Not since the emergence of YouTube has a website generated as much buzz as Spotify. The music site is home to four million songs, which visitors can select and listen to at will, as long as they can tolerate an advertisement every 20 minutes or so.

But can it turn a profit? With YouTube itself balking at royalty deals in the UK and Germany, seemingly because it cannot generate enough advertising to pay for all the music it streams, Spotify faces a real challenge. This month Spiral Frog, another once-hyped ad-funded music site, quietly went under.

The Spotify plan, though, is to diversify and to cobble together as many revenue streams as it can, beginning with radio-style ad breaks and display adverts, coupled with a subscription alternative for those who want to switch off the ads. But given that only a tiny proportion of people tend to pay a subscription, it is hard to believe that that will generate much cash.

So, this week the Swedish start-up did a deal with 7digital, the fledgeling download site. Anybody listening to a track on Spotify through their computer will be given the option to pay to download songs from 7digital.

Spotify will take a cut of the price of every download, though it would not reveal how much. A spokesman said that the deal was not exclusive, and “the door was open” to make similar partnerships with other download sites. This could add up to a viable competitor to Apple, which is on the verge of allowing some of its prices for songs to increase to $1.29 (87p).

However, with so much available to be streamed, Daniel Ek, the co-founder, says that alternatives are needed. He talks about a tie-up with the musicians that could prove attractive to advertisers. “We're talking to artists to become integrated within the advertising,” Mr Ek said. “They will speak about the message for a brand.”

Certainly, with YouTube and Google, its parent, being increasingly criticised by artists (led this week by Billy Bragg, the veteran protest singer) in a royalty row, there is an opportunity for Spotify to become an artist-friendly site. Sources at the PRS (formerly the Performing Rights Society), which collects songwriter royalties, hint that a deal could be struck soon.

With a founder's zeal, Mr Ek says he believes that the company is on course to turn a profit by the end of the year, emphasising the merits of targeted advertising, as users have to register for the service. “With Spotify, you know exactly that you're reaching the 20 to 25-year-old in London that's listening to cool and hip music. That is something certain brands might want to be associated with.”

Perhaps. Targeted advertising has been heralded as the saving grace of clever internet start-ups for years. The “freemium” model — offering internet services to users for nothing, instead paying for itself indirectly, such as through advertising — has looked increasingly unworkable, particularly as advertising dollars have dried up.

Spotify began life in 2006 when Mr Ek and Martin Lorentzon, a fellow entrepreneur, invested about 80 million Swedish kronor (£6.8 million). There was some additional investment from other backers. Mr Ek is a former executive at Stardoll, a website aimed at teenage girls, and Mr Lorentzon is the co-founder of TradeDoubler, an internet marketing company.

But if Google and YouTube have a rethink — and with £3 billion of profit last year, they can afford to — it faces a battle. Despite YouTube's problems in Europe, Google launched an online music service in China on Monday, offering hundreds of thousands of track licences from the four music majors — a big intervention in a market that Spotify would otherwise hope to colonise.

One music executive predicted that “Spotify will be bankrupt in a year”. The gloomy prognosis is hardly helpful. The music industry desperately needs legal business models to succeed and, so far, only Apple has. It is not clear that the industry can afford Spotify to fail.

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