"Famous Last Words"

Royalty Calculations (January 2008)

Dear Jim:

When we made our last game dev deal, the first for us with royalties, we never expected to actually recoup. Last month, the first royalty statement was received. Now we realize, fully, how much of a long shot it is to ever hope for royalties.

In reviewing the statement, even for games selling at full price, the per-unit royalty is much less than we expected.

And it does not look like we are getting paid for all sales.

We understand that promo copies and our studio samples do not earn royalties. But why is the per unit royalty so low? And don't they have to pay us for all copies of the game that are sold?

Unnamed Studio Lead

Dear Unnamed:

Royalty statements are complicated and best read with help from your games industry experienced accountant or lawyer.

Royalties are not paid on all sales – but only on what is known as “net sales” or “net receipts.” This is a number that is calculated by taking deductions from sales to reduce the number to the amount from which your royalty is calculated.

Examples of deductions (and these are significant) include sales costs, commissions to sales reps, dealer advertising (commonly referred to as “MDF”); freight, warehouse costs, cost of manufacturing the game (often called “COGs” or “cost of goods”), platform royalties to the console manufacturers, third party royalties to content licensors, discounts, markdowns, price protection, and in the more extreme cases, general marketing costs and publisher overhead.

Each publisher has its own formula. Each will tell you this is standard and no deviations can be made.

Generally, the only thing I believe is critical in a definition of “net receipts” or “net sales” is certainty. In the end, so long as you understand how “net” is calculated, and there is no wiggle room for surprise publisher deductions, you can negotiate your royalty rate accordingly.

If there are more deductions, the percentage rate should increase. At some point, to be fair, when publishers are looking to deduct costs that are actually marketing and overhead expenses, we are beginning to move toward a “net profit” number rather than “net sales.” If a developer is to share in “net profit,” the royalty rate should be significantly higher, and a strong argument can be made that development costs should actually be a deduction from sales, like all the other costs, rather than fully recouped from the developer's royalty account. But that's a topic for another day.

Here are a couple of suggestions that may help improve the royalty outlook in future projects:

1. Be careful when reading the “net sales” or “net receipts” language.

Recently, I have come across definitions that contain clauses like “such as, but not limited to” and “and not in limitation” when listing deductions. This sort of open ended language could permit adding additional unnamed deductions to the list that further reduce the amount from which royalties are calculated. There is no certainty when the definition is open ended. And an open ended definition may severely undercut the developer if it ever comes to a royalty audit. In the case of this key definition, certainty is critical.

2. Before you agree on a royalty rate, ask for a “pro forma” royalty statement. This is an example that shows how your publisher calculates royalties. Make sure you understand all the deductions. This can help you arrive at a working number that can approximate net. It can be very useful in understanding the economics of your deal. Of course, this information is confidential information of your publisher and is not to be shared.

3. Be sure you understand the “royalty reserves” language.

Publishers do not calculate and credit royalties on all unit sales. In most contracts, there are provisions for “royalty reserves.”

“Reserves” are an amount that is withheld by the publisher so there will be a fund to use in the event some units do not sell, have to be marked down, returned for credit, are defective, or for any reason in the end are not fully royalty bearing. Since the developer is paid only on actual sales experience, until the dust settles on sales made in each accounting period, holding reserves provides the cushion to apply against these royalty reductions based on marketplace experience.

The reserves language in a game dev deal should provide for a maximum reserve (15% of net sales or net receipts is common) for the accounting period. And reserves should be liquidated (paid or credited to developer), to the extent they are not applied to royalty reductions, according to a schedule set forth in the game development contract.

It is in the best interest of developer for reserves to be liquidated as quickly as possible. I have seen liquidation clauses that begin as soon as the next accounting period after the reserve is taken. Some require reserves to be held for as long as a year. Reserves can be liquidated in stages, a portion in consecutive accounting periods spread over some length of time. And while old reserves are being liquidated, new reserves will be taken on then-current sales.

When negotiating the reserves clause, developers might consider adding language that permits the developer to get a publisher analysis of the reserves account and field inventory at any time, and a requirement that publisher liquidate reserves that may be greater than those reasonably required to protect its field inventory position.

If the developer may be so fortunate as to have a huge hit, holding 15% for long periods of time may well be excessive. For example, with worldwide sales of $300 million in the first week, and acknowledged huge retail sell-through, it is difficult to imagine that Microsoft has any reason to hold a full measure of reserves for the full term for Halo 3.

And one final tip regarding royalty reserves – if your game is not headed for retail – but is a download game only, there may be no reason for reserves.

With no field inventory to protect, and with few, if any, returns or defectives, and no risk of markdowns on unsold goods, the concept of royalty reserves really may not apply to download only sales.