"Famous Last Words"

15% of What? (July 2006)

Dear Jim:

We're an art and animation shop with studios in China. We've been hired by a game developer to provide artwork and animation for a console game the developer is creating for a mid-level publisher.

The developer cried poverty over our fee for the work. We can't make a profit on the milestone payments alone. But the deal provides that we will get a 15% royalty. We are elated about that!

Things will be tight, but we are very pleased with the back-end. The royalty should make up for the low fee we get for the art.

We haven't brought this up with the developer, but how can it pay such a high royalty to us?

It makes me wonder what we could be getting if we had a deal directly with the publisher.

Dear Sub:

As games get bigger and more complicated, we are seeing specialty shops emerging, and outsourcing or “partnering” becoming more commonplace in the games industry.

Many of these suppliers are locating in lower wage areas of the world. Parts of Asia, India, Eastern Europe, and even South America are home to companies that are competing to participate as specialty asset shops in game development.

I have to say first of all that I am impressed with your ability to negotiate a royalty of any kind for this work.

A lot of specialty subcontracting for game assets is on a flat fee, all rights assigned, work for hire basis. While there are no standards of which I am aware, I hope the game industry is careful not to be doing business with asset “sweatshops.” Poor working conditions do not result in inspired results. At the first hint of these practices, industrial watchdogs who monitor offshore labor practices in the garment industry could turn their attention to game development!

As for your negotiating a very tight deal, I can never recommend anyone working on a “no-profit' basis. My suspicion is that you and other companies in your situation may be using this pricing strategy to enter the market. But once established, the cost differential between the best off-shore suppliers and their western counterparts should shrink.

After all, a quality asset is a quality asset.

In analyzing the royalty in your contract it is important to read beyond that 15% number. The operative question is “15% of what?”

In a typical game development deal, the developer might receive a percentage, we'll say 15% for purposes of this discussion, of the publisher's “net sales.”

If the game has a wholesale sales price of $25, the natural presumption is that this 15% royalty would net the developer $3.75.

But that is never the case.

“Net sales” is a defined term in every development agreement.

It generally starts with the invoice price, then deducts many items to scale back to the number on which that 15% is paid.

For example, in a console game deal, the publisher may deduct the cost of goods (known as “COGs”), shipping costs, sales commissions, uncollected amounts, warehouse costs, dealer accrued advertising (known as “MDF,” “DAF,” or some similar term), markdowns, price protection, and defectives, and a reserve held by the publisher against actual returns or markdowns.

Some agreements go further and deduct trade show expenses, all advertising and marketing costs, in-house sales costs, and a portion of the cost of special ad campaigns (television for example). Creativity is the name of the game, here.

In the end, that 15% may be whittled down to an effective rate of 10% or less. So the 15% royalty based on net sales may actually come in at $2.50 per unit or less.

But that's not the end of it.

The royalty described above is what will be earned by the developer based on net sales from the publisher.

As the subcontractor here, I have to ask one more time, “15% of what?”

Read your contract closely. Unless the deal pays you 15% of “net sales at source,” meaning 15% of net sales where the money is paid and collected from the sale of the game to the shop for resale, your royalty number stands to be further reduced by each party at each step along the way.

So, for example, if the developer has its own 15% of net sales deal with the publisher, and that deal pays $2.50 per unit as described above, your own deal at 15% with the developer may bring you $0.375, or 15% of the developer's 15%.

Taking everything into account, that may be a fair royalty for the work you are delivering – only you can make that determination.

But it isn't as large as you might have believed and may not be cause for elation.

Also, be sure to see the updated/extended June column on unenforceable contract clauses.