1.0 Overview

1.1 The Basic Royalty System

Under the system as traditionally operated by the majors, the company pays for everything and assumes all financial risk. However, certain expenses are recovered, or “recouped” from the artist’s royalties. The artist never has to pay money back to the company from his own pocket. Recoupment forms a very significant part of the calculation of the payments to be made to the artist. A common misconception is that recoupment has something to do with profit. However, the point at which “recoupment” is achieved bears no relation to the point at which the company may begin to make a profit.

1.2 Recoupable Expenditure

So what is recouped from the artist’s royalty and how does this work? The artist will be entitled to a royalty for each record sold. The “per unit” royalty calculation is complex (see paragraph 3.0 below). Assume the royalty for each album sold is £1. If the company sells 100,000 albums, the artist is owed £100,000 in royalties. The company will first recoup from this any advances previously paid to the artist and any other recoupable expenditure. Recording costs are always recoupable. Manufacturing and distribution expenses are not recoupable. Nor, ordinarily, are marketing and promotional expenses. However, a number of grey areas have developed.

1.3 What is recoupable?

1.3.1 Recording Costs

Recording costs are fully recoupable and the recording agreement will include a wide definition of such costs which will extend to studio costs, musicians’ fees, equipment hire, travel and accommodation expenses and producers’ fees and so on. The definition will also extend to “cutting” and mastering costs but where does the recording process end? One grey area is the extent to which mixing costs incurred after “delivery” of the finished master should be treated as a recoupable recording cost. Some companies (and artists) like to release many different mixes of a particular track. Arguably, this is more in the nature of a marketing exercise, so the costs involved should be borne by the company on a nonrecoupable basis. An artist very rarely achieves this; the best that might be done is to restrict the company’s ability to recoup remix costs from royalties which accrue in relation to that particular remix.

1.3.2 ReMixing Costs

Aside from marketing exercises of that kind, record companies often spend substantial sums on mixing and remixing an album, even before any of the material is released. Again, these costs are recoupable. As a limited means of protection an artist should try to secure a right of approval over the budget for any remixing.

1.3.3 Promotional video costs

As a rule, promotional costs incurred by a company are nonrecoupable. However, the company will argue that promotional video costs are in the nature of recording costs, which are recoupable. The usual compromise is that 50% of video costs are recoupable from the artist’s record royalties. The company will invariably insist that any video costs which are unrecouped (including the 50% which is not recoupable from record royalties) may be recouped from video royalties. The opportunities to profit from videos are generally limited to the release of compilation videos, video juke box payments and broadcast. The recoupment provisions ensure that most artists are unlikely ever to receive any income from the exploitation of promotional video material.

1.3.4 Independent promotion costs

An artist may try to persuade the company to use independent promoters. Some companies will resist this because they have their own in-house promotion teams, and will not wish to incur the expense of outside promoters but many such teams have fallen victim to the redundancy programmes which have plagued the industry over recent years so that there is a greater willingness (and sometimes a necessity) to “outsource”. Independent promotion is sometimes the only means of ensuring that a new release is given sufficient priority and is worked hard enough. The company is likely to insist that some or all of the costs must be recoupable. US companies tend not to have strong inhouse promotion teams. Some cynics assume this is because it would not be seemly for a record company employee to do some of the things which promotion teams have to do in order to help break a new record. It is difficult in the US to break a new artist without liberal use of independent promoters (and US independent promoters are particularly expensive). Often, the pressure to use independent promoters tends to come from the artist or the artist’s manager. The company will often turn this pressure back on the artist/manager by insisting on the right to recoup all such expenditure.

1.3.5 Tour Support

Likewise, there will often be pressure from the artist/manager for the company to provide tour support. Again, this is a promotional expense. The artist would not be touring at a loss (which is what gives rise to the need for tour support) except to promote record sales. At one time, tour support payments tended to be 50% recoupable but for some years the trend has been for 100% of any such payments to be recoupable and, indeed (see paragraph 7.4 of part II of this Chapter) there is a trend towards the record company participating in any eventual profit from the touring activity.

