The Royal Scam Part 1: How the rush for the equity trough trades artist royalties for stock

“All animals are equal, but some animals are more equal than others.”

Napoleon in Animal Farm by George Orwell

The U.S. Copyright Office has raised a relevant question in its request for comments on music licensing:

Please address possible methods for enhancing transparency in the reporting of usage, payment, and distribution data by licensees, record labels, music publishers, and collective licensing entities, including disclosure of non-usage-based forms of compensation (e.g., [1] advances against future royalty payments and [2] equity shares).

Many artists and indie labels are probably not even aware that some deals they are being asked to opt-in for have some hidden economics that make the deal better, and often much better, for some artists or labels than others.  We first noticed this underhanded approach in the DMX-type deals where companies like DMX paid early adopters to take a low royalty in return for a big advance that may have been non recoupable.  Then they hold out that low royalty as an MFN type rate to others without disclosing the advance paid to the early adopters.  We’ve seen it perpetuated in the Spotify deals and maybe some other recently announced licensing deals.

Why is this a problem?  Because it’s not formally disclosed to the less equal animals, and sometimes it hides behind the NDA culture that Google has introduced into the music business.  It’s also a problem because those who need the money most are paid the least.

This is different than the “I’ll give you some stock if you say something nice about me to your friends” deals that we see all the time.  Those are corrupt for a different reason, the same reason that payola is against the law on radio and TV (and we all know how much Pandora wants to be treated like a radio station and YouTube thinks they’ve replaced TV).  Be careful what you wish for.

Thankfully, the U.S. Copyright Office is now focused on these under the table payments as a matter of public policy and we commend them for that stance.

Digital Music News has done a great job of surfacing this issue of the inequity of equity.  As Paul Resnikoff reported (How Streaming Services are Screwing Lady Gaga (and Every Other Artist), there are clauses in artist agreements, even highly negotiated ones, that deny artists a share of advances that are made for a label’s entire catalog in a clause like this one that Paul posted:

gagacontract small

Focus closely on what this clause actually says:  If the label gets “payments…pursuant to any blanket licenses” for the label’s catalog, the artist–the one whose contract it is–doesn’t get any of those “payments.”  Paul uses this clause to attack the equity that labels got in streaming services.  He’s kind of right, but not for the reason you might think.

This clause is a very old concept in record deals and it has a legitimate above the table rationale and also a below the table one.  If a label makes a distribution deal for a blanket license of their entire catalog they typically negotiate a minimum guarantee, sometimes called an “advance”, against revenues that come in for their catalog during the life of that distribution deal.  The minimum guarantee is paid up front by the distributor, so it is a kind of bet by the distributor that the catalog will produce enough money to recover (or “recoup”) the minimum guarantee from royalties otherwise payable to the licensing label.  (Leave aside for the moment whether this is a “license” or a distribution deal for sales–see the Eminem litigation.)

That advance earns out over time depending on how the label’s catalog sells.  Advances are typically “recoupable but nonreturnable.”  The advance is recoupable, i.e., applied against the label’s share of the catalog’s sales during the distribution term.  The advance is “nonreturnable” meaning it doesn’t have to be paid back if the label’s share of revenues during the deal don’t equal or exceed the amount of the advance.  If the label is “unrecouped” at the end of the deal, the label keeps that delta.

Example:  Label X gets an advance of $100 from Distributor Y for the country of Airstrip One.  The deal lasts 5 years.  At the end of 5 years, Label X’s catalog has earned $90.  Distributor Y just sends royalty statements to Label X showing an unrecouped balance and doesn’t have to pay the $90-because Label X has already had it in the form of the advance.  If the deal is still unrecouped when it ends–meaning Label X got a bigger advance than it earned–then Label X keeps the extra $10.

From Label X’s point of view, Label X still has to pay its artists their royalties for the $90 of sales.  Say Label X has three artists, Hear, See and Speak.  Assume that artist Hear earns $85, See earns $5 and Speak has no sales.  (It’s actually more complicated because the artists will get less than 100% of the money, but leave that aside.)

The advance, then, is a kind of bet that Distributor Y makes on the Label X catalog.  It’s paid in cash and it’s paid up front, like ante.  Because that advance is a payment against actual future sales, there’s really no fair way to divide it up among the artists on the day that the deal is done, that is, before there are any sales.

This is the reason that you get for why this clause is in there.  That’s the “above the table” reason.

Here’s the “below the table” reason.  What if Label X was very valuable to Distributor Y, either because it was a huge catalog without which Distributor Y wouldn’t really have much of a business, or it was just a very hit-rich catalog and was likely to continue to be valuable to Distributor Y in Airstrip One.  Label X could very easily say to Distributor Y, you know that $100?  I have to share that with my artists.  How about you pay me $20 of that flat and just give me an $80 advance?  Meaning–Distributor Y pays Label X $20 on a nonrecoupable basis (“flat”) and Label X puts that money in its pocket.  And because it’s a “payment” for the blanket license, the label doesn’t have to share it with any artist.

Is it fair?  Is a nonrecoupable payment just a way to get a higher royalty or revenue share for the label?  That depends on how you look at it, but one thing that is certain is that the reason that the label is able to get this nonrecoupable payment is because of the value of the catalog.  That value is a mix of the work product of the label’s investment in the artist, but it’s also partly the value of the present and future work product of the artists.  And you won’t be surprised to know that we think it’s largely the work product of the artists.

Consider another aspect of the same example.  If the deal with Distributor Y is a true license, most of the time the revenue is split 50/50 with the artist (this is what the Eminem case was all about.)  However that advance earns out, you can see that if there is a portion of the money that is nonrecoupable, the nonrecoupable part is not shared with the artist.  Distributor Y will still have to pay Label X for sales occurring after the advance part is recouped, so it’s not like the artists are not getting paid for their sales.  (Assuming that Label X is accounting properly.)  There’s just a chunk of cash that never hits the artist royalty statement because it is paid directly to Label X as what some might call a vig.

The practice has been that when the label leverages the work product of their artists to get a payment for the label that they don’t share, they trot out this clause that Paul has found as the justification.  It’s still often kind of revenue neutral for the individual artists, it’s not like the label said give me this money and underreport sales, or give me this money and I won’t audit you.  Well…maybe they did say I won’t audit you.  But from the artist perspective the deal should be revenue neutral.

Now consider the same facts, but in addition to the nonrecoupable payment, Label X also demands shares of stock in Distributor Y.  Distributor Y says hold on there–I already gave you the nonrecoupable payment and you want stock, too?  What are you giving me for the stock?  Hmmm….who is not at the table here?  Let’s take their money.  So the label says sure, if you give me stock and a nonrecoupable payment, I will let you [increase your distribution fee/decrease the royalty base price/decrease the net sales on which the artist royalty is calculated/increase the reserves that are never liquidated] that determines the royalty I have to pay to the artist.  But only by a believable amount.  Say 10-20%.  This works particularly well in places like say Venezuela, China or Cambodia.  Or on the Internet.  Any place no one expects to get a decent accounting.  Or feels lucky to get any payment at all due to rampant piracy.  (Remember the three legged stool from Old Boss, New Boss.)

Why does this happen?  Because if you are not at the table, you are on the menu.

Back to Lady Gaga’s contract.  Do you think that this clause also covers stock that was extracted in return for a lower royalty rate?  In other words, what if the clause that Paul quotes ended with “in return for lowering your royalty rate to an abysmal and unsustainable level while your label gets rich beyond their wildest dreams”?  Or even if it said “payments in cash, shares of stock or other securities or other things of value”?  How do you think that would go down with the artist’s representative?

Another part of the vig is what happens at the end of Distributor Y’s contract if Label X is unrecouped.  Frequently, Distributor Y is allowed to extend the term under some conditions to try to recoup the unrecouped balance.  This doesn’t go on forever but it might be another 6 months or a year.  In the land of Internet where the living is easy, the fish are jumpin’ and the cotton is high, when the deal is over, the unrecouped balance often is not rolled into additional time on the contract.  Instead, the term is renegotiated and a new advance is paid for a new deal.  This pocketing of the unrecouped balance is sometimes called “breakage.”  Does Label X share the breakage with their artists?

What do you think?

If this is just a miscalculation by Distributor Y, that’s one thing.  If, on the other hand, Distributor Y for the Land of the Internet overpays the advance by what anyone would find to be an amount that is highly unlikely to recoup, and also has a crappy accounting system so that the accountings that Label X will use to account to their artists underreports sales–like reducing the percentage of net sales in the physical world–who benefits?  If Label X gets a big enough nonrecoupable payment, high enough breakage and enough shares of stock in a company that is likely to go public or have a big exit–while still making most of its current revenue from sources other than the Land of the Internet–do they really care that much?  Particularly if they distribute some of those shares of stock to Label X executives to hold personally?  Who’s going to complain?

If you’re not at the table, you are on the menu.

Of course if Label X lacks market power, it is unlikely that Label X will be able to extract any of these vigs.  And this leads us to the indie labels’ claims against YouTube.

To Be Continued.

One thought on “The Royal Scam Part 1: How the rush for the equity trough trades artist royalties for stock

  1. David, I’m so glad to see you bring awareness to this issue, the single biggest issue facing artists who want major label deals. As I’ve said for over a year now ‘the greatest rock & roll swindle’ of all time.
    A Katy Perry type superstar act is given an advance she can’t refuse, so Capitol can say ‘look, Katy Perry is on Spotify with her album’s release… if you don’t want to be then we’re not interested in you because this is the new paradigm.’
    I was shopping Lifehouse to a major I’ll keep to myself for now, and it looked like we were ready to make the band a brand new deal. In a phone conversation with their A&R guy I told him I’d like to remain off Spotify, have a lyric video up on YouTube and try to inspire Lifehouse fans to buy the physical or digital album before we make the songs streamable.
    I didn’t hear back from this label again for a year… and we were on the verge of a deal! Finally one year later a call from A&R guy saying ‘sorry man I got a little swamped’.
    This is when I knew it was ‘contribute to our bundle or go make your indie record’. I guess label’s weren’t happy with that 85/15 deal when now they own it all and manufacture nothing.

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