Offering a free, ad-supported tier has been key to Spotify (NYSE:SPOT) becoming the leader in music streaming, representing a funnel of users that the company works to convert to premium subscriptions. While that business is less profitable -- it had a 15% gross margin last year compared to the premium segment's 27% -- Spotify has an opportunity to improve profitability as its ad business continues to evolve.

In no uncertain terms, much of Spotify's financial future will hinge on the ad segment.

Reception area of Spotify headquarters

Image source: Spotify.

New ad products to drive ad sales

Spotify has been talking up the potential of its two-sided marketplace strategy for years, and the company has only recently started to really expand on that effort. One of the tools that Spotify will provide to artists trying to connect with listeners is called Marquee, which lets artists pay to promote their music, sponsor recommendations, and notify users when a new album has been released. Marquee has a minimum suggested spend of $5,000.

Importantly, this type of ad revenue would carry higher margins compared to the long-standing ad-supported tier. When free users listen to ad-supported music, Spotify has to pay the associated per-stream royalties and then monetizes that engagement with ads. These types of ads don't carry those costs, and essentially represent ad revenue that Spotify can bring in before the royalties start to kick in.

Chart showing Spotify ad revenue

Data source: SEC filings. Chart by author.

Bloomberg notes that Spotify is already pitching another similar tool to record labels and artists, although details are scarce. Spotify's licensing agreements also grant record labels a portion of all revenue, including ad revenue, according to the report. The Swedish company typically keeps key aspects of those deals close to the vest, so that revelation is quite significant to Spotify investors. The good news is that both Spotify and the labels reportedly concur that the arrangement doesn't make sense and are working toward restructuring the terms.

Spotify has even reportedly considered selling access to user listening data, which sounds similar to Twitter's data licensing business (also affectionately known as its "firehose" segment). That trove of data is one of Spotify's greatest competitive advantages because it feeds the content discovery algorithms that set it apart from rivals.

Favoring the big players?

Marquee isn't without criticisms, though. There is a fear among smaller artists and independent labels that paid promotions like Marquee will tilt the playing field in favor of larger artists and companies that have deeper pockets and can afford to pay. Dominant labels and the artists they represent could siphon engagement away from independent players, depriving them of royalty revenue in the process.

Labels have to pay Spotify $0.55 per click, according to Rolling Stone. That would translate into an additional 9,000 listeners per $5,000 spent. Spotify argues that paid promotions are already common throughout the rest of the music industry, so bringing those types of ads to its tech platform isn't some type of sea change. Spotify exec Beck Kloss told Bloomberg that approximately 25% of users who see a Marquee add choose to listen to the promoted content, calling it "one of the most effective digital marketing tools available."