CASE Forum

Abbey Road Studios: How to Make the Right Investment Decision?

The business model for recording studios like Abbey Road is not what it used to be. In the face of so many uncertainties, what should the studio decide to do when a new band comes up with an unorthodox business proposition?

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Note: Forum open until March 23, 2017

THE CASE

As a veteran of Abbey Road Studios, Ian Jones felt that the glory days when recording studios could count on long-lasting, lucrative collaborations with artists like The Beatles and Pink Floyd were over.

Since being acquired by Universal Music Group, the legendary London studio had been trying to add other services to its core business of recording, mixing and mastering artists signed with major labels. This change of business model reflected a wider industry trend: of the $15 billion generated by the global music industry in 2015, only 40 percent came from physical sales; the rest came from digital downloads (20 percent), streaming (25 percent) and performance and synchronization rights (15 percent).

It was against this backdrop that Jones received an intriguing business proposition. Abbey Road was recording the debut album of an up-and-coming group, The Condors. If the album proved successful, the band's manager offered to pay Abbey Road $500,000 for the production and commercialization rights to the second album. In exchange, Abbey Road would have exclusive rights to record the second album. Should Jones accept the offer?

The Money Behind the Music

Record companies run considerable risks when they produce records: 80 percent of their releases lose money, and only 1 in 20 is a smash hit that helps make up for the losses generated by the majority.

As such, million-dollar recording projects funded by record labels are increasingly rare, reserved for artists who all but guarantee big sales. Recording budgets for lower-tier artists are much smaller, running between $15,000 and $50,000 per album.

In the case of The Condors' debut album, the total planned investment was $1.2 million, which included signing bonuses for the artists, recording, video production, marketing and promotion.

Jones pored over data from previous years on sales of new albums during their first year -- physical product as well as downloads and streaming play. He found that the vast majority exhibited a strong early peak in sales during the first four weeks after release, followed by an exponential decline.

To estimate the net present value of revenue from The Condors' debut album, he used his own rule of thumb: he multiplied the expected revenue for the first year by a factor of 3, which was roughly equivalent to computing the net present value of declining cash flows with an annual decrease of 20 percent over a decade, assuming a hurdle rate of 10 percent.

Jones knew the chances of The Condors recording a second album were slim. But if the first album were successful, the second one probably would be, too. Half of second albums sold 20 percent more than the first one, and 3 out of 10 sold 50 percent more. Only 2 out of 10 failed, bringing in on average only 10 percent of the sales generated by the first album.

Since investments in new albums yielded returns on future albums, the recording rights for debut albums were almost always bundled with the rights for subsequent releases. The Condors were one of the few bands that had not signed a long-term contract.

Jones figured that if the group achieved success with their first album, they would surely ask for more money to record a second album. This would entail additional costs for marketing and promotion, amounting to an increased investment of around 25 percent relative to the debut album.

However, if new models of digital distribution and promotion were used, those costs could be reduced. Of course, digital distribution was not without risks: by having less support from the record label, the visibility of a new band like The Condors could be seriously compromised.

Considering that Abbey Road -- now belonging to one of the three major record labels in the world -- was beginning to diversify its business with online services, should it bet on this project? How could Jones reconcile the band's novel proposal while still adhering to Universal Music's stricter contractual requirements?

In weighing up the $500,000 offer, Jones combined the standard data analysis with the lessons learned in his four decades of experience at Abbey Road. On the face of it, the deal seemed risky, given the extra investment typically required for second albums that underperform. But what if The Condors defied expectations and turned out to be the next Beatles?

The case study "Abbey Road Studios" (AD-353-E), prepared by IESE Prof. Roberto García-Castro, is available from IESE Publishing at www.iesep.com.


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