On June 5, 2003 Apple Computer held a half-day seminar at their campus in Cupertino, CA to introduce their iTunes Music Store to the independent label community. Future of Music Coalition representatives Kristin Thomson, Brian Zisk and Shoshana Samole Zisk were in attendance and here’s what we learned:

The Basics
iTunes Music Store is a virtual record shop where you can buy and download either complete albums or individual tracks from many major artists of different genres. Unlike some other digital distribution services, iTunes is not a stand-alone website or a subscription service — it’s an entire application that’s integrated into the iTunes jukebox software that’s downloadable for free for Mac users.

Single songs are all priced the same — 99 cents. Albums are priced at a range between $7.99 and $12.99 but the vast majority are $9.99, a price point that Apple encourages for consistency. There’s no monthly subscription fee, and no sign up charges.

What happened when I searched for “PJ Harvey” through the search function — I got a complete list of PJ’s songs off of her seven records. Note you can click the “buy song” button on the right to purchase a single track, or you can “;buy album” up at the top. Plus, if you click on her name up in the blue area it opens up her own artist page.

Who Can Use It?
Right now iTunes is available to anyone with a credit card and a US billing address. However, at this point, you also need to be a Mac user running OS 10.1.5 or later. Apple has only a small sliver of the consumer computer industry — about 3 percent — and even fewer of these folks have upgraded to the latest Mac operating platform. Despite this, Apple was proud to announce that they’d had over 3.5 million downloads since the store launched in early May [now 5 million as of June 23]. As good as that is, things are predicted to explode when Apple releases a Windows version of iTunes, which they said they’d like out before Christmas.

Why Apple Built It
There were two phrases that were repeated a lot during this seminar, one of them being “We wanted to build a system that lets honest people stay honest”. There’s a strong belief at Apple that, given an easy and reliable way to download music, consumers WILL gravitate to legal digital download systems instead of using illegal systems like Kazaa or Limewire.

Other legal systems exist — eMusic, Rhapsody, Musicnet and Pressplay to name a few — but to this point they’ve had limited success competing with “free”, mostly because the systems have had difficulty licensing content, or they’ve placed so many restrictions on the downloads — songs that “time out” after a certain period of time, songs you can’t burn onto CDs or move onto a portable player, etc — that consumers have been turned off.

It’s clear that Apple has a number of assets that has made it easier for them to “compete with free.” First of all, they own or have licensed every portion of what’s needed to make their store function — from the bandwidth, to the one-click shopping capacity, to the credit card processing capability, to the computers, the software, and the iPods. They’re also a company with cash in the bank and a long track record, which means they’re not trying to fund a startup plan on the backs of musicians and labels.

It was a combination of all these elements plus Apple’s integration of a digital rights management system that allowed Apple go to the major labels with leverage that no other company had. As they tell it, Apple went into negotiations with the major labels saying they were willing to spend a significant amount of money to build a legal alternative to Kazaa et al but, in return, they insisted that the labels agree to a broader set of user end rights — giving music consumers more options about how they can listen to and store their music. So, iTunes users are allowed to:

• burn CDs of their purchased songs
• put songs on unlimited iPods
• put songs on 3 computers
• buy songs on a per-track basis (as opposed to just albums)

This gives iTunes the most liberal policies seen on the consumer’s right to use of digital music and, many would say, make the iTunes Store more compelling.

How Apple is Combating Piracy
Apple’s success in convincing the major labels to join them in this endeavor is based on Apple’s integrated (but invisible) anti-piracy measures. Songs are encoded in AAC format at 128 KB/sec. AAC is a compression format that Apple has licensed from Dolby that is apparently better sounding and better at compression than the more familiar MP3 format. Plus, AAC works in conjunction with Fairplay — a digital rights management system that blocks certain file uses in an attempt to reduce music piracy. Without getting too technical, basically songs are encrypted when consumers download them to their computer, and songs are tied (in a transparent way) to the user’s Apple account, making it relatively difficult for the average computer user to re-post any songs bought through iTunes to any free download sites.

Apple admits that they cannot stop piracy altogether, but they think their liberal user rights combined with subtle but strong anti-piracy protections — not to mention Apple’s very cool and simple store interface and broad song selection — makes their store “better than free” for the average music fan.

PJ Harvey’s artist page. According to Apple, every artist will get one of these.
Note the “top downloads” and other comparison lists on the right, all clickable.

ITunes, Musicians and Labels
During the presentation, Apple representatives explained that they had approached the five major labels first — Sony, Universal, EMI, Warner and BMG — because they knew they would need to have the labels agree to the iTunes model for this to work. In addition, the major labels control a vast amount of copyrighted material — whether it’s new releases or back catalog records — and having a good, broad selection of music in place for iTunes launch was essential to the Store’s success.

Now with a month of downloads under their belt, Apple was moving on to the next stage of the iTunes Store — acquiring more songs, so on June 5 they invited representatives from some of the best independent labels to their campus in Cupertino, CA to demonstrate the store and encourage them to add their titles to the Store. Apple emphasized that indie labels are getting the same “A” deal that they offered the major labels. But in return for this they said they were not willing to negotiate on the rates or the contract. They said they don’t have the time or the interest in talking to 200 lawyers on this stuff — it’s a “take it or leave it” offer.

The Agreement
The arrangement between Apple and labels is considered a “reseller agreement”. That means they’re not licensing content from any labels but instead buying songs “wholesale” and reselling them to consumers — a lot like a terrestrial retail store that purchases CDs wholesale and sells them retail.

The deal is straightforward. Of the 99 cents of a download, Apple keeps a portion and the rest goes back to the label, which is then responsible for distributing back to the artists, songwriters, publishers, and so on according to the existing terms between the labels and their bands. This makes it really simple for Apple to acquire content because they don’t have to deal with stuff like licensing agreements or paying publishers — all that stuff is the labels’ responsibility. There’s no cost for labels to join the store and, conversely, Apple isn’t paying any upfront advances for content (a method that has been used in the past by other digital download sites to attract certain labels to make exclusive deals with them).

No Paid Placement
One of the most talked about pieces of Apple’s presentation was their stance on “paid placement”. Apple insisted that “it’s all about the music” and that they’re not interested in accepting advertising, banners, or any types of payment for placement on the website. But if you look at the home page you’ll see that there are both banners and these areas called “swooshes” that highlight 16 albums per swoosh (new releases, up and coming, just added, etc). Apple said that any highlighting of albums or artists — whether for banners or swooshes — is purely at the discretion of Apple’s music editorial staff.

Once again, Apple has a unique position in this. As a technology company with lots of assets they don’t NEED to accept advertising money to make this work, and they’ve never done anything like this in the past (like selling space for icons on their computer desktops). We hope that Apple will remain committed to this pledge. Not only is it refreshing to see a list of songs that doesn’t belie the “superstarness” of any one track over another, or a list cluttered with smiley faces or stars or other attention-getting icons, but it also stops the iTunes virtual space from being sold to the highest bidder.

Simple Machines as Test Case
From 1990 to 1998, FMC’s Jenny Toomey and Kristin Thomson co-ran an independent record label called Simple Machines. Over its eight year history, we released about 75 records that have sold about 250,000 copies worldwide to date. We are very interested in posting the entire Simple Machines back catalog to the iTunes Music Store, pending each band’s consent. For us, there’s really no drawbacks or major issues. We don’t have any complicated contracts, distribution deals or licensing agreements with our bands and most of our back catalog is sitting dormant in our basement anyway. Plus, it gives us the opportunity to flow more money back to the bands.

Simple Machines worked on a simple profit split. Once costs were recouped for recording and making a record, SMR split the profits 50/50 with the band. But with the iTunes Store, we intend to make the profit split more favorable for the bands — more like a 75% band / 25% Simple Machines arrangement. We recognize that, after some initial work uploading the existing CDs to Apple’s store, the rest of the work is constrained to administration of royalties and some basic promotion. Because Simple Machines was set up as a profit split, we’re able to recognize the changes in distribution models and compensate our bands accordingly.

The Money Flow for Major Label Artists
For bands and artists signed to major label contracts, we have some reservations about just how much they will benefit financially from iTunes. While we would expect that Apple will faithfully pay the labels their appropriate portion for each song sold, just how much money will end up in the artists’ pockets? That answer is contingent on the contract that the artist signed with the label.

