Oct 6, 2012 · 7 minutes

At The Wrap’s annual media conference earlier this week, Live Nation’s executive chairman Irving Azoff called Pandora’s $1.8 billion valuation “horseshit” and described the service as “shitty” compared to Spotify. Without being so hard on Pandora, which was an early innovator in this space, I agree with him.

Pandora has been intensifying its lobbying in favor of the proposed Internet Radio Fairness Act, which would cut down the proportion of revenues that Internet radio stations have to pay to copyright holders. The Act would result in a flatter system in which music streaming services would pay the same rates as paid by satellite radio, which right now are about 8 percent of total revenues. Pandora currently pays more than half its total revenues in royalties. While the startup community should root for Pandora’s lobbying efforts, the bill inadvertently highlights the public company’s vulnerabilities.

Under pressure to turn a profit, Pandora is stuck in a difficult position. Cutting the amount it has to pay in royalties is a good start, but that’s not enough. Ultimately Pandora relies on advertising for most of its money. (Its $4-a-month ads-free service accounts for less than 12 percent of its total revenues.) Advertising is a tough way for a public company to make a living.

Pandora’s potential profits will always be at the mercy of marketing budgets, which have been slow to adopt streaming audio as a place to buy. Radio ads have typically been bought and sold locally, which is a challenging market to play in (just ask Patch and Groupon). Worse, the company is struggling to fill its inventory for mobile, which accounts for more than 70 percent of total listening hours. The situation looks particularly dire as it looks like offline dollars are becoming mobile pennies. Making matter worse, the company has been butting heads with the traditional radio world on measurement and verification every step of its journey.

Spotify, meanwhile, doesn’t need to panic as much as Pandora does because it has a broader base of long-run revenue options than does its American rival. (I’m not going to cover MOG, Grooveshark, or Rdio in this article, because I am not as familiar with their services and they have only a fraction of Spotify and Pandora’s user bases.)

Simply put, Spotify is superior to Pandora as both a business and a service. I’m not at all convinced it is worth the rumored $4 billion valuation that CNET has reported, but even with the consternation over yesterday’s report that its losses increased by 60 percent from 2010 to 2011, I believe it has a bright future. What most observers fail to recognize is that Spotify is more than just a streaming service that gives away songs for free in the hope that people will sign up for subscriptions. It is, in fact, building a mini music economy that leverages the creativity of third parties and offers brands a platform to engage audiences beyond just advertising.

Let’s start with the most obvious comparison: advertising. Spotify has that, just as Pandora does, albeit at a smaller scale. For non-subscribers, Spotify inserts an ad every few songs. Pandora has an advantage over Spotify in that the latter doesn’t have a browser version or a free smartphone app (well, technically the app is free, but you have to be a subscriber to be able to listen to songs on it), and in that it sells video spots. But Spotify’s music library is more expansive (16 million songs versus not quite 1 million), more up-to-date, and its users more international, so it is likely to be able to match Pandora as an ad magnet in the long run. (My colleague Erin Griffith wrote about Spotify's ad challenges and opportunities yesterday.)

When it comes to subscriptions, Spotify offers far more compelling reasons for users to upgrade. Its $10-a-month premium service lets users play songs on the mobile app and offline, which effectively makes it an iTunes competitor. Pandora has no such offline mode, which is a major handicap. For example, I tried to use Pandora on my iPhone while on the train from New York to Baltimore the other night. Even though I had a reasonable WiFi connection, Pandora told me its service wasn’t available in the country I was in. On the train is exactly where I like to listen to music.

Then there’s Spotify radio feature. This is what makes Pandora’s problems obvious. Spotify’s radio feature is not only excellent – automatically creating playlists based on individual songs – but it also achieves the entirety of what Pandora does. That is to say, Spotify’s Pandora-like feature is just that: A feature. Pandora, on the other hand, has staked its whole company on it.

Spotify Radio is better than Pandora, too, because it ties into the user’s library, which is the centerpiece of Spotify’s service. That means whenever you “like” a song you encounter on Spotify Radio, that track gets automatically added to a playlist in the library. That two-way system makes the choice between the two services easy for any serious music fans – and they’re the ones who spend money on music and its peripherals.

The true killer aspect of Spotify’s business model, however, is its platform. And this is where Pandora is so far away from Spotify that it hurts. Spotify’s platform, through which third-party apps are offered, is only in its infancy, but it is already a serious experience-enhancing feature. One day it could be a serious money maker too. It closes the loop on a music consumption ecosystem in the same way that iOS does for iPhone apps and Facebook does for social games.

We’re in the very early days of the platform. I know many sophisticated Spotify users who aren’t really aware of the apps. Spotify surely hopes to change that. But to people like me who do use the apps, the value is obvious. For example, Pitchfork’s app – which lets you read reviews and add albums and playlists to your library with just one click – adds another dimension to the experience and improves discovery. Another favorite of mine is Songkick’s app, which scours your library and then alerts you whenever one of your favorite artists is playing a gig in your area.

Both those apps are free, but it’s not hard to see paid versions coming one day, which would open up revenue opportunities for both Spotify and its platform partners, including artists, labels, and promoters. If paid apps don’t come, it could always make money by taking a cut of revenue from in-app purchases, such as Facebook does with Zynga. The service has already got the ball rolling on branded apps, too, with a partnership and vote of approval from Coca-Cola, one of the biggest advertisers on the planet.

On the other hand, Pandora does have some considerable advantages over Spotify. It has broader brand recognition in the US, making it a mainstream favorite. Even if it can't beat Spotify on technology or scope, that entrenched popularity might be enough. After all, the best technology doesn't always prevail – just look at Betamax versus VHS, or Tesla versus Edison.

For many people, Pandora is already the default music app on their smart TVs and in cars, but that dominance will depend on how low the barriers to entry are in those devices. In a sense, Pandora exploits the market’s laziness by delivering a total no-brainer music experience at the touch of a button. Spotify requires a little more work on the part of users, who have to seek out the music they want to listen to – unless they just turn on the Radio function.

Pandora also has more users. As of July, it had 55 million active users (out of a total of 150 million registered users), compared to Spotify’s 15 million. But Pandora has been around for a while. Spotify is six years old and has only been in the US since July 2011. Pandora was founded in 2000 and definitely feels like the older cousin. Its problems are broader than just the burdensome royalties. Its problems are that of an early Internet company with serious legacy baggage that is being out-innovated by a savvier rival.

The revelations of Spotify’s mounting losses point to serious problems for the company. But for its rival, the situation is much more grave. For Pandora, the passage of the Internet Radio Fairness Act could be a matter of life or death. And that’s an extremely uncomfortable position for a public company to be in.

[Illustration by Hallie Bateman]