Principles of Contracts: Nothing But Net

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Previous Chapter: Interlude: Think Contracts Don’t Matter?
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Most of this series concentrates on general contract principles. This week’s entry is a little different. It’s devoted solely to the creative industries (businesses like films, music, books, theater, etc. which depend on artists for their grist), and I’m posting it now rather than later because recent events have thrust it to the center of my attention. If you’re in a creative industry, this one’s for you.

It may surprise you to learn that Babylon 5 has never turned a profit. Not a cent. In fact, according to an Internet post earlier this year by creator J. Michael Straczynski, his most recent royalty statement informed him that the entire franchise is still $80m in debt. For perspective, all 5 seasons, plus 5 movies, plus the spinoff series, plus the follow-up Lost Tales special, cost under $200m to produce in aggregate. The franchise’s total revenues now totals in excess of $1.2b.

And, according to Warner Brothers, it’s never made a profit. Not a cent.

Babylon 5 is not alone in this. The Lord of the Rings films are, according to New Line Cinema, massive money pits. In fact, most movies, particularly the big money-makers, never officially break even. All of them lose money, despite being spectacularly successful, year-over-year, raking in long-tail revenues from streaming, reruns, home video, cable, spinoffs, merchandising, and remakes.

How is this possible?

For the same reason that Enron always turned a profit, and housing prices always go up: Because the bookkeeper said so.

Welcome to the world of creative bookkeeping.

“So what?” I hear you cry. “Who gives a damn if Hollywood fat cats are cooking their books? Isn’t that a problem for the IRS?”

Well, yes it is. But it’s also your problem if you’re in business with an outfit that pulls these kinds of shenanigans–and in creative industries, there are a lot of companies that make their living pulling shenanigans like that.

How do they get away with it? By subtly tweaking the basic business model to their advantage, in the hopes that no one will notice.

Business Models
The Intellectual Property business is made up of creators, secondary creators, middle men, retailers, and audience.

The creators are the writers and their analogs who produce the property (a manuscript, screenplay, sourcebook, script, musical score, etc.).

Secondary creators are writers, directors, film editors, cinematographers, programmers, graphic designers, and game designers who take the primary property and transmute it into packaged products and/or derivative works ready for market. The principle thing that distinguish these folks from the next category is that these folks create derivative works as part of their job and (by law) they retain the rights to some part of those works.

Middle men are book editors, copy editors, producers, marketing folks, sales people, distributors, and all others involved in actually bringing the product to market, but who do not create additional intellectual property.

Retailers are companies like Amazon, your local movie theater, or anyone who makes the products of middle men directly available to the audience.

The audience, of course, is the customer toward whom all this rigmarole ultimately directed.

Creative industries have a few basic business models. The most popular is the publisher model.

Whether a production company, a record company, a traditional publishing house, a game company, or a graphic novel company, the business of a publisher is to license intellectual property and try to make a profit from it. Money flows to the creators through the middle-men who give them access to the market.

When you license your property (intellectual property is normally licensed rather than sold) to another party, you do it because either
1)you don’t want to take it to market yourself, or
2) you think you gain more money and prestige by letting someone else do the legwork.

In either scenario, the party to whom you license your work has (at least) better market access, better marketing people, a loyal customer base, and a secondary creative team that can package your product.

In this business model, the creators supply the product, and the middle men are their customers. The other links in the chain are hands which the product passes through on the way to market.

The second major business model is that of the independent producer: authors who take on publishing responsibilities for their own work, independent filmmakers, many new media artists, and other such folks fit here. In these, the creative and production jobs are conflated and handled in-house. Specialty labor, such as marketing or graphic design, is subcontracted out, and those subcontractors work either for a fee (work for hire) or for a share in the property as a whole. In these instances, the indie producer maintains control of the project, and the subcontractor is accountable to the producer to perform to the contract’s specification.

The third business model is the work-for-hire. In this instance you (the creator) are the subcontractor, working either for a fee or for a percentage of the property.

These are the three major legitimate business models in the creative arts. Notice which one isn’t there?

That’s right. Profit sharing. With profit sharing, the creator gets a share of the net profits, after expenses are deducted. Imagine, for example, that your film rights or graphic novel contract entitles you to, say, 60% of the net profits. Pretty good deal, right?

Not really. In the creative arts, there is no such thing as profit sharing. There is only revenue sharing and graduated revenue sharing. And the reason why is bound up closely with the how you define “net.”

Defining “Net”
Net is pretty simple, right? Everyone knows what it means, right?

Not really. Net is one of those terms that means whatever the contract says it means, and only that.

Take, for example, this clause in a graphic novel contract I saw recently:

[transmedia publisher] shall pay to [author] a royalty of sixty percent (60%) of all net sales received by [transmedia publisher] for [property] licensed hereunder or subsequently created by [author] under this Agreement and funds for which have been received by [transmedia publisher].

The contract then goes on to define “net” in these terms:

[transmedia publisher]’s expenses to be deducted from gross sales receipts before net sales revenue is calculated and royalties distributed to [author] include, but are not limited to advertising creative, media buys, third-party vendor fees, printing, travel, lodging, typical office supplies & equipment, clerical support, consultants, convention registration fees, entertainment, advances paid, graphic design, photography, subagent commissions, applicable taxes, collateral materials, etc, incurred at [transmedia publisher]’s sole discretion to benefit the marketability of the [property].

At first glance that might look reasonable–after all, if you put yourself in the publisher’s situation, you can legitimately see why all those things are business expenses–and business expenses subtracted from sales receipts equals profit, right? If you’re sharing in the profits, it seems reasonable that this is what profits mean, right?

Not to put too fine a point on it, but no.

How Does Profit Sharing Work?
With profit sharing at, for example, a tech company, an employee earns a salary and/or a share of the company in exchange for his time. In addