"Famous Last Words"

Why Royalties are Rare (November 2005)

Dear Jim:

We keep hearing how difficult it is to earn royalties on a game. Is it really getting harder?

No Name or City Please

Dear No Name:

When it comes to royalties, game developers are caught between two ends of a giant vice.

One end is the advance and recoupment business model.

Under this system, which is also used in the recorded music and book businesses, the cost of producing the final “product,” whether a game, audio CD or book, is lent to the talent to spend on the production. Before the company is required to pay any royalties, it is permitted to recoup (be repaid) the amount of the loan by withholding royalties that would otherwise be paid to the creator.

This means the creator, whether it is a game developer, recording artist, or book author, pays for the creation of the product. In the case of games and master audio recordings, these assets that are paid for by the talent end up the property of the game publisher or record company.

In the book business, the model is slightly different. While the author uses his or her own money to write the book (and generally uses the loan for living expenses while writing), the copyright is typically retained by the author.

The money lent to the creative talent is treated as an “advance” on royalties – which generally means if the work does not sell enough to repay the loan – that is if the talent does not “recoup” -- the balance is not repaid.

Some publishers may point to the fact that they do not require the game developer to repay the balance of the loan/advance if the game does not recoup.

To do so would further strain an already hugely inequitable financial model. In such a case, the developer would be paying money to the publisher in connection with a product it neither owns nor controls, and which was developed to the subjective standards of its publisher.

This advance and recoupment model was adopted by the games industry at least as far back as the 1980's. In the old days, when game development costs were in the high five figures, or low low six figures, and retail prices hovered around $30-$35, developers could routinely expect to recoup and see a reasonable royalty stream.

Today, game development costs are in the mid to upper six or even seven figure range (and quickly heading toward high seven figures!), but retail prices have not increased proportionately.

A lot of money is lent to developers to create games. And the economics of the advance and recoupment model have made it extremely unlikely that any game short of a mega-blockbuster can recoup.

If this were the only issue in royalties, it would be difficult enough. But there is a second side to this vice.

The second side of the vice is the calculation of “Net Sales.”

Royalties are paid on game sales. But publishers have taken a lesson from recorded music companies. Reductions are applied to sales numbers that result in a substantially lower effective royalty rate than the rate that appears in the pages of the contract.

If DevCo signs a deal that provides for a 20% royalty based on “net sales,” it is well advised to look at the definition of “net sales” and recalculate that effective rate down.

A $39.95 retail game may have a wholesale price of $28, but DevCo will not receive 20% of that number.

Publishers apply broad deductions to their sales numbers in order to reduce the effective price on which royalties are calculated.

Common deductions include the cost of manufacturing the game (so-called “cost of goods of “COGS”), license fees paid to platform manufacturers and third party content providers, advertising costs, sales commissions, freight costs, taxes, discounts, credits, dealer advertising, middleware license costs, and a range of other deductions that keep getting longer and longer.

When the dust settles, the 20% royalty may actually be closer to 12% or less.

In a game that costs $1.2 million to develop and has an effective royalty rate of 12%, you can see that before any royalties will be paid, more than 350,000 units must be sold at full price!

By the time the game has sold 350,000 units at $28, it is certainly hugely profitable for the publisher.

I believe the absence of royalties to developers will become a bigger issue in the next few years. Development of console games is extremely difficult work. If developers can not earn a fair return for their efforts, the best developers will look elsewhere for creative opportunities. We will all be much poorer for the loss of this talent!