I was talking to an executive at a major label the other day. We were talking about startups and he noted that they either sue these companies out of business or legitimize them out of business. That is not far from the truth. How many legitimate, standalone digital businesses can you name that rely on licenses from the labels for their primary business and are profitable? Let’s categorize by business model:

E-Commerce/Transaction-based: iTunes immediately comes to mind. It may be profitable on its own, but we all know that Apple’s main business is to sell iPods and now iPhones. eMusic is the other one, and I think it has a real business on its hands — of course the vast majority of its repertoire is non-major label.

Music Subscriptions: This segment is dominated by Rhapsody and Napster. Neither is solely a music subscription service, but that’s what both are best known for. At any rate, neither is profitable. RealNetworks’ music business lost $1.9 M in the second quarter of this year. Napster? Well its stock chart kinda says it all; it’s currently trading for a little less than the cash it has on its books.

Ad-Supported Music: This includes on-demand audio and video and also Internet radio. The major players here are the radio divisions of companies like Yahoo, AOL, CBS (Last.fm and CBS Radio), MTV, Clear Channel, MySpace, Facebook and then independents like iMeem, Last.fm, Pandora, Live365 (my alma mater) and a number of others. It has been widely reported that the standard license for on-demand consumption is $0.01 per play, which amounts to a $10 cost-per-thousand plays, not including other costs such as publishing, bandwidth/streaming and ad sales and serving costs.

In short, I think its very hard for any of the ad-supported players to build a meaningful basis from licensed music. Instead, many of the larger players will use it as part of a larger strategy to attract audiences and offer related products that generate higher-margin revenues. For instance, Clear Channel might have a sponsor for its Stripped series, which will probably not have the same license cost as a regular music video. Or MySpace will sell an ad campaign around an event that it hosts. As for Internet radio, there is a lower royalty rate, but the CPMs are lower, too. Pandora’s founder was recently quoted as saying the service may have to throw in the towel if things don’t change with the fee structure. iMeem has licenses from several labels but it’s been reported that it gave up a significant piece of the company and agreed to onerous terms, so, needless to say, it likely isn’t profitable on its licensed music either.

This is by no means a comprehensive list of business models nor of the companies within each segment, and there may be companies within each that are profitable. But that’s beside the point.

The point is that the labels have been lulled into the conviction that their rates are ‘market’ since some of companies have been willing to pay such rates to license music as a loss leader. The labels have been penny-wise and pound-foolish in cutting deals with seemingly lucrative rates. However, that is not the recipe for a vibrant, competitive ecosystem of licensees large and small, with no one company having too much market share — which is exactly what I’d want if I were in their shoes.

The good news is that I know this has been recognized by people with the major labels, and they’re experimenting with new licensing schemes. Hopefully it’s not too late.

Raghav “Rags” Gupta is VP of International Partnerships at Brightcove, where he has worked since ‘05. His blog can be found at www.ragsgupta.com.