1.3.6 Television advertising

Most recording contracts allow the record company to decide whether or not it wishes to spend money on television advertising. However, the company claws back all or part of the costs either by reducing the royalty payable on sales promoted by the advertising campaign (see paragraph 3.8.4 below) or by treating all or part (often only 50%) of advertising costs as recoupable.

1.4 Profit Shares

The alternative to the basic royalty system is the profit sharing arrangement. No major would be interested in sharing its profits, but most indies adopt this approach. Again, the indie pays for everything and assumes all of the financial risk. However, the relationship between the indie and the artist is more in the nature of a joint venture. The artist supplies his talent, the indie provides its resources, and they split any profits, usually 50/50. This system bears no relation to the basic royalty system, so they are difficult to compare.

For example, an artist may be offered 50% of the net profits from an indie, with no advance beyond actual recording costs. A major might offer a traditional royalty deal of say 20% of the dealer price of each record sold and an advance exclusive of recording costs of £50,000. Even if the artist knows how many records the indie is likely to sell compared with the major it will not be possible in advance to work out which deal is more financially attractive. This will depend on the amount of recoupable expenditure the major spends and on the total expenses incurred by the indie. The equation would also have to take into account the costeffectiveness of the indie’s manufacturing and distribution arrangements.

In working out profits, the indie deducts all expenditure from its total receipts from the exploitation of the recordings, including recording costs, remixing costs, mechanical royalties, manufacturing costs, artwork origination costs, promotion, advertising, marketing costs, distribution fees and any other costs directly related to the recordings. Only the indie’s own overhead costs are excluded.

1.5 A Practical Example (Profit Share v Royalty)

Using the example in paragraph 1.4 above, and giving ourselves the benefit of hindsight, let us investigate, in relation to a particular album, which deal is financially better for the artist. We will make the following assumptions:

1.5.1 Recording costs are £50,000. Indies are normally more sparing about recording costs, but for this example assume that the costs would have been £50,000 either way.

1.5.2 The album sells 100,000 copies. The major might argue that given its resources and more efficient distribution arrangements it would expect to sell more than the indie but, again, for the sake of simplicity, we will ignore this.

1.5.3 The dealer price is £7 (excluding VAT).

1.5.4 The royalty offered by the major after taking into account packaging allowances and other royalty mitigation provisions and after deducting any share of the royalty payable to the producer averages out at, let us say, £1 per unit (for the sake of simplicity we will ignore the fact that singles may have been released from the album which would also affect the royalty position).

1.5.5 The indie receives only £4 of the £7 dealer price after deduction of a £2 distribution fee and £1 manufacturing and printing costs.

1.5.6 The indie spends £20,000 in marketing and other allowable expenses.

1.5.7 The total mechanical royalties on 100,000 album sales amounts to, let us say, £50,000.

1.5.8 Video costs are £20,000 (ignoring the fact that the major would normally make available a bigger budget for this than the indie).

Based on these rough and ready assumptions the indie would receive the £7 dealer price less the manufacturing and distribution costs of £3, making £4 per album. On 100,000 sales total income would be £400,000. Out of this it would have to recover £140,000 of expenditure (recording costs, copyright royalties, marketing and video costs), leaving £260,000. On a 50/50 split, the artist would receive £130,000.

How would the artist fare with the major? At £1 per unit the artist would earn £100,000 royalties on 100,000 sales. This would be set against £110,000 of total recoupable expenditure (made up of the £50,000 advance 50% of the £20,000 video costs and £50,000 recording costs). The artist’s royalty account would therefore still be unrecouped by £10,000.

Accordingly, in this example, the artist would eventually receive £130,000 from the indie but from the major he receives only the £50,000 “up front” advance.

This example serves to illustrate the differences between the two systems but not too much should be read into the result. The first point a major would make in relation to this example is that for a new artist seeking mainstream success the marketing and promotion costs will often be enormous. Under the traditional royalty system most of those costs would be nonrecoupable, and so entirely borne by the record company; whereas, even if the indie could afford to meet costs at that level, they would all be taken into account in determining the net profits.

An established artist signed to a major would certainly expect to earn more if he were paid 50% of the company’s net profits from the sale of his records than if he were paid a royalty (even a particularly high rate of royalty) under the traditional system. It should also be borne in mind that 50% of the major’s net profits would probably be greater than 50% of the indie’s net profits from the same sales because the indie’s costs are normally far higher. For example, the major has its own distribution network. The record label will have to pay modest distribution fees to its affiliated distribution company but indies generally pay higher distribution fees to their distributors (anything between 15% and 30% of the dealer price).

A 50/50 net profits deal means, clearly, that profits are divided in the ratio 1:1. Typically, under the traditional royalty system, profits are likely to be divided in a ratio nearer 2:1 or even 3:1 in the record company’s favour.

1.6 Who Takes What?

Let us look at the cost structure from a different angle. What happens to the money paid by the customer in the record shop? A full price CD album might sell for £14.99. The dealer has to account to HM Customs & Excise for VAT which at the rate of 17.5% is £2.62, leaving the dealer with £12.37. The PPD (published price to dealer) of the record might be £8.45 exclusive of VAT. In the case of a dealer with multiple stores (such as HMV and WH Smith) the dealer will have sufficient clout to secure a substantial discount. We will assume discounts of 10% across the board for this exercise although the discounts are often far greater. This means that, ignoring VAT, the record company receives £7.61 leaving £4.76 for the dealer.

What happens to the £7.61 received by the record company? The record company has to pay a mechanical royalty of 8.5% of the dealer price. This amounts to 64p. If the artist wrote the song a substantial part of this will find its way back to him or her under any publishing deal.

The record company is then left with £6.97. In the case of physical sales part of this is paid to the distributor as a distribution fee in return for physically putting the record in the shop. For a major, distribution will be undertaken by another company within the same group. Nevertheless, a fee (probably quite low) will have to be paid. For an indie, the distribution fee will be quite substantial. Assuming a distribution fee for the indie of 20% of the published dealer price, this amounts to £1.70 leaving the indie with £5.27. If the major only has to pay a 10% distribution fee, i.e. 85p then it is left with £6.12.

The record company has to pay the manufacturer for any printing/pressing/duplicating costs. Again, the major may pay less than the indie per unit (because of economies of scale), but for this exercise we will assume total manufacturing costs of 50p per unit both for the major and for the indie. This leaves the major with £5.62 per unit. Out of this, the major will have to account to the artist for his royalty. If we assume a rate of 20% of the dealer price (inclusive of the royalty payable to the producer) after deduction of a packaging allowance of 25% (see paragraph 3.0 below for a more detailed explanation of this) then the artist will receive £7 x 75% x 20%, i.e. £1.05. This will not begin to apply until sales are sufficient to reach recoupment so that the major will be left with £5.62 per unit for a good many sales but then reducing to £4.57 per unit. The indie would be left with £4.77 per unit (because it has to pay higher distribution fees) which is split with the artist after any other expenses have been deducted. If there is a profit sharing arrangement then it is difficult to see clearly how the unit price for a particular record might be divided. In the case of the traditional royalty system the breakdown (based upon the above example) in the case of a full price CD sold by a major (ignoring the fact that the artist royalty will be available for recoupment and remembering that the artist royalty is usually inclusive of the producer’s royalty) is as follows:-

Customs & Excise £ 2.62 Dealer £ 4.76 Publisher £ .64 Distributor £ .85 Manufacturer £ .50 Artist and Producer £ 1.05 Record Company £ 4.57

£14.99

On this analysis the record company takes a little over four times the combined amount taken by the artist and producer. However, this is an over simplistic approach. After taking into account all of the marketing and promotional expenditure (but ignoring the record company’s overhead costs) the profit ratio might typically be in the region of 2:1 or, perhaps 3:1 in favour of the record company. This conclusion is supported by the evidence in the George Michael case. The record companies argue, of course, that they need to retain profits in this ratio in order to support their substantial overhead costs (including all of the A&R costs written off in relation to unsuccessful artists).