"Famous Last Words"

The Common Case of Missing Royalties (February 2006)

Dear Jim:

My studio was the developer of one of the biggest console hits of 2004. To put it politely, we are disappointed with the royalties we have received.

Any suggestions on how to better protect ourselves in the future?

Dear Famous:

First of all, congratulations on your success! Developing a top selling game is one of the most difficult achievements in the entertainment industry. It says a lot for the talent, work ethic, and vision of your team.

Here are a couple of thoughts regarding the shortfall of your royalties:

1. Royalty rates specified in development contracts are never what they seem.

Remember that you are paid based on “net sales.” If, for example, the contract provides for a 20% royalty rate, and the game has a wholesale price of $40, you will not receive $8 per unit.

Calculation of what constitutes “net sales” is one of the most heavily contested issues in development deals. Publishers will be looking to deduct such items as sales costs, commissions paid to reps (and sometimes in-house sales staff), freight costs, cost of goods (the cost of building the game, or purchasing inventory from the console manufacturers), platform royalties, and in more extreme cases, marketing costs, dealer advertising, promotion costs, trade show costs, and other marketing expenses.

Deduction of all these items can quickly reduce that 20% royalty to an effective rate of 12% or less.

When negotiating the definition of “net sales,” it is not unusual for the publisher to argue that the formula is fixed and cannot be varied because of the accounting practices of the company. You can decide whether you will accept this position.

In any event, it is good practice to request a pro-forma royalty accounting so you can see how the wholesale price will be reduced when typical costs are deducted.

Once you have a realistic understanding of the effective per unit royalty rate, you may decide to fight for a higher starting rate. For example, in the case above, if you had a contract rate of 30% rather than 20%, you would end up closer to the anticipated rate of 20%.

When large cost areas are deducted from the invoiced price to arrive at a reduced “net sales” figure, a more accurate description of the royalty should be a percentage of “net profit” rather than “net sales.” When a developer is being asked to share in net profit, it is not fair or appropriate to expect the developer to assume a full burden of recouping 100% of development costs from its share of “net profits.”

2. One further deduction from royalties is a reserve for returns and markdowns.

We know that all games shipped into retail do not sell for their full price. Some may be returned as defective. Some may be marked down to a lower price in order to sell them through.

Publishers pay royalties based on the actual price they receive from their customers (adjusted as described above!).

Therefore, at the end of a calendar quarter, royalties will be calculated, but a portion will be withheld by the publisher and placed in a “reserve” account in the event games are later returned or marked down. The reserve is applied against the markdown so that the developer receives only the amount that would be due based on the actual sales experience of the publisher.

Reserves language can be negotiated in a development deal. There are two issues with which to be concerned.

The first is the maximum amount of reserve that may be withheld in any quarterly accounting period. Publishers will prefer to be permitted a “reasonable reserve;” but this is too ambiguous for the developer.

When pressed, maximum reserves of 15%-20% in any quarter can generally be realized.

The second issue is the liquidation schedule of the reserves. If there are no markdowns or returns, at what point is this money paid to the developer (remember, it is the developer's money that is being held!).

Publishers may prefer to hold onto the reserve for as long as possible, but it is reasonable to expect some partial liquidation as soon as the first accounting period after a reserve is taken. To the extent a reserve is not liquidated by returns or markdowns, it should certainly be fully liquidated within one year after it is taken.

When reviewing your accounting statements, do not forget to look for liquidation of royalty reserves!

3. A royalty audit may be justified.

In your circumstance, if you understand the effective royalty rate, return reserves do not explain the shortfall, and you believe the game should have generated more income to your studio, it may be time to consider a royalty audit.

Audits are very common in the motion picture and recorded music industries. While less common in games, we are seeing more and more developers examining the books of publishers looking for money. And while my information is strictly anecdotal, in each instance of which I am aware, developer auditors are finding it!

Audit rights are negotiated as part of development deals. The issues of which to be aware are for how long audit rights will continue, who may audit, and who pays for the cost of the audit (it is not cheap!).

Every deal has what is known as a “statute of limitations” or “sunset clause” on audit rights. That is the time period during which the developer may audit the books of the publisher.

Game deals generally start at one year or two years from the date a statement is due; and can sometime be stretched to three years or more from the date a statement is received. The developer must audit designated royalty statements within the agreed time period, or the right may be lost.

Because an audit can be expensive, it makes sense to audit multiple statements at one time. If your development deal has a two year sunset clause on audit rights, and your game was a big hit in 2004, I'd advise you to consider pretty quickly whether to go in and conduct your inspection. Failure to do so may cause you to lose the right.

There is one way to get around the statute of limitations on audit rights. If you can allege fraud in the failure to account or provide accurate statements, a court may permit you to go back beyond the time limit set in the agreement. However, showing fraud may be difficult and the court must agree with you before it will disregard the time limits in your deal. It is best to proceed during the agreed upon calendar period.

The second issue to consider is who may audit. Many first drafts of publisher development deals require that the audit be conducted by a Certified Public Accountant not engaged on a contingent fee basis. I view this and similar language as an attempt to narrow the audit rights of developers. Many fine, professional, experienced royalty auditors are not Certified Public Accountants. There is no reason to limit who can be selected to represent the developer.

Publishers do not like to see auditors working on a contingent fee basis (ie, auditor is paid if money is found). They characterize such audits as “fishing expeditions.” Many highly qualified royalty auditors will not work on a contingent fee basis. But I believe the compensation issue between auditor and developer is none of the publisher's business. These sorts of limitations should be resisted when development deals are being negotiated. For a poor developer, an audit conducted in a contingent fee basis may be the only alternative.

Many development deals provide that if any audit turns up shortfalls greater than 5% or 10% of royalties paid, the cost of the audit will be paid by the publisher. Be sure this language is clear.

Royalty audits can be costly. It is critical to engage a qualified professional auditor who has experience with royalty accounting issues. You will only get one bite of the apple to audit any statement. It is of the greatest importance that it be done thoroughly, accurately, and professionally the first time.

Royalty accounting auditing is a specialty. Take your time to interview candidates for the task at hand. Research the field. Ask your colleagues and professional service providers for recommendations. There are specialists who should be considered.