Music startups strike a chord

What’s an old media company to do when the business of selling physical CDs has hit a sour note?

The answer: Play venture capitalist. Invest in new online music startups. And maybe buy up the companies that show the most promise.

In late April, Sony Corp. of America announced it was buying VC-backed Gracenote for $260 million. The Emeryville, Calif.-based company maintains an online database of music metadata. Gracenote had raised about $50 million in venture funding from Sequoia Capital and Bessemer Venture Partners.

A week after Sony’s purchase of Gracenote, Sony BMG Music Investments, which is half owned by Sony and half owned by Bertelsman Music Group, teamed up with Universal Music Investments and The Angels Forum to invest $2.8 million in MOG, a Berkeley, Calif.-based music discovery service founded in 2005 by Gracenote’s former CEO, David Hyman.

The Gracenote exit and the investment in MOG show that investors are seeing more and more opportunity in the new music landscape, says Larry Kubal, a partner with Labrador Ventures, an early investor in popular music startup Pandora Media Inc.

“You don’t need a big recording studio anymore to record a quality piece of music,” Kubal says. “In terms of distribution, you can put music out on the Internet and connect with lots and lots of people. That turns the business model upside down.”

An especially hot space in music technology is one that Labrador is tapping into called music discovery. Pandora and other music discovery sites, such as La La Media, enable consumers to learn about new bands and songs based on a user’s likes and dislikes.

“If you want to discover new music and you no longer have a college roommate, services like Pandora do that for you,” Kubal says. “The key for the music startups is how well does that matching work?”

Pandora has raised more than $20 million in venture funding from Labrador Ventures, Crosslink Capital and other investors since 2005. With more than 7 million people using its advertising-supported service, it stands out as one of the better known emerging music discovery sites. But it’s far from the only service that’s creating buzz.

In April, social media networking site Buzznet Inc. received an investment from Universal Music Group. Los Angeles-based Buzznet launched in 2005 with funding from Anthem Venture Partners.

The details of the most recent investment were not disclosed, but the company reportedly raised a $25 million funding round with investors that included Universal. Similar to other music discovery sites, Buzznet helps users find new bands and songs by networking with friends and streaming songs.

Last year, Warner Music Group invested an undisclosed sum in music discovery site iMeem Inc. following a lawsuit settlement with the Palo Alto, Calif.-based company. The company raised early stage funding from Morgenthaler Ventures in 2004 and 2005 and late stage funding from Sequoia Capital in April, the details of which have not been disclosed.

In Warner Music Group’s May 2008 quarterly earnings call, Warner CEO Edgar Bronfman boasted that Warner’s involvement in iMeem was a good investment, but the company has not disclosed any details. “If we look at what is happening with the company right now, I would suggest that our investment is worth a great deal more than what we paid for our original investment,” he said.

Paul Resnikoff, founder and publisher of Digital Music News, expects that the major recording companies will continue to invest in music startups as a way to diversify.

“Right now, the major [recording studios] are thinking that if they diversify their portfolios and invest in some of these startups, maybe they could pull in revenue from other areas.” Resnikoff says.

For example, Pandora is partnering with another old media giant. Last week, Billboard reported that Pandora would team up with ClearChannel Communications, offering its services across all of ClearChannel’s Web properties, as a way of remaining operational under higher online licensing fees for music.

MOG CEO Hyman says it’s possible the company could one day join Gracenote and by getting purchased and becoming part of a bigger service. “It’s hard to say,” he says. “It’s an option, for sure.” Last year, CBS Corp. paid $280 million to buy, which raised more than $5 million in funding from Index Ventures and individual investors Joi Ito, Reid Hoffman and Stegan Glaenzer.

Not all, but certainly more music startups may hope to partner or be bought out entirely, says David Card, an analyst with JupiterResearch.

“Some are quite aware they are building something that doesn’t feel like a complete product,” Card says. “ felt like it could be part of a bigger service. Pandora is the same way.”

Kubal says that an acquisition is an option for Pandora.

“Any major media company would be a potential acquirer,” says Kubal, who sits on the board of Pandora. “The exit opportunities for a company like Pandora are numerous. You have the hope and expectation that they will continue to grow to hit the metrics so they could be a public company. But the M&A opportunities are certainly there.”