Negotiating Development Contracts
by Alan Behr and Katherine M. Wallace
Although console manufacturers and the major game publishers have in-house game development talent, independent development studios remain the core creative force of the entertainment software business. When entering into a licensing relationship with a game publisher, the development studio, together with its attorney, must address unique financial, marketing and legal challenges. This article addresses the situation in which a development studio retains the copyright in its game but licenses the publishing and related rights to a game publisher for a specified territory and a specified duration. The publisher, in turn, either publishes the game for play for the PC or for one or more game consoles. In the latter instance, the developer will have received an software development kit from the console manufacturer and the publisher will have been accepted as an authorized third-party provider of software for the console.
Financial Considerations
Developers generally seek to enter into a publishing contract as early in the development process as possible because, once a publisher is on board, the fare for the ride from concept to gold master is customarily borne by the publisher in the form of an advance—really a loan repayable solely from future acquired royalties. The first financial challenge for the developer will come if the publisher should demand that the developer use all advance payments directly for the actual costs of the game being developed and not for the general overhead of the development studio. If the developer agrees to those financial conditions, not only will the developer show no profit until the game recoups the amount of the advance (and the publisher at last begins making royalty payments), the developer also may find itself unable to meet general operating expenses (rent, electricity, telephones) while waiting for the first royalty check. As a result, a development studio without multiple (and successful) projects, and with only a lean advance, can quickly find itself in financial difficulty. (The alternative—self-financing in exchange for greater creative control and potentially higher royalties—increases risk to a level that most smaller, independent developers hope to avoid.)
To add insult to injury, because few games actually earn back their advances and harvest additional royalty payments for the developer, the initial advance provided by the publisher may be all the money the developer will ever receive for its troubles. The developer should therefore attempt to build not only coverage for overhead, but also a measure of profit into its advance for each project.
A developer can further limit its financial exposure by having the publishing contract provide for payment to the developer in the event that the project is canceled during development. Payment would be in the form of a kill fee, meaning a specific sum paid on cancellation. A typical kill fee is the amount due under the contract on completion of the milestone currently in production, as well as the subsequent milestone. (Milestone schedules are discussed in more detail below.) A developer also can seek to include a turnaround clause, allowing the developer to “shop” a canceled project to other publishers. In fact, the subsequent deal—made when the development of the game is further along—is often richer for the developer than the original one.
It is to the royalty percentage that developers usually devote their greatest financial attention, but that can be a mistake. The developer typically will be compensated with a royalty based on a percentage of net receipts. While the developer of a computer game usually can expect royalties of about 20 percent to 25 percent of net receipts, top developers can command 30 percent to 35 percent, and sometimes more. Console-game royalties generally are lower because three parties—developer, publisher and console manufacturer—are involved and because console manufacturers, who need to make up on software the losses they suffer in selling consoles at below manufacturing cost, end up with a healthy piece of game-unit revenues.
The problem is that just about everyone defines net differently, often with vastly different financial consequences. The game business, however, is not as bad as Hollywood, where studios have deducted so much from gross profits to cover expenses that even successful films have failed to show a “profit” for contract purposes. Fair and reasonable deductions from gross receipts include the cost of goods, shipping and insurance. Red flags in a publisher’s form development contract include the deduction of cooperative advertising expenses from net receipts and deductions for the value of an unlimited number of promotional or giveaway copies. Developers also should beware of rights asserted by publishers to give credits to their customers rather than to take payment; the net effect could well be that the developer gets nothing for those sales. (A good way to keep from being surprised by what a publisher may consider deductible is to have an agreed-to form of royalty statement attached in blank to the license agreement.)
A related issue is a reserve for returns. Though many copies may be shipped to stores, few may be bought by gamers. The publisher therefore will rightly insist that it withhold a portion of royalties to cover for the likelihood that much of what it “sells in” at retail may not “sell through” to consumers and may instead be returned. The question is, what does a license agreement mean if it provides only for a “reasonable reserve” for those expected returns? Is 10 percent enough? A publisher may insist that even 40 percent doesn’t represent its true returns figure for certain types of games. The developer and its counsel should ask themselves whether a high returns reserve proves that the publisher is willing to take risks to build hits, that the publisher simply kicks product out the door whenever it needs to puff up the bottom line or issue a press release, or that the publisher’s lawyer was just hoping no one would ask. Whatever the reserve, the developer should counter that it be liquidated within a prescribed period. An annual liquidation is customary.
Development Schedule: Milestones
Delivery of the game is typically made in accordance with a multiphase development plan articulated in the publishing agreement, most commonly structured in the form of a milestone schedule. There are customarily between eight and 15 milestones. While the first milestone is often the execution of the agreement itself, each subsequent milestone will likely be for delivery of game work product, each to be presented to the publisher by the developer for comment, approval and payment.
Although well-written milestone schedules are rarely identical, there are certain standard deliverables that most milestone schedules contain. One is for the original design document, which outlines the story, method of play, objectives, puzzles, level design, technical capabilities and specifications, and which contains preliminary artwork. There also may be a subsequent milestone for delivery of a prototype, which consists of a small segment of the game in its earliest, minimally playable form, filled with placeholders. Indeed, in a prototype-based deal, the balance of the milestone schedule may not even be agreed on (and the project given the green light) until after approval of the prototype. Whatever the structure of the milestone schedule, the last three milestones will almost invariably be carefully defined: the alpha, beta and gold master versions. The alpha version will likely be the game in a form that is more than 95 percent complete; some levels and details will be incomplete, however, and the version likely will contain bugs. The beta version must have the game in a form ready for full quality assurance testing. Any major bugs in the beta version must be closed prior to the delivery of the gold master for distribution and sale. Given that the elimination of all bugs is almost impossible, it is important for the developer to ask for the contract to state clearly what constitutes an unacceptable bug for the purposes of quality assurance testing.