In the terrestrial world, artists’ royalties for sales are computed as a percentage of the record’s suggested retail list price (SLRP). The SLRP is an approximation of the price charged by retailers, usually about $16.98 for a new release for a mega artist (note that this is just a suggested price for retailers — you know you’ve seen CDs priced lower than this). Most artists get paid between 10 and 14 percent of the SLRP. But wait! First the record label deducts a packaging cost — usually 25 percent for CDs — since, in theory, artists are being paid for the music and not the packaging, but really it’s just a false way to pay the artists less. So now it looks like this:

$16.98 SLRP
-$4.25 25% packaging deduction
$12.73 royalty base price

But wait! There’s ANOTHER deduction. Most major labels also hold money in reserve to cover “breakage”. This a ridiculous, antiquated deduction that goes back to the days when vinyl records could actually break during shipping, but it still exists. Now our formula looks like this:

$16.98 SLRP for a CD
-$4.25 25% packaging deduction
$12.73 royalty base price
-$1.27 10% breakage deduction
$11.46 new royalty base price

But WAIT. There’s ANOTHER DEDUCTION. Despite the fact that CDs have been around for about twenty years, they’re still considered a “new technology” in many major label contracts. And because new technologies imply some sort of “risk” to the labels, they feel like it’s within their right to hold some more of an artists’ sale royalties. The standard “new technologies” deduction is 25%, so that makes our formula look like this:

$16.98 SLRP for a CD
-$4.25 25% packaging deduction
$12.73 royalty base price
-$1.27 10% breakage deduction
$11.46 new royalty base price
-$2.87 25% new technologies deduction
$8.58 new royalty base price

So now the artist gets 10 to 14 percent of this price — or somewhere between $0.86 and $1.20 — per retail sale. And, of course, artists only get this money AFTER they’ve recouped the costs of making the album which, in many cases, never happens at all. [note: This is a simplified version of things using averaged figures and not dealing with other common deductions like “free goods” and “reserves”. For a more nuanced explanation we suggest you read Donald Passman’s All You Need To Know about the Music Business].

The question is: how does the contracted royalty rate jibe with the iTunes model? Unlike traditional retail sales with the iTunes Store there is:

• No overstock
• No breakage
• No returns
• No packaging costs

…thus making all of those ridiculous deductions listed above even more pointless.

So, in theory, musicians signed to major labels should be getting 100 percent of their 10 to 14 percent royalty rate since all of those antiquated deductions are totally illogical. But even at that price, these standard contracted rates seem dismally low. If the same contract terms apply to digital sales as terrestrial sales, at the $9.99 retail price for albums on iTunes, an artist would get somewhere between $1.00 and $1.40 per sale. For a 99 cent single download, an artist would get 10 to 14 cents.

Could Deductions Still Apply?
Once we open this digital can of worms there are other contract clauses that may affect the rate at which you’re paid. Will the major labels try to say that electronic transmissions are a “new technology” that, like CDs, kicks in a 25 percent deduction per sale? Will the labels consider online album sales as “top-line” sales, or does the price of $9.99 mean that it’s considered a “discount” sale? If it’s a discount sale that may mean you only get HALF of your contracted rate (5 to 7 percent from our example above). We’ll have to wait and see.

Contract Reform: Treat Digital Downloads Differently
With the music industry shifting towards digital distribution, now is the time for artists, managers and advocates to push for major label contract reform on the calculation and payment of digital distribution royalties.

Instead of getting 10 to 14 percent of a sale, the FMC believes artists could — and should — be getting something closer to the rate that was agreed upon for non-interactive webcasting, which is:

Labels: 50%
Featured Artists: 45%
Non-Featured Artists: 5%

In addition, while the iTunes Store is considers the transactions sales, there is some discussion amongst artists that it might actually be a licensing agreement, which in most cases would be much more advantageous for musicians royalty-wise.

We urge major label musician to ask their label representatives about the rate they’re getting for digital download sales and what deductions, if any, apply. If it’s in alignment with their terrestrial sales, think about renegotiating for a higher rate for digital sales. With no deductions for shipping, storing, breakage, packaging and returns, the marginal costs of selling songs through digital download services is almost nil. As a result major label artists should demand to be compensated for these sales at a unique and higher rate.

Conclusion
Overall, we were impressed with the iTunes Store. Once again, Apple has designed an interface that’s both cool and completely functional. We were also impressed with their reseller agreement. In true Apple form, it’s simple, user-friendly and egalitarian. Finally, we were excited because of the unique position that Apple maintains in this environment. They know they have all the puzzle pieces they need to make this work, and they seemed unwilling to compromise their goal of establishing broad user rights to alleviate the major labels’ fear of piracy. And the fact that they walked about 200 indie label people through this arrangement together gave us a tacit feeling of equality.

If Apple can stick to its mantra that “it’s just about the music” they may have designed a business model that will truly provide a legitimate and accessible platform for all musicians to distribute their music.