Royalties and Essential Financial Commitments
In addition to territories and conditions for exclusivity, any deal should, at a minimum, address the following terms that have a direct impact on the financial success of the relationship: periodic royalties; advances against future royalties; and a defined term limit, as well as non-monetary commitments, such as deliverables and the roles and responsibilities of both parties.
Royalties can be at a fixed percentage, or they can increase, or even decrease, over time. Advances against future royalties can be paid up-front or periodically. For large projects that take place over a long period of time, advances may be paid upon reaching certain milestones: a percentage upon signing the contract; another portion at some stage during production; and a final payment due when the product goes to press. Minimum guarantees are not always a given. There may be reasons, which I will discuss later, to either insist on or forego them.
The deal should be structured so that the licensor receives a royalty stream based, in most cases, on the licensee’s net receipts, which means the revenue that it keeps after deducting the cost of goods and any discounts, returns, and sales expenses. “Net receipts” should be explicitly defined so that there is no ambiguity as to what is or isn’t deducted from gross revenue. Sometimes development costs or marketing expenses are deducted before calculating net receipts, which should be resolved during the negotiations. E-book revenue can be tricky since physical returns aren’t a factor, but instead an order could be cancelled after royalty payments have been made and before any downloads were accomplished. So in the case of e-books, net receipts should account for any cancelled purchase orders or invoices.
Royalties are not always calculated on net receipts. Some publishers prefer to use the selling price of the book as the basis or, in some cases, a fixed amount regardless of the list price. Net receipts, when defined correctly, is usually the fairest standard for everyone, but most importantly it provides the licensee with the flexibility it needs to offer normal discounts or to make bulk deals without drastically reducing margins or possibly losing money on a sale because of fixed royalty commitments.
If a publisher doesn’t have the flexibility to maximize all marketing opportunities, neither the publishing partner nor the licensor will benefit in the long run. The publisher may simply have to turn down business opportunities because royalty obligations make them financially unviable. This scenario can be avoided by defining net receipts in a way that allows the publisher the ability to take advantage of opportunities (perhaps in collaboration with the licensor) that may not be anticipated at the time that the agreement is made. In exchange for providing maximum flexibility to the licensee to respond to market conditions and sell products at varying margins, a minimum royalty can be established so that the licensed product isn’t excessively discounted or used as a loss leader, or premium, to enhance the sales of other products.
Royalty rates can vary quite a bit, but the typical range is between 5% and 20%, depending on development costs and any ongoing third-party expenses that might provide additional financial burdens on the licensee. They can start at one rate and go up (or down) after hitting defined revenue milestones. For example, they may start at 10% for the first $100,000 of revenue and shift to another percentage after the next $100,000. If the licensee has invested a considerable amount of money at the start of a project, it may insist on a lower rate for the first year so as to recoup some of its investment, and agree to a higher rate once it has broken even.
Royalties are normally distributed either quarterly or semi-annually, and are usually paid, along with the submission of an accounting report, on defined dates. Once the royalty rate is established—as a fixed, escalating, or descending percentage—and the basis for the calculation determined (e.g., net receipts, list price), some consideration should be given to advances that will be applied against future royalties.
Advances can be useful in helping to determine the partner’s seriousness and to motivate performance. The more that it is willing to invest up-front in the product, the more likely it is that it will bring the product to market quickly and finance a meaningful marketing campaign. However, any advances should not be too onerous and should take into consideration the investment that the partner has to make to accommodate its market’s expectations, including the cost of translation, which can be substantial depending on the project. In the end, advances should be in line with anticipated earnings. If, for example, both parties agree to quarterly royalty payments, a typical royalty advance should be equal to the royalties expected from the first quarter’s forecasted revenues. What should be avoided is a situation where the advances are so high that it takes the licensee an unreasonable amount of time before its earnings equal the paid-out advances.
Advances against future royalties aren’t an absolute requirement in the agreement, nor is a fixed ratio against a sales forecast a standard. In cases where sales prospects are largely unknown and where the licensee has to make a substantial investment to bring the product to market, advances should probably be avoided. Usually an advance is a good-faith number and a token expression of commitment. Sometimes, especially in a competitive situation, an advance can well exceed any definition of “token” and can be a serious commitment that may be difficult to recover. In the long run, both parties should be more interested in the lifetime value of the product in the market, not in the size of a speculative advance.
Another way a licensee can be motivated to perform without creating the unnecessary burden of an advance is to specify a target date for publication and to make the first royalty payment due by a certain date after the signing the agreement. Either way, the objective is to confirm that the licensee really intends to publish the work and not just hold onto the rights to prevent someone else from publishing it in their market. This doesn’t happen very often, but it can, depending on the market and the competitive environment. On the other hand, the licensee may have had all intentions of publishing the product, but simply ran out of funds or had a change in priorities. Regardless of the intentions or reasons for missing a publication date, the result is the same. The licensor cannot receive revenue if the licensee doesn’t publish the product with a solid marketing plan in place. Commitments built into the contract with time requirements help to create some urgency for the licensee to publish by a specific date and not just let the license to publish languish.
The benchmarks for advances and royalty rates described above apply mainly to educational titles, general reference works, travel books, and most children’s books. When it comes to blockbusters—fiction or nonfiction—celebrity books, or “star” titles with unusual marketing hype or potential, payment terms may be very different. Although the royalty rates may be similar, non-refundable advances can be very substantial and highly speculative. In these elite publishing categories, where there is often competitive bidding for the original publication as well as foreign-language (and even movie) rights, advances can reach six and even seven figures. In some cases, these advances may not be recoverable over the life of the publication, and publishers can wind up incurring huge losses on the books when sales fail to meet the astronomical expectations driven by the advances. A good place to follow the trends in royalty advances with these types of books is in Publishers Lunch, a free online newsletter (with an optional premium upgrade), or The Book Standard, which is also available online.
In addition to royalties and advances against future royalties, two other essential economic factors in a deal include the term limit of the contract—the length of time the agreement remains active before it expires and action needs to be taken to allow it to continue—and minimum guarantees.
Three- or five-year limits are standard initial terms in most licensing agreements. After the initial term, contracts can automatically renew or expire unless renewed by mutual agreement. Minimum guarantees can be established during the initial term of the agreement as a way of setting revenue expectations. The length of time a publisher is willing to give up rights for a product in a market is sometimes determined by set minimum guarantees. In other words, the term limit could be automatically extended provided that defined revenue hurdles have been reached. In this way, the licensee can continue to publish a product that is finding success in its market without having to renegotiate the contract. There is no need to allow an agreement to terminate as long as both parties are benefiting from the arrangement.
By establishing term limits, the licensor puts the burden on the partner to maximize the value of the original product in its market. If both parties are satisfied with the financial performance of the product at the end of the term, the agreement should be renewed or extended for an additional length of time.
In a conservative deal where the licensee is held accountable for success, the term of the agreement will not renew automatically unless the specified minimum guarantees are achieved or a new term limit is substituted. In this case, the term of the agreement automatically expires, and the license does not renew unless the parties take definitive action to renew it. An expiration date gives both parties an opportunity to re-examine the relationship and quantify the viability of the product for both sides. In addition, it prevents the unhappy situation where the architects of the original deal may have since departed from the company and left others with an open-ended, perpetual agreement that they cannot undo. Since I have faced this situation myself, I make sure that I don’t put others in this position. No one should be obligated to live with something that they inherited and that cannot be undone. There are usually ways to get out of a bad deal, but having a fixed expiration date provides some flexibility for everyone.
As in the case of advances, minimum guarantees must be realistic. But even if they are still not achieved during the initial term of the contract, both parties may decide to continue the relationship, either on an exclusive or non-exclusive basis. Unfortunately, just like in other consumer businesses, many unknowns exist in publishing, and how a specific market will actually respond to a new product, or how long it takes for the product to achieve critical mass, is not always predictable or may take longer than anticipated.
Determining minimum guarantees that are realistic is more of an art than a science. Both sides should avoid the outcome where minimum guarantees actually exceed the amount of the earned royalties. High minimum guarantees may sound desirable for the licensor, but in this scenario, the licensee will probably not be motivated to renew the agreement after the initial term, ending a revenue stream for the licensor and putting the licensor in the position of having to start all over with another partner. It is far more preferential to have earned royalties outpace the minimum guarantees, which means that the product is exceeding expectations. If this is the case, both parties will be eager to continue the relationship beyond the initial term.
The process of establishing minimums and reporting earned royalties assumes, of course, that the accounting is trustworthy. Some publishers will insist on having minimums if they feel that they cannot trust the licensee’s royalty reports and therefore will use the minimums to be certain of the financial value of the relationship. They will set the minimums high enough so that they do not have to question the accuracy of the royalty reports. (It’s natural to be skeptical of royalty reports that show earnings just short of the minimum guarantee.) Or, to be even more conservative, some publishers will even forego an upside altogether and will accept a fixed amount of revenue up-front in lieu of royalty income. This may be a lower-risk strategy, but it’s not a good basis for building long-term relationships. A relationship that lacks trust in any part of the process—from the transfer of the IP to the disbursement of payments—is not worth having. Sooner or later it will fail. I have had several licensing deals where the earned royalties from a licensee never surpassed the minimum guarantees and had to decide whether to continue with the deal or not. As long as the minimums are paid, it usually makes sense to continue the partnership.
Minimum guarantees can be useful for motivating performance and to provide an incentive on the part of the licensee to exert best efforts. However, they put a lot of pressure on the licensee, and therefore reaching a mutually agreeable number may be difficult. But the subject should be raised as part of any good negotiation. Sometimes minimums start low and escalate over time as the licensee builds momentum in its market and recovers its initial investments in launching the product. Its ongoing product investments will naturally decrease over time, which will then allow for greater guarantees as the product matures and gains traction in the market. Since most products have a lifecycle, at some point sales will begin to decline, which should be reflected in the minimum guarantees.
With or without established minimums in a contract, both parties should always have expectations in mind that will trigger the renewal or termination of the agreement at the end of the established term limit. If minimum guarantees are built into the agreement.