When agreeing to the milestone schedule, a developer should set realistic goals for itself. That is because the publisher will almost certainly have the right to consider any unexcused delay in delivery to be a breach of the publishing contract. Publishing contracts sometimes provide for a pocket veto, whereby the publisher’s failure to approve a deliverable item (even if delivered on time by the developer) has the same effect as an explicit rejection by the publisher.
If the publisher rejects a delivery, the developer must resubmit the deliverable for that milestone, potentially placing the project behind schedule and further delaying the developer’s receipt of crucial advance payments. It is therefore in the developer’s interest to press for a milestone schedule that pushes back the deadline for all deliverables in the event of reasonable delay caused by the need to rework and resubmit any deliverable due to its rejection. Just as important is a provision in the contract requiring the publisher to accept a particular deliverable (where appropriate) based on an objective technical standard, or at least a standard based on reasonably acceptable commercial standards.
Sequel Rights and Later Projects
The fact that this is an industry that can announce a major title called “Final Fantasy XI” without a trace of irony indicates how important sequels are to the market. The developer may take the position that it should retain sequel rights. The publisher will likely counter that having spent the time and money to launch a title good enough to warrant a sequel, the publisher deserves the right to participate in the revenue, regardless of whether it is ultimately the publisher of the sequel.
The parties may agree to a provision whereby either of them would have the right to call for the creation of a sequel and give the other an opportunity to participate financially under each of the following contingencies: The developer makes the sequel and it is published by the original publisher; the developer makes the sequel but another publisher picks it up; or another developer makes the sequel but it is published by the original publisher. An alternative arrangement would be to grant a limited sequel option to the initial publisher, one that would expire within a certain period of time following the release of the initial game. The contract also should consider the potential that the publisher will seek the rights not only to a sequel or two, but to an entire franchise arising from a hit game.
Related to the franchise question is the broader issue of later projects. As in the music business and the book-publishing business, entertainment software publishers often take the position that they are investing in talent, not merely a particular project. There is logic behind this: Consumers generally don’t choose games based on the publisher’s brand any more than they choose music recordings based on the record label or select books based on the publisher’s imprint. (One notable exception is the EA Sports brand, which generally means more to consumers than the names of the development studios that create the titles.) For that reason, a developer receiving its first contract from a publisher may be surprised to find a clause that gives the publisher first dibs on one or more future projects, even if they are not part of the instant product’s franchise. At the least, the developer should insist that future projects will have advances appropriate for the specific work required to develop them.
Cross-Collateralization
If the publisher expects multiple releases, either through different versions of a game or through sequels or later projects, it may ask that royalties from most or all of them be “cross-collateralized.” That odd term of art, sounding as if it more properly belongs in a contract of indebtedness, could, at its worst, make the developer’s employees feel that they have become debtors of the publisher. Cross-collateralization means that royalties for one project that has earned back its advance may be used to recoup advances on another project that has not yet earned back its advance. The strongest kind of cross-collateralization clause makes every game in every version “fully crossed.” In theory, a developer that is steadily delivering games for a publisher could find itself being paid nothing under such an arrangement, because royalties that would have been paid to it for games that have been on the market for some time will instead be applied toward the recoupment of advances for games that have just been released.
The solution for the developer is to gain at least a partial uncrossing. For instance, the developer could take the position that once sales of a game have allowed the publisher to recoup the advance for it, royalties from that game should no longer be applied toward any other advance. In that way, a developer with one game that is earning royalties and two that are not may continue to obtain royalties from the one game that is in the black. There are other possible compromises, but the main lesson to be learned from cross-collateralization is that careful drafting and knowledge of the financial implications of what has been drafted are the best protections against later disappointment.
Copyright, Trademark, Advertising and Packaging
In a license agreement of the kind discussed here, the developer will retain copyright ownership, but it may be asked to cede to the publisher the trademarks in the game. If the developer owns the copyright in the game itself and the publisher owns the trademarks (for the title, logotypes and characters, among other elements), things can get murky—and, if there is a creative or business disagreement, things can get ugly—if the agreement does not clearly delineate the rights of the parties.
When it comes to packaging, advertising and public-relations issues, it is nearly always the publisher, rather than the developer, who has the final word. The publishing contract also may restrict the developer from issuing press releases about the product without prior approval by the publisher. The contract may further provide that key development personnel must be available for promotional activities arranged by the publisher. These small but potentially sticky issues—being more personal in nature than others—should be given due consideration by the developer and its counsel, even if, at first blush, they don’t appear as important as issues directly affecting revenue.
Conclusion
Negotiating a workable development contract is critical to a development
studio that hopes to reap financial rewards commensurate with its hard work.
Careful drafting and consideration of all the issues prior to signing an
agreement can help a studio avoid unnecessary risks and allow it to concentrate
on the important task of developing games.
Authors' Bio
Alan Behr, counsel in the New York office of Alston & Bird, focuses his practice on intellectual property and entertainment law. He is a member of the firm’s IP-Transactional and IP-Trademarks Groups and is former chief legal officer at GT Interactive Software Corp. (now known as Infogrames), a computer game publisher. Telephone: (212) 210-9400; email: abehr@alston.com. Katherine M. Wallace is an associate in the Atlanta office of Alston & Bird and focuses her practice on intellectual property law. Telephone: (404) 881-7000; email: kwallace@alston.com.
The opinions expressed in this article do not necessarily represent the IGDA.