By Simon Glickman

“This whole thing is derived from when I was a film composer,” explains Pandora chief Tim Westergren. “My job was to try and figure out the director’s taste. I would do that by playing songs for them and getting their feedback. Then I’d try to mold that feedback into a profile of their taste. What kind of voices, harmonies, tonalities do they like? Ultimately that’s what they’re trying to capture.”

In case you’ve been holed up in a bunker with your Rare Earth 8-tracks, Pandora is a streaming radio service—available free (with commercials) or in a paid, hi-fidelity, ad-free version, Pandora One—that enables users to create customized stations based on as little as a single song. With one track or artist as a seed, Pandora’s technology provides continuous music that a fan of that initial tune or band is likely to enjoy.

But that technology is fueled by human effort. Rather than relying on collaborative filtering (the “if you like this, you’ll like that” data used by some of its competitors), the firm’s team of music analysts scrutinizes about 10,000 songs per month, classifying them according to hundreds of musical attributes related to melody, harmony, rhythm, form, instrumentation, vocal performance and so on. “We have the ability to take a song no one’s ever streamed or liked or purchased,” hazards Westergren, “and without any data we can make a pretty good guess about where it should go.” User feedback as a station streams provides further information—as songs in, say, a Lumineers station get thumb-rated by Pandora users, the platform constantly refines what songs should go on such a station.

Pandora currently spins more than a million songs in 350 genres, 95% of which are streamed at least once per month. And some 70% of these songs are by independent artists.

Pandora doesn’t champion bands or singles—to do so, Westergren insists, would undermine the custom-station concept. “If I were to tell you, ‘This is the top song on the charts right now, so you should like it,’ that would be the opposite of personalization,” he says, adding that Pandora is utterly blind to popularity, so an entirely unknown act that happens to fit on a Bruce Springsteen-themed station has the same odds of inclusion as a famous one.

And that’s a key advantage of Pandora: discovery. In fact, it’s a top affiliate to iTunes and Amazon, prompting significant purchases by listeners who are introduced to artists by their stations. “We hear a lot from musicians who talk about the Pandora Effect on their careers,” he asserts, noting that bands will trace a spike in iTunes sales to the day they were added to Pandora, or meet new fans at shows who were introduced to them via the service.

But artists don’t have to wait for downloads or ticket sales to realize revenue from Pandora. In fact, the service issues streaming-royalty checks to SoundExchange every month (as well as publishing royalties to PROs), and in 2011 forked over about half its total revenue in performance royalties. The company is at pains to mention that, by contrast, SiriusXM paid 7.5% and cable radio 15%.

While Westergren emphasizes that such royalty payments are one reason the industry should be supporting services such as Pandora, he argues that the way such rates have been calculated (via what he calls a “patchwork of legislative fixes and backroom deals”) puts his company at a disadvantage. “Pandora operates on a completely different standard from satellite and cable radio, yet we compete with them everywhere,” he insists. And since it pays per stream, his firm must expend increasingly large sums as it grows audience—thus potentially becoming a victim of its own success.

Westergren also notes that because Pandora runs “very lean as a business,” royalty pressures tend to slow innovation. “There are so many features we’d like to build that are just a matter of asset allocation,” he says. “Product prioritization is an exercise in frustration—you’ve got 200 things you want to do, and you get to do six.” Still, he believes the situation will improve markedly if some royalty relief follows the arbitration of licensing rates in 2015.

Most of the company’s revenue comes from advertisers, and since the lion’s share of Pandora listening now happens in the mobile sphere, that’s where the ad action is—particularly in the local space (for both local business and national brands targeting specific markets). According to the company, its mobile ad revenue leapt from $25 million in fiscal 2011 to more than $100 in FY2012, place it behind only Google in the U.S. for mobile dollars.

And despite being the second-most downloaded free iPhone app of all time, according to Apple, the service is still a highly targeted, very affordable alternative to the scattershot approach of broadcast advertising for dentists, local grocers and other small businesses. Pandora enables its advertisers to target listeners by age, gender and zip code (“We’d also love to know if you have kids,” Westergren adds), but can also specify musical style. “Some advertisers come to us with a clear idea of what their clients are likely to listen to,” he volunteers. “Most of the time we just have a conversation to figure out the approach.”

Pandora’s myriad partnerships have seen it featured in more than 50 car models (by the likes of BMW, Lexus, Mercedes, Ford, Lincoln, Cadillac, Toyota, Honda and Nissan, among others) and 650+ electronic devices, including gizmos by Samsung (which offers a networked fridge, we shit you not), Vizio, Sonos and Roku. No money changes hands in these deals, but they’ve helped Pandora insinuate itself into virtually every corner of American life. Such penetration has assisted its drive to translate its listenership into dollars at a greater clip.

“We’re getting more efficient at driving revenue per hour, and getting that where it needs to be is the cornerstone of our business,” says Westergren. “We’ve done that on the Web, and we’re catching up to it on mobile.” Between the royalty burdens and the challenge of fulfilling user expectations, he acknowledges, it’s a tough business.

“Hopefully it looks easy and simple to the consumer,” he muses. “But it’s hard to do well.”