joint venture.

ZIFFPAGE TITLECollaboration or Collusion

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Collaboration or Collusion?

Of course, the music industry isn't the first to come up with a collaborative solution to a bedeviling process problem. Perhaps the most well-known business-process utility is Orbitz LLC, the collaborative effort of five airlines—American, Continental, Delta, Northwest and United—to create an online travel site. Orbitz has been a huge success, drawing in hundreds of business partners, going public in 2003, and eventually being acquired by Cendant Corp., in 2004, for $1.2 billion.

The comparison of Royalty Services to Orbitz brings up a sticky subject for the music industry, however. Many industry observers already have concerns about the potential for collusion among the major labels. The 2004 Sony–BMG (Bertelsmann Music Group) merger was bogged down by an extensive investigation by European Union and U.S. Department of Justice regulators as to whether the reduction in the number of major labels would lead to "tacit collusion." And the movement of the labels in lockstep toward raising online music prices has renewed those fears.

Add to that the industry's repeated failures to pay royalties in good faith, and there could be regulatory hurdles ahead. "In any market that is dominated by an oligopoly, the natural impulse will be to collude," says Aram Sinnreich, managing partner of Radar Research LLC, a Los Angeles-based media research firm. "And I can only assume that this system would be less auditable than the older systems. You can build a computer system to be as transparent or opaque as you want. I don't see any incentive for them to be transparent."

Concerns about collusion are hogwash, says Universal's Henny, and he's got the attorney bills to prove it. "These people are misinformed," he says. "We will not be sharing proprietary information, we will not be informing our competitors of our relationships. This is the back office. It's not competitive, it's just keeping costs down." DeTullio also says that the platform is being built to be more open, with auditors, and Sarbanes-Oxley, specifically in mind.

After the project is completed, says Henny, Sony BMG and EMI will be given a chance to evaluate it and sign up for the service, but the chance for them to share in the success, or failure, of Royalty Services may have already passed. "They are still in wait-and-see mode," he says. "If another company comes in and uses the service, our unit costs will go down. But that doesn't mean that equity will be available to them at that point."

DeTullio decided to resign from Universal and join Royalty Services this past spring, after an exhaustive, six-month search for a CEO came up empty. Since then he hasn't had time to wonder if he made the right career move. He focuses mainly on managing the software development process, and keeping the lines of communication open with his two biggest sales targets. "We are still talking to Sony BMG," he says, staring at the wall outside his window. "And EMI, which was at first the most standoffish, is at least expressing an interest again. I'm hoping there's a little more open-mindedness."

And Henny is driving DeTullio as hard, or harder, as when they were both together at Universal. "I didn't lose Joe; he's now working full-time on my royalty system," Henny says. "I like to think of myself as his most important client."