Business Descriptions In 1993, Brown launched Small World Music in Nashville, Tennessee with husband Gary West and

then went on to create Compass Records in 1995. Compass Records is a small, independent artist-run company that established their niche in musical genres such as folk, roots, and Celtic. In the context of the 2-billion dollar music recording industry, Compass Records has low market share in comparison to the multi-national corporations dominating the business. Brown was formally an investment banker with an MBA from University of California Los Angeles. In addition to her business knowledge and experience, Brown is also a talented musician who won a Grammy on her first album as a Banjo artist. By 2005, Compass Records had 50 artists on contract and were averaging approximately 20 releases a year, with 40% of their albums selling over 5,000 units. Their company makes profit on approximately 80% of their titles. In May 2004, Brown and West acquired a recording studio, which gives them flexibility in the creative process and contributes to their low production costs from not having to rent out a workspace. Key Issues Affecting the Music Industry Stagnated Growth in Music Industry: There has been stagnated growth since 1995 in the music recording industry. In 2003, it shrunk to 32 billion, down from its peak level of 40 billion in 1995. Small Fish in Big Sea: Large multinational corporations dominate 86% of the music industry, including Universal, Sony, Warner, and EMI. Licensing Contract vs. Recording Contract A recording contract is an agreement whereby the label has the right to promote, own, and market recordings of the artists music, indefinitely. In contrast, a licensing contract is when a record company licensed an artists finished recordings for a limited period of time. With each new client, Compass records had to determine whether to produce and own Adair Roscommons next album or license her finished recordings. Adair Roscommon is a new and up-and-coming folk musician artist. Produce and Own Pros High return: due to increased risk Lower fixed cost: Record label paid artist no up front payment More control: label owns the rights to determine an artists career choices. Lower recording royalties cost: the record label can underwrite the expense of album production Cons Full risk: Own the rights to exploit the artists music indefinitely, but unknown return. Higher initial investment cost: to launch a new artists career License Partial risk: Right to exploit the artists finished goods for only a predetermined period of time Lower initial investment cost: do not pay the significant upfront investment to launch a new act Higher IRR

Low return: due to lower risk Higher fixed costs: Record label required to pay artist an up front fee (advance) Less control: over artists decisions

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Lower IRR

Higher recording royalties cost: cant underwrite expenses incurred

Solutions Compass Records should license Adair Roscommons finished music. Table 6 shows that the record label will return 60% licensing compared to 29% owning the artists material. Also, Table 6 reveals that licensing the material results in a higher NPV compared to owning the material.
Table 1 Table 2

ASSUMPTIONS Sales projections U.S. sales U.K., Ireland, Europe sales Japan, New Zealand, Australia sales Canada sales Units sold by artist Totalprojected sales (units) Inventory loss Weighted average cost of capital
Table 3

Units 5,000 2,000 1,000 500 1,500 10,000 0.3 12%

Pricing U.S. wholesale unit price Less distribution fee U.K., Ireland, Europe price (euro) Euro/US$ exchange rate U.K., Ireland, Europe price (US$) Japan, NZ, Australia price (US$) Canada price (US$) Unit price for artist-sold units Distribution fee

$11.45 $9.05 EUR 7.00 1.224 $8.57 $6.50 $7.00 $6.00 21%

Marketing and promotion Print advertising Posters and photos E-card mailings Independent radio promoter Retail placement Total marketing & promo cost CD mail-out units Cost per mail-out unit per unit Postage and collateral per unit Total cost for CD mail-out
Table 4

$3,000 500 1,000 2,500 5,000 $12,000 2,000 $0.50 $2.00 $5,000

CASH FLOWS (OWN) Annual percentage sold U.S. forecasted units sold U.K., Ireland, Europe forecasted units sold Japan, New Zealand, Australia forecasted units sold Canada forecasted units sold Units sold by artist

0%

75% 3,750 1,500 750 375 1,125

20% 1,000 400 200 100 300

5% 250 100 50 25 75

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Total sales Cost of goods sold Mechanical royalties Recording-artist royalties Recoupables not recovered Promotion & marketing not recoupable Loss on inventory Upfront fee (advance) Taxable income Taxes @... 40% Net operating profit after tax Change in inventory Change in recoupables Free cash flow Per unit $0.90 $0.85 $1.45

61,023 6750 2,709.38 9,243.75 -11000 $0 $0.00 0 $42,319.50 $16,927.80 $25,391.70 $4,491 9,244 $39,126.45

16,273 1800 722.50 2,465 0 0 0 0 $11,285.20 $4,514.08 $6,771.12 $1,235 2,465 $10,471.37

4,068 450 180.63 616.25 13,675 0 $2,295.00 0 $(13,148.70) $5,259.48 $(7,889.22) $450 616 $9,147.03

-11000 4400 -6600 ($8,471) (26,000) (41,071)

NPV IRR
Table 5

Own

$8,721.47 29%

WORKING CAPITAL (OWN) 0 Assets Inventory, incl. overage @... Recoupables Recoupables Production costs Marketing & promotion (1/2) Advance Total 30% $8,471 26,000 $20,000 6,000 0 $26,000 1 $3,980 16,756 2 $2,745 14,291 3 $2,295 13,675 $15,970

Table 6

CASH FLOWS (LICENSE) APS US forec. Units Sold UK, Ir, Eur, forec. Units Jap, NZ, Aust. Forec. Units Canada forec. Units Sold Units sold by artist Total sales COGS MR

0%

75% 3750.00 1,500 750 375 1,125 61022.63 6750 $5,418.75

20% 1,000 400 200 100 300 16272.70 1800 1,445

5% 250 100 50 25 75 4068.18 450 361.25

Per Unit 0.9 0.85

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RA R REC NR P& M NR Loss on Inv. Upfront Fee Taxable Inc. Taxes NOPAT Chan. In Inv. Change in recoup. FCF License

$1.75 -11000 -3000 -14000 5600 -8400 ($8,471) (9,500) ($26,371) NPV IRR

11,156 $0.0 $0.0 0 0 $37,697.63 $15,079.05 $22,618.58 $4,491 9,500 $36,609.58

2,975 0 0 0 0 $10,052.70 $4,021.08 $6,031.62 $1,235 0 $7,266.87 $14,155.99 60%

744 0 0 $2,295.00 0 $218.18 $(87.27) $130.91 $450 0 $2,875.91

Table 7

WORKING CAPITAL (LICENSE) 0 Assets $8,471 9,500 Recoupables Production costs Marketing & promotion (1/2) Advance Total $3,980 0 $2,745 0 $2,295 0 $2,295 $500 6,000 3,000 $9,500 1 2 3

Table 8

Base Case 8.00% 9.00% 10.00% 11.00% 12.00% 13.00% 14.00% 15.00% 16.00%

WACC NPV OWN $8,721.47 $11,395.66 $10,701.30 $10,024.57 $9,364.83 $8,721.47 $8,093.90 $7,481.56 $6,883.93 $6,300.50

NPV LICENSE $14,155.99 $16,039.66 $15,552.62 $15,076.57 $14,611.14 $14,155.99 $13,710.78 $13,275.19 $12,848.91 $12,431.67

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Table 9

Base Case 3,000.00 3,500.00 4,000.00 4,500.00 5,000.00 5,500.00 6,000.00 6,500.00 7,000.00

US Sales NPV OWN $8,721.47 $1,089.26 $2,997.32 $4,905.37 $6,813.42 $8,721.47 $10,629.52 $12,537.57 $14,445.62 $16,353.67

NPV LICENSE $14,155.99 $8,865.25 $10,227.55 $11,556.96 $12,856.47 $14,155.99 $15,455.50 $16,755.02 $18,054.53 $19,354.05

Copyright 2005 by the trustees of the University of Virginia Darden School of Education