By: Dean M. Gloster and Kat H. McCabe

With CD-ROM software sales expanding at an annual rate of several hundred percent, more and more companies are becoming multimedia developers and publishers. Many of them (and their lawyers) are grappling with the key business terms of development agreements for the first time.

In the standard publishing arrangement, a recognized software publisher with both money and effective distribution funds the title development (what in the film world would be called the production). As production values and consumer expectations steadily rise, the cost of developing CD-ROM titles has also increased. For high-quality titles, many developers are budgeting substantially more than $500,000. For a smaller number of extremely high-end titles, development costs may exceed $1 million.

These costs are funded by a series of publisher's advances, as various milestones in the project are reached. The publisher then manufactures, packages, markets and distributes the CD-ROM. In such an approach, the economic risk is borne largely by the publisher: The publisher faces the considerable risk that the developer's creative team may split up or be unable to finish the title.

The publisher also faces a marketing risk -- what if a better but similar product is released first by someone else? The publisher also bears substantial inventory risks, since consumer software retailers can often return unsold inventory for full credit. To promote and market the product, the publisher may have to spend hundreds of thousands of dollars (or in the case of a few hit game titles, perhaps even millions) in publicity, advertising and marketing support.

ROYALTIES REFLECTING RELATIVE RISKS

The publisher's high risks in the traditional publishing deal results in a standard royalty arrangement that reflects these relative risks. Conventional wisdom is that major CD-ROM publishers who fund the entire cost of title development not involving outside licensed properties will pay a base royalty to the developer of only 10 to 15 percent of the title revenue, less certain specified costs.

There are certain key areas of negotiation in a standard publishing agreement between the publisher and the developer. Additionally, there are also numerous affiliate label and hybrid or co-publishing arrangements with far different economics and arrangements.

1. Royalty rates. Numerous publishers claim that they will not pay a base royalty of more than 10 percent in a standard publishing deal to a first-time developer, and many other publishers (including Microsoft, StarPress Multimedia and numerous publishers doing film-related projects) pay even smaller royalties that look more like work-for-hire agreements done for a flat fee. Often, smaller publishers with less effective distribution will promise higher royalty rates.

To many developers, even a 15 percent royalty seems outrageously low, given that the developer in many cases comes up with the idea and creates a compelling product using its own cutting-edge technology. In fact, the standard publishing deal is a tough business model for developers: A 1994 survey of 912 multimedia software developers found that 96 percent of them reported that their CD-ROM titles were unprofitable. Developers can address the meager royalty issue three ways.

First, developers argue, with some justification, that the typical industry royalty rates for CD-ROM titles should be modified, because they are based partly on business models from the cartridge-game industry. Because with CD-ROMs the publisher's inventory risk is substantially less because of the lower cost of goods sold, the royalty should arguably be adjusted to reflect this.

Second, well-advised developers try to ensure that the milestone advances from the publisher are sufficient to cover all the developer's costs, including the salary of the principals, plus some amount to cover inevitable cost overruns and delays. Budgeting and planning are absolutely critical.

A developer who is late with a product and who comes back to the publisher seeking additional advances because of continuing overhead will meet with enormous resistance. If there are costs that the developer cannot pin down at the time the development agreement is signed (cost of required content, name vocal talent, etc.), then the milestone advances could be a specified amount plus the unknown costs of these additional items, which are to be jointly determined later.

Finally, even where the publisher will not budge on the base royalty, a developer can often obtain a step-up royalty after a certain number of units are sold. Thus, the 15 percent royalty might increase to 18 percent after 50,000 units are sold, increase to 20 percent after 100,000 units, and increase again after 200,000. Given that software publishers' gross margins are typically 60 percent or more, they often agree to a higher step-up royalty.

2. Royalty calculation. Typically, royalties are payable on some sort of net sales revenue, adjusted gross income or other similar formulation, based on the publisher's actual receipts less certain expenses or reserves. Typical deductions include sales taxes, duties, shipping and insurance charges actually paid to third parties, replacements, refunds (including reasonable price-protection refunds paid by the publisher to its retailers or distributors), and sometimes a reasonable reserve for returns.

From the publisher's perspective, it is important not to pay royalties on items that are not ultimately receipts. From the developer's perspective, the deductions from gross income should be narrowly defined to ensure that they do not swallow the obligation to pay royalties or reflect the publisher's general overhead costs.

A deduction for shipping and handling might be replaced by actual shipping costs paid to unaffiliated third parties, and a reserve for returns might become a reasonable reserve for returns for 60 days, not to exceed 5 percent of the units shipped. While these provisions are reasonably negotiable, there are limits: A publisher with numerous titles on the market is not going to completely reinvent its royalty accounting system for a single developer.

3. Royalty recoupment. In a standard publishing deal, the milestone development payments are usually treated as an advance against royalties and are recouped out of the royalties otherwise payable to the developer. The way these royalties are recouped, however, makes a huge difference to the developer.

In a standard recoupment arrangement as proposed by a publisher, where the milestone advances to finance development were $500,000 and the developer's royalty is 15 percent, the developer would not see any royalty income until 15 percent of the publisher's net sales revenue equaled the $500,000 advance. By that time, the publisher would have received a total of $3.33 million in net sales revenue and (with most CD-ROMs) would have enjoyed substantial profit.

Because of the lower inventory-carrying costs with CD-ROMs compared to 16-bit game cartridges, CD-ROM publishers are often flexible on the recoupment formula. Developers are sometimes able to negotiate an arrangement for payment of royalties shortly after the publishers break even. There are several ways to accomplish this, including a higher deemed or shadow royalty rate on the first 30,000 units sold, or an agreement that after a certain number of units are sold or the publisher's net sale revenue exceeds a certain dollar figure, the milestone advances will be deemed to have been recouped.

An alternative approach is for the developer to demand payment of a smaller "unit one" royalty immediately (that is, a royalty payment upon the first unit sold), before recoupment of the advance. Thus, for example, two-thirds of the developer's royalty otherwise payable will be applied to recoup the milestone advances, but the remaining one-third of the royalty rate would be paid immediately to the developer. Unlike the other formulas, this does not increase the ultimate amount of royalties paid to the developer for a successful product, but it does accelerate the payment of royalties to help with the developer's cash flow.

SEQUELS AND DERIVATIVE WORKS

To profit from a potential hit, publishers need the right to create upgrades, sequels and foreign-localized versions, and want the right to port the title to other platforms (CD-i, Sony PSX, Sega CD, 3DO) or to license the right to do the port. Typically, publishers also want the right to license derivative works like novelizations, and to license the characters for merchandising, television and movies. Often, the publisher may even want the explicit right to create follow-on products using the same interface and underlying software engine, as with the Living Books product line.

In addition, a publisher interested in working with a talented developer again often gets a right of first negotiation or right of first refusal on the developer's next title. On the other side, if appropriate, developers should demand either to retain certain rights or to receive a royalty from these ancillary uses. A typical negotiated agreement might result in the developer having a first right of refusal to do ports, sequels and derivative software works for a specified (or unspecified) royalty; in any event, even if the port, sequel or derivative work is created by someone else, the original developer gets a smaller, passive royalty.

Publishers that pay for the entire cost of creating a title generally insist that they own the code. Developers often need to have the right to reuse tools, the underlying software engine, or even portions of the code and the basic interface for later product. The agreement should clearly spell out the rights of the parties. Developers who retain ownership of their tools often define the bulk of what they need to create their next title in the list of tools set forth in the agreement.

Publishers generally reserve the right to reject any milestone deliverable that it deems deficient, and to terminate the developer if the identified deficiencies are not cured within a specified time. In addition, publishers usually reserve the right to cancel a project at the publisher's absolute discretion, for any or no reason. Given rapid change in the marketplace, this provision is critical for publishers. They want to have the right to cancel a project if it no longer makes marketing sense.

On the developer's side, there are several important termination issues. If the contract is terminated at an early stage, the developer of an original title often insists on the right to take the project elsewhere, and in return must often refund all or a portion of the original publisher's advances upon striking a new publishing deal.

If the milestone schedule is set up so that the bulk of payments are at the end of the project, the developer should negotiate either to change this milestone schedule or to require a kill fee from the publisher that cancels the project simply at its discretion. A kill fee both makes project cancellation less likely, and ensures that the developer is paid for all the work performed to date.

Publishers need explicit representations and warranties that the developer has obtained all necessary rights in the title and that the publisher's use will not infringe any rights of any third parties, together with a broad agreement to indemnify, defend and hold harmless the publisher if the representation and warranties are not true. A developer will want a reciprocal provision covering any materials or licensed content provided by the publisher. Publishers will want a continuing obligation of the developer to cure identified errors and may want some additional consulting services in connection with ports or foreign localizations.

The developer will want a time limit on these provisions, particularly if they require the developer to provide additional services for free. A developer should have the continuing right to audit the books of the publisher to verify the accuracy of the royalty payments, and if the audit reveals a significant underpayment, the cost of the audit could be borne by the publisher. If any confidential information (proprietary tools and the like) is being disclosed, there should be a confidentiality/non-disclosure provision.

Finally, developers in particular -- who often have far less money for resolving legal disputes -- will want a quick and relatively inexpensive dispute resolution mechanism like arbitration. The arbitration paragraph can provide that the arbitrator must be knowledgeable about the consumer software industry.

This is just an overview of some of the deal points that parties, and their lawyers, should be aware of in negotiating standard consumer CD-ROM publishing agreements. The critical issue, though, for developers and publishers alike, is that their agreements are carefully drafted to address their needs and to reflect their mutual understanding of their business deal.