For some music fans, it was a week that belonged to the Fab Four. After a slick campaign to promote a digitally remastered collection of the group’s albums, it felt as if Beatlemania had never been away.

For the younger generation, a launch of another kind provoked the sort of excitement usually reserved for rock stars. Spotify, the digital music service that provides millions of songs free, made its debut on Apple’s iPhone. Customers of the year’s hottest internet start-up can now listen to its music on the move — they no longer need to be tied to their desktop PCs.

The Beatles’ return showed the music industry can still create a headline-grabbing event with a CD release, charging £170 for a box set of music that is getting on for five decades old but can still make the charts. Instead of looking back, record labels struggling to cope with rampant internet piracy are hoping that Spotify is the future — particularly if it can break Apple’s dominance of digital music and give youngsters making illegal downloads a reason to obey the law.

Unlike the Beatles, Spotify, which was launched in Britain less than a year ago and has 2.5m registered users, is struggling to make the hype pay. Set up by two Swedish web entrepreneurs, Daniel Ek and Martin Lorentzon, Spotify — the name is a blend of spot and identify — hoped to sell advertising slots to fund a free music service and persuade enough users to pay a monthly £9.99 fee to dodge the ads.

However, Spotify has been a victim of its own success, with most users happy to listen to the ads rather than trade up. It is a familiar story. “So far, apart from Apple with iTunes, nobody has really managed to monetise the switch to digital music,” said Frederic Court at Advent Venture Partners, a finance firm.

“The high-traffic websites focused on music, such as Last.fm [acquired by CBS] or iLike [acquired by MySpace], have found it very hard to turn this vast usage and audience into cash through a model based predominantly on advertising.”

Industry observers calculate that Spotify streamed 700m free songs in July, at an estimated cost of $5m (£3m). That rises to $6.5m when overheads and the payment for internet bandwidth are added in.

Set against that, advertising income has been slow to materialise, standing at perhaps $100,000 (£60,000) in July. Despite 2.5m UK users, as few as 10,000 are subscribers, giving Spotify another £100,000 of income. The company would not comment on the figures.

Some record labels get paid for each subscriber, instead of each song, depending on take-up, but it is easy to see why the doubters may have a point.

“From a start-up perspective, things at Spotify may look quite bleak,” said one executive at a music group that has licensed songs to the company, “but if you analyse the trends of what they are doing to convert listeners to subscribers, you can see they are doing an exceptionally good job.”

If they never sell another ad, record labels think Spotify can break even if 10%-12% of its listeners switch to a subscription. Factoring in advertising income, too, brings that proportion down to 5%-7%.

That may sound ambitious, but in some territories record labels say Spotify is already closing in on that level. In Spain, for example, an estimated 4%-5% of listeners have converted. Spotify is also showing promise in becoming a significant alternative to Apple, which accounts for 75% of all digital music sales.

In Spain, it is believed to already have more paying customers than iTunes, Apple’s download store. Selling more advertising has made Spotify’s commercial breaks longer and more intrusive, giving users another reason to trade up.

Crucially, the music industry is willing it to succeed. “Getting more premium subscribers is one of the keys to establishing themselves,” said Ariel Sommer, vice-president for digital sales at Sony Music in Europe.

The four biggest labels — Universal, Sony, Warner and EMI — took a collective 16% stake in the business early on, in lieu of licence fee income.

The quartet was diluted in Spotify’s last funding, when Wellington Partners, the venture-capital firm, and Hong Kong tycoon Li Ka-shing’s charitable foundation stumped up $50m in a deal that valued the business at close to $250m.

The idea is that the fresh funds will take Spotify to break-even but also help it launch in America early next year.

Upstart technologies often need the deep pockets of an established player to realise their potential. In the hope that the government’s new legislation will crack down on digital pirates, HMV paid £7.7m for a 50% stake in digital music provider 7digital this month.

Eye-catching events such as the Beatles’ relaunch cannot stem the tide of a decline in income from CDs and music DVDs, which fell 8% to £856m in 2008, according to figures from BPI, the music-industry trade body. Digital sales rose 48% to £106m, but the overall pie shrank 4% to just under £1 billion.

Gaining access to the iPhone was a key step forward for Spotify. Listening to music on the move is only going to be available to premium subscribers, making its launch a key test of whether consumers are willing to pay, not for something they can source free on illegal file-sharing sites, but for a service they like.

“Spotify will never make me go totally legit because it will never have everything,” said Steven, 16, who used to download 200 songs illegally every week. Last Monday he paid £111 upfront to listen to Spotify on his iPhone for the next year — revenue that otherwise would not have reached the music industry. He added: “I usually go to Spotify first now to find a new song instead of hunting round the internet. It is almost like a third way between the CD and MP3 music file.”

Record label bosses are encouraged by Spotify’s progress. “The mobile application is probably the biggest and sharpest weapon they have in their armoury now, but it is not the only one,” said an executive.

Ek, Spotify’s chief executive, is aiming to bring out services shortly that are compatible with the BlackBerry, the Symbian operating system and Google’s Android platform.

“We have a plan to grow the number of subscriptions over time, but also have a great ad-supported product,” said Paul Brown, Spotify’s UK boss, who insisted it is still early days for the company. “We are keeping pretty much to plan.”

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