Realities of Pandora's business model catch up to IPO

After initially surging out of the gate to $26 in early morning trading, Pandora's highly anticipated IPO ended giving up much of its gains by the close of trading on Wednesday. At the close, Pandora was only up $1.42 -- about 8.9 percent -- from its IPO price of $16 per share.

The music service's results were drastically different than that of LinkedIn, which saw its shares more than double in its first day of trading last month. It should be noted though that the social networking site's shares have given back about half of those gains, but are still trading some 65 percent above its IPO price.

Part of the issue for Pandora may very well be its business model itself. While the company does have a premium service offering, a large majority of its users have signed up for the ad-supported free service, and make up a large portion of its revenue.

Recent SEC filings indicate that 87 percent of its revenue -- or about $119 million -- comes from the sales of ads. While that is no small change, it's nowhere near enough to cover its costs. In fact, in its 10-year history, the company has yet to make a profit.

One of the issues facing the company is royalties. Currently, about 45 percent of all its revenues go just to paying SoundExchange, the group responsible for giving Pandora the right to stream music. It's no secret that the company struggles to pay these fees.

Its founder Tim Westergren regularly complained to the press about three years back how royalties were ready to cause his company to shut its doors. While compromises on royalty agreements have made things easier for companies like Pandora, it's still a struggle to pay those fees.

The key to the future of Pandora -- and any other service like it -- will be how to further monetize their products outside of the money they generate through advertising. So far, few have been able to do that successfully.