Understanding Royalties

Royalties are overwhelming if you’re not used to working with them. Royalties operate on two levels in most contracts—first, there’s the language used to determine the kind of royalty we’re dealing with, and next is the actual number that applies. Therefore it is necessary to know both the terminology and the math involved. I am going to explain this word-by-word, with examples, because it’s the only real way to keep track of the details. *Note: The deal points and amounts set forth in the examples are NOT real world examples and are totally arbitrary.

Advance: An advance is a lump sum or installments of a lump sum (i.e. milestone payments), paid out to the developer and later charged against the developer’s royalties.

    Example: Publisher will pay Developer an Advance of Thirty Six Million Dollars ($36,000,000) payable pursuant to a mutually agreed upon milestone schedule.

Guarantee: A Guarantee, Minimum Guarantee, or Minimum Commitment is more common in license or distributor agreements and is sometimes used incorrectly (in other words, it’s sometimes used interchangeably with "advance"). It means that the party responsible for revenue is promising the other party that the other party will earn a specific dollar amount in royalties by a specific time. If that amount isn’t earned, the party responsible for the revenue promises to pay the rest of the guaranteed amount out of its own pocket.

    Example: XXX guarantees to sell at least the minimum quantities of _____________ for each of Company Y’s Product within thirty-six months of Delivery ("Guarantee"). In the event that XXX does not achieve the Guarantee, XXX agrees to pay, at the expiration of thirty-six months after Delivery, the difference between the royalties which would have been payable had the Guarantee been achieved and the actual royalties paid to Y Company. 

Recoupable: Advances are usually a) recoupable and b) non-refundable. B is self explanatory. A sounds like gibberish. Recoupable means that the amount of an advance must be paid back through sales. Specifically, it means that the royalty you’re entitled to under the contract won’t be paid to you until you’ve paid back your advance directly from your own royalties. 

    Example: Publisher will pay Developer a non-refundable, recoupable Advance of Thirty Six Million Dollars ($36,000,000) payable pursuant to a mutually agreed upon milestone schedule.

    Example- Application: The publisher must earn back that $36,000,000 from the developer’s royalty rate. If the Developer has a royalty rate of 10% of Net profits, then the game would have to earn $360,000,000 in Net Profits before Developer is entitled to royalties.

Royalties: Simply put, royalties are the percentage of earnings you are entitled to. You sell your intellectual property rights (or a substantial portion of those rights) to a publisher. In exchange for those rights, the publisher gives you a royalty, which is usually a percentage of Net Profits. Note: Even though you are no longer the legal owner of your intellectual property, your royalty gives you an equitable interest in that property. That means that you still have standing to sue as a "beneficial owner" in the event of infringement.

 Example: Developer shall receive a Royalty equal to 30% of Net Profits.

    Example- Application: Assume that Advance has been recouped. After recoupment, Publisher earns an additional $100,000 in net profits. The developer is entitled to 30% of that $100,000. The developer is therefore entitled to receive $30,000.

Gross Profits: Gross profits or gross revenue is the total amount earned in sales before deductions and expenses.

    Example: Publisher has sold 10,000 units at $15. The gross profits/gross revenue is $150,000.

Net Profits: Net profits mean revenue earned AFTER deductions. Deductions may include cost of goods sold, reserves, "free goods", shipping and transportation, taxes, duties, and tariffs, marketing allowances, and earnings of third parties (i.e., if the game is based on a movie, the IP owner of the movie may have a royalty senior to the developer’s royalty. The amount paid to the licensor is deducted from the net profits.)

    Example: "Net Profits" shall mean all monies received by Publisher, its affiliates, subsidiaries, assigns and licensees less customary reserves, cost of goods sold, lost and damaged goods, returned goods, promotional units and free goods, rebates, trade/marketing discounts, allowances and credits in connection with Product, and earnings due to third parties.

    Example- Application:

Gross Revenue

$10,000,000

Cost of Goods Sold

$2,000,000

Free Goods

$10,000

Reserves

10%= $1,000,000

Lost and damaged goods

$10,000

Marketing discounts

$50,000

Senior royalties

10%= $1,000,000

Net Profits

$5,930,000

 

    @ 30% royalty, you earn $1,779,000. If you aren’t recouped, this amount goes towards your Advance and you never see it.

Reserves: Reserves are typically a percentage of the receipts that are withheld for a specific period of time to cover returned units. Retailers are entitled to return units that they are unable to move, and they can get a refund from the Publisher for those units. Publisher may try to pass those losses onto the developer.

    Example: "Reserves" shall mean 10% of Net Profits for all returns, discounts, markdowns and allowances of Units. Publisher shall liquidate Reserves if Reserves are not used within 180 days.

    Example- Application: Your deal sets a reserve amount of 10% for a period of 6 months. This means that at a maximum Publisher can withhold 10% of revenue as reserves against net profit calculations for 6 months (this doesn’t include lost or damaged goods, those are accounted for separately). Publisher sells 1,000 units at $20 to Retailer. Of that $20,000, Publisher can withhold $2,000 for 6 months from royalty accounting to cover returned goods by Retailer. Of those 1,000 units, retailer returns 50 units. Assuming there is no penalty Retailer is entitled to a refund of $1,000. Publisher can then use the reserve to cover the $1,000 loss, which is deducted then deducted in Net Profits calculation. At the end of 6 months, the remaining $1,000 is added into the accounting for Net Profits assuming there are no more returns.

Free Goods: Somewhat self-explanatory—publishers will give away units to various media entities for promotional purposes. Those units are typically marked "For Promotional Purposes Only, Not For Resale." Those promotional units are not considered "sold" and provide no revenue. Therefore the cost of those units is deducted from Gross revenue.

    Example: No royalties shall be earned with respect to (a) Units used for promotional purposes or furnished free to the trade, press or for public relations use; (b) Units furnished free to distributors, sub-distributors, retailers, or others; or (c) prior to a uniform wholesale price reduction, Units sold to distributors, sub-distributors, retailers or others for less than the actual per unit cost (i.e. "at-cost" price) of the applicable Unit.

Cross-Collateralization: Cross-collateralization means that revenue earned from one game title can be used to cover unpaid advances and development fees of other titles. This is typically the case when one developer works with one publisher over various titles. The term can also be used in reference to sale of the same title over multiple platforms. 

    Example 1: All royalties shall be cross-collateralized across all platforms and version of the Title.

    Example 2: Publisher may recoup Advance and all additional fees in whole or in part from all Royalties earned by Developer under this Agreement or any other agreement between the Parties.

OEM: Original Equipment Manufacturer, or "bundling." Publishers may license a game title to OEMs (i.e. console manufacturers) to be bundled into the product. OEM agreements are typically treated as "ancillary" compensation. Under OEM deals the publisher grants the equipment manufacturer a license to distribute the game software in a very specific manner, usually as part of a bundle with equipment or a console. To do this, the publisher usually delivers a master CD of the game to the equipment manufacturer, and the manufacturer is responsible for printing and packaging that product pursuant to approvals by the publisher.

    Example- Application: Your game is ported to Nintendo Wii. Your publisher then enters into an OEM Agreement with Nintendo to bundle your game product with the sale of each Nintendo Wii. The royalty rate for OEM bundled products is ordinarily substantially less than the retail list price. If OEM products are included in your deal as ancillary revenue, and your ancillary royalty rate is 50%, you’ll be entitled to 50% of the publisher’s OEM royalties from the Nintendo OEM deal.

Ancillary revenue: Ancillary revenue is usually calculated separately from Net profits because ancillary revenue doesn’t involve the sale of traditional units. Instead ancillary revenue is derived from licensing of the game product. For instance, strategy guides, merchandising, and licensing your game’s IP to a movie studio all constitute ancillary revenue.

    Example: "Ancillary Rights" shall mean any and all ancillary items, including, but not limited to, strategy guides, toys, books, comic books, photographs, posters, television series and motion pictures, derived from, based on, or in any way related to, the Title and/or content of Title.

Future Products: In the event that the Developer doesn’t create sequels, prequels, or additional ports for the game, the developer may still be entitled to additional compensation for future products that use the game’s IP.

    Example: Publisher shall pay to Developer X% of Net Profits for Future Products not developed by Developer, including any future ports, sequels, prequels, and other game products derived from the Title’s content.

These are the general principles behind royalties. However, how royalties are calculated depends very much on the specific agreement, and relying on "general" principles can therefore be dangerous. Your best bet is to read the definitions section of your agreement. If royalty terms aren’t spelled out there, review the "royalties" Or "contingent compensation" section of your agreement. If something isn’t clear to you, consult a lawyer. It’s the only way you can be sure that your royalties are properly being accounted for.

Comment (1)

  1. Drew

    Damn that’s some good stuff. I’ve had experience with royalties in book publishing, but never with an advance as I only contributed work. I remember the basics from reading similar stuff elsewhere, but not in such detail. Oh, BTW – http://snipr.com/250vj (scroll down to the bottom)

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