Music Licensing and the Rhythm Game Conundrum

    I've discussed music licensing in a prior post and recent news in the media suggests that the landscape for licensing music, particularly for music-centric games, is a-changing. I typically keep this blog instructional, but as I've brought up this topic before it seemed appropriate to analyze the issue more carefully here.

    Background

    Warner Music Group recently came out against the publishers of Rock Band and Guitar Hero because Warner claims that the recording industry is getting the short end of the stick with regard to royalties. I don't know whether this is the common vibe from the music industry, and as I'm not sure what the current royalty rate is for those specific titles, it is difficult for me to say whether they are in fact getting a fair stake in the success of the Harmonix-created franchise. Regardless of whether the current royalty rate is "fair", it should be noted that Warner Music Group has a lot of licensing experience. They have entire departments dedicated to crunching numbers and royalty rates. The bottom line is that Warner and other record labels went into these negotiations as mature and responsible corporate entities with substantially more licensing experience than their video game publisher counterparts (bearing in mind that the music industry has been around for literally decades longer than the video game industry).

    So Warner is threatening to withhold future licensing unless they get a better deal. This is a completely rational business response—if you see that your product has contributed substantially to the success of another product, it's completely reasonable to want a bigger slice of the pie. Whether they intend for this to be retroactive is unclear, but this has created at least a small ripple, and it's worth taking a look at.

    Breakdown of Music Licensing

    I've discussed music licensing previously, but I'm going to cover it again here briefly. Music licensing is used to incorporate music into other media products (i.e. film, television, and video games). The licenses allow the video game producer to incorporate a specific sound recording into a game. Now, there are two different sets of rights in a sound recording. The specific recording itself is protected, and the musical composition is also protected. Music licensing is therefore broken down in two ways:

    Master Use License: Master Use licenses exclusively concern sound recordings. Keep in mind, sound recordings and musical compositions are protected separately under the copyright act. Master Use licenses are issued by the record labels who own the rights to specific sound recordings to be used in the video game.

    Sync License: Sync licenses exclusively concern the musical composition (i.e., the song itself as distinguished from the performance on the sound recording). Typically the ability to license musical compositions is left to a music publisher like EMI, Chrysalis or Warner Chappell, who make a business of exploiting (a la licensing and promoting) music and collecting fees and royalties. On the other hand, some artists retain 100% of their publishing and publishing administration rights. You can determine who you get the license from by performance rights organizations like ASCAP and BMI.

    In most cases this means that the video game publisher or developer (whoever is responsible for music supervision under the contract) acquires a Master Use license from the record label, and a Sync license from the publisher. How licensing is structure depends entirely on the deal. It could be a flat fee, an installment fee (more common for musical scores), or a royalty rate. It may also be a combination of an advance and a royalty, where an initial advance is paid by the licensee but the royalty distribution isn't triggered until the advance is paid from the royalties.

    Warner's Argument

    Warner argues that games like Rock Band and Guitar Hero are so reliant on the music they license that the music licensors should get a substantially greater share in the profits. The company compared these games to the licensing schemes devised when iTunes and MTV first arose. This is one of the more patently ridiculous comparisons I've heard, mostly because comparing a game product to a content provider seems horribly misguided. However, there is no disputing that these games do rely on the music licensed, and the argument could be raised that the games "provide content" in the form of song packs. The question, then, is what constitutes a fair licensing solution for the future.

    The Cost of Making a Game like Rock Band

    It's no secret that AAA title games cost several millions to make. It's also no secret that the entire games industry depends on the success of a handful of titles, which finance the creation of the games that barely (or don't) break even. As a result publishers like EA dump millions and millions into their AAA franchises in order to benefit from the newest and highest quality technologies and talent. This is the case in every entertainment industry, including music. The entire music industry scrapes by on the success of a relative handful of major acts. It's worth noting that both industries consist of subsidiaries owned by major media companies like Time Warner and Universal. So at the end of the day everyone is either in bed with each other or in competition. More than likely, it's both. All of that is aside from the point, but should be remembered when we get to finding a royalty rate.

    Let's break this cost down more completely. AAA titles tend to have longer development cycles (approximately 3-5 years depending on the game) and larger development teams than your standard indie game, with both operating on a shifting scale—typically the smaller the team, the longer it will take to make the game. A development team includes programmers, designers, artists, engineers, QA testers, and your project leads. Top programmers earn anywhere from $90,000 to $130,000, and the national average programmer annual salary is approximately $84,000 as of 2007. Top end designers can earn twice as much as the average, with an average of approximately $50,000-$55,000 a year. Artists and Animators earn on average approximately $66,000 a year.

    Keep in mind that these averages include low end (anything over $10,000 a year and lots of survey responses by people unhappy with their current wage)—AAA title publishers like EA tend to employ high quality employees with proven records and solid titles under their belts, and as a result the salary requirements are substantially higher than the national average. The top business people such as executives and attorneys may earn three to five times that. Add that to hardware and software costs that include the latest technology, leasing space, middleware licenses and engine licenses, manufacturing costs, distribution costs, marketing and promotion, and it is obvious why games need to sell extraordinarily well to make money. Also keep in mind that a game's distribution cycle is substantially shorter than an album or film. A major album may generate income for the record label and publishers for literally decades; however, a game will only be published for an average of three years, which means a game has significantly less time to earn back its cost. All of this explains is why a CD or DVD will cost $12-$25, compared to a game's standard $50 price tag.

    Titles like Rock Band and Guitar Hero tend to cost even more to make than their standard console counterparts due to the OEM peripherals required to operate the games. This cost is passed on to the consumer in the form of major increase (total cost to consumer: $99.99 for full guitar kit, $189.99 for the band kit) from the standard game cost. Naturally this presents a slightly greater risk in the games market—will gamers pay $50 more for a plastic guitar that lights up? Apparently they will, and Harmonix banked on that hope when they first decide to make the games. There was no guarantee of success for these titles. Although music-based games like DDR and Karaoke Revolution has seen major popularity in Japan for years, no one could have anticipated the leap of State-side success with the new major peripheral-based franchises.

    Finding a Fair Royalty Rate

    There's a big problem with determining a "fair" royalty rate in this situation, because unfortunately the fact that these games are based on music doesn't change the cost of making the games. If anything that fact tends to inflate the cost due to the expense of manufacturing and distributing the peripherals as part of the game. While this cost is passed on to consumers, basic economics suggests that this will obviously have an effect on the number of people who will buy the product. If the basic principles of economics are a reliable gauge, the fact that the game costs $50-80 more than the average game means that there are fewer consumers than there would be if the cost was competitive.

    So what's fair? More to the point, at what point in a game's success can the publisher afford to increase the royalty rate for music licensing? Ultimately that becomes the question, because until a game breaks even or becomes a breakthrough success there is little room to negotiate. Royalties are only relevant when there is a profit margin. Before that all income earned from sales goes to paying back the costs of making the game. Sometimes licensing deals may require distribution of royalties prior to complete recoupment, or "net revenue" excludes certain expenses that enable licensors to get a priority share. But ultimately this only hurts the publisher and in turn the developer, who is typically the last party to see any return on their work beyond the milestone payments (having the largest advance to pay back; also, "net revenue" in most publisher/developer deals excludes pay-outs to third party licensors, including music licensors).

    There are a couple of possibilities for finding a fair rate:

    Variable rates: One possibility is establishing a variable royalty rate that increases the rate of return based on sales. This is probably the simplest method for the game publisher, although it will not completely address the argument Warner makes—i.e., the games are based on the music Warner et al. provide, and therefore they should have a substantially greater cut. As publishers rely on their big hits to keep their lights on, the percentage increase can't be so drastic as to be prohibitive to the game publisher's profit margin. Game companies simply won't go for it.

    Song Packs: Drastically increase the royalty rate to music licensors for song packs. The problem here is that the cost of licensing has already been passed on to consumers once and once again, economics will invariably raise its ugly head. Unless game publishers are willing to take a big financial hit by basically giving this revenue to the licensors, this is a fairly risky option.

    Co-Financing: Another option is a complete cost/profit sharing scheme—this makes the most sense for the music industry, if the argument comes down to the fact that without the music there is no game. This may also create a myriad of problems, one being the fact that WMG's parent company is a competitor in the games market. That doesn't mean that this can't work. Plenty of competitors co-finance and co-distribute entertainment products. This is often the case in film, particularly in smaller projects. Two or more companies may co-finance an entire project, whereby each offers to contribute a particular amount to the cost of production and creative control is shared. One or all of the companies may assume responsibility if the cost of production exceeds the anticipated amount. The biggest issues are creative control and a far more complex transaction as far as determining and certifying lines of credit that may require both sides to give up more than they're willing to give. There is also the fact that co-financing with only one record label would severely hinder the game publisher's ability to get content from other labels.

    While it is reasonable to request a higher return on your contribution to a work, it's also important to note the effect these games have had on the music industry. Song packs and licensing alone are an additional source of revenue that would not exist but for these games. It gives artists a new marketing and distribution outlet, something that is extremely valuable in today's economy. Warner is looking a gift horse in the mouth, which it is entitled to do, but at some point the horse may just bite back.

      * UPDATE: Speaking of biting back, Activision's lead responded rather snarkily to allegations that record labels aren't earning enough from game sales. See his comments at Kotaku.