Advance Against Royalties vs. Development Fee: Round 1

Disclaimer: I'm not a lawyer.

I feel the need to cover some commonly asked topics. My goal is that it that might help any fellow developer get his head wrapped around some of this legalese and prompt future research on your own. If this is useful enough I may turn it into a small series of posts with information on various other topics.

With the advent of the independent developer (we're all developers I'm not big on the term "indie") and designers with great ideas that attract big companies the two common models of Advance Against Royalties and Profit Sharing seems like a good starting point. Those of you with the next Braid or World of Goo have probably already been contacted by various publishers that would like to "help you".

Whether you self-publish on your own website, the Apple Store, Steam or any of the console services there's a big chance you're going to encounter legal terminology and obligatory documents. This paperwork and the accompanying terminology can be quite daunting and, without proper representation or preparation, may beat the hell out of you. For good or bad I've had the opportunity see various documents ranging from non-disclosure agreements (NDAs), letter of intent (LOI) down to full contracts and licensing agreements.

What I've learned is that a sizable amount of this terminology isn't necessarily intuitive, especially if you didn't spend a few years in law school.  And worst, by the time you encounter it, you may already be deep into negotiations with a potential distribution, publishing or marketing partner. The last thing you want is to appear green or uninitiated in the legal aspects of the business. Sure, you can make a fantastic game, but can you handle your contracts? I hope so because if you can't, it has the potential to turn negotiations into a one-sided, uphill battle.

As a reminder I'm not a lawyer, this information is intended as that--information. Any developer who has gone through the process may not find this as useful as someone who hasn't. Also, developers who have gone through the process probably already have a good lawyer to protect their interests.  Definitely consult a lawyer before doing anything remotely related to reviewing documents and signing away your first and last born child--or rights of refusal.

Advance Against Royalty Model

This is the bread-and-butter of publishing, but not the only way to go for developers. However, it's fairly commonplace and publishers may not want you to know there are other options (judges don't tell the jury about jury nullification either). In many developer-publisher deals you, as a developer, get paid in advance a royalty of the net receipts, but not actually for development--at least not directly. The development fee that you're charging the publisher and ultimately getting paid isn't a development fee at all so much as the money you'd eventually earn--just ahead of time.

In case you're wondering (and even if you're not), you may not technically get paid for development in some publisher-structured deals. The publisher is giving you an advance against the future royalties that would have been earned on a given project. You're essentially giving your development and ideas for free. Regardless of my personal bias, keep in mind the publisher is taking a massive risk by funding a project and all that goes with it such as development, production, marketing, manufacturing, customer service etc. But you're not the publisher, you don't care about its risk, you care about yours. That said, the ramifications of the advance against royalties model aren't immediately obvious until you understand how the numbers work and realize what they mean.

Here is a quick example. For the sake of keeping things short we're not going to include any deductions or reserves (the latter of which really only apply to physical goods, usually). We're also going to assume that the gross and the net receipts are identical (this is highly unlikely)--meaning that the publisher's cost is the advance and the advance alone.

- Let's say Publisher X pays you, as advance against royalties, a total of $250,000 for development with a 20-percent royalty
- Let's say the same publisher earns a total of $10 Gross/Net after the carrier's share (service irrelevant) per download
- The game sees a total of 100,000 downloads
- Gross/Net Receipts: $1,000,000
- Royalty payable to Developer under current scenario: $ 200,000. Technically you owe the publisher money ($50,000) because the advance is not fully recouped yet. That's because the publisher is recouping at 20-percent rate (and, no, it doesn't matter that the publisher has already made 4x its investment back)

- Estimated Gross/Net Receipts to receive additional Royalty: $1,250,001

Publishers will typically define net receipts as whatever money they see from sales of the game less some commonly accepted deductions like taxes, returns, distribution fees, marketing, PR, reserves, testing, ESRB fees etc. However, Net Receipts, how to handle them in negotiations and trying to avoid them could be a post all on its own (those deductions are costs of running the publisher's business, not yours).

Back to the advance against royalties, it doesn't make sense at all does it? Well, technically it does. First, forget about the "development fee" entirely and tell yourself that money you earn on the game is entirely a royalty-based fee. In the most literal sense of the term it's an advance; your development work is "free". Let's consider the advance against royalties a "loan". The publisher loans you $250,000 to make Shopping Kart Racer. The publisher has to, rightly so, get its investment back. Here's where it gets tricky, the publisher "recoups" at a rate of 20-percent for each download. Simply put, the publisher is taking $2 of every $10 and keeping track until the advance has been "paid back". You won't get any additional money until the advance is recouped.

If we factor in other publisher deductions like manufacturing, marketing, testing and other costs that will affect the break-even point, it could very well be possible that you might not seen any additional royalties until 1.5, 2 million dollars or EVER.

Profit Sharing Model

In a Profit Sharing Model, the publisher will pay a royalty to the developer after it has recouped the development fee, publisher's out of pocket costs and a pre-determined percentage of gross receipts to cover overhead. The royalty will be calculated as a percentage of net profits.

This time the publisher pays you $250,000 as a development fee and 10-percent as a royalty (after the publisher recoups the $250,000 development fee, of course):
- Publisher X pays you, as development fee, a total of $250,000
- The publisher earns a total of $10 Gross/Net after the carrier's share (service irrelevant)
- The game sees a total of 100,000 downloads
- Gross/Net Receipts: $1,000,000
- Developer Royalty: $75,000 (10-percent of the excess $750,000 beyond the publisher's break-even)

- Estimated Gross/Net Receipts to receive additional Royalty: $250,001

In short:
Total Net Receipts: $1,000,000
Advanced Model Incoming Revenue: $250,000 (you owe Publisher X $50,000)
Profit Sharing Model Incoming Revenue: $325,000 ($250,000 for development and $75,000 in royalties)

It doesn't take much to realize that you made more on the second deal, even though the royalties were half of what they were in the advance deal. That's because you're not waiting for the publisher to make five-times its initial investment before you get more money. Again, the two models have been extremely over-simplified for the sake of this comparison. This explanation is for the first-timer who is either too scared to ask or doesn't have anyone to ask.

We haven't touched on cross-collateralization,  non-recoupable versus recoupable and many of the other aspects of these two models. It's also a bit more transparent when you're dealing with the publisher's IP on a for-hire job versus th game being your own IP.

You need to remember whether or not you receive royalties under either model depends on revenue generated from your game. To me, the latter example is a more-straightforward business model with less legal funk masking a publisher's break-even point and when you get more "royalty" money. Your own personal and professional goals will determine if you accept an offer for a game as an advance or development fee with royalties.

Which model is better? That's for you to decide. How badly do you need the money? Do you need operating capital? Is it a licensing deal for an old game? There will always be elements of negotiations that will factor into and you are ultimately the one signing the contract.