LinkedIn summary – Running a business that streams video will always be a better business than one that streams music. The reason is simple: marginal cost. As I explain here, when you pay for video rights, it is uncorrelated to volume watched. But for music, your cost changes depending on the number of listeners. So, more listeners more royalties even though you may enjoy discount which improves unit economics.  If a Zen master comes to you and offers these: take one of these startups – one streams video, the other music. Go with video. You have a better chance of scaling faster and making money. You see, you may need to take accounting class as your success can be bounded by unit economics even before you begin.

Marginal Cost is “the cost added by producing one additional unit of a product or service”. It is one of the most important cost elements in any digital business. While the production of the product seems like a done deal, the marginal cost which captures the distribution and transaction costs drive the scalable advantage. In sectors like ecommerce, the marginal cost of distribution is the main reason why operators bound the geography where they operate. In other words, they cannot be in Yola since it would be expensive to ship an item from Lagos to Yola even though a user in Yola can open a web account in the digital store [the marginal cost is offline making pure ecommerce business a non-web business on operations].

That same marginal cost is the reason why music streaming is a challenged business when compared with video streaming. It has to do with the structure of most music contracts: as the numbers of listeners increase, the acquisition costs also increase even though the unit economics may look better on bulk purchase. In other words, you pay more on royalties to music creators for more music listeners. For video, the cost is the same irrespective of the number watching. That explains why Netflix (video streaming service) will always be a better business than Spotify (music streaming service). Spotify has a marginal cost problem while Netflix enjoys an increasingly near-zero marginal cost on scale.

However much Spotify resembles Netflix in spirit and business approach, the services diverge in a way that makes Spotify’s path to profit significantly trickier. The video streaming company’s programming expenses don’t rise as it lures more subscribers. But as Spotify gets bigger, its streaming music costs increase; it can’t grow its way to profitability. Spotify’s product—35 million songs—costs the company more as more people sign up. Its contracts with music companies are confidential, but generally the business pays the owners of song rights a fee for each paying user or a percentage of company revenue.

In some cases, the royalties it pays decline as it signs up more subscribers or reaches other milestones, according to company disclosures

From the plot above, as the music service grows, the change in average revenue per user drops. In other words, the company is not maximizing the economics of scale. Yes, it is paying more on royalties as the user base goes up even though it may get a discount for volume.

Simply, it is better to start a company that streams video than music. Music contracts are structured in ways that your problem can start when you start growing as that would mean more money to musicians, reducing expected scale benefits.  That explains why in digital business, you need to pay attention to marginal cost.

Yet, it is important to note that music streaming gives you chance to start small while video may be harder since you need to have an optimal price to pay for video rights without knowing if people will or not watch. For music, you can start small and as scale picks up, it dynamically calibrates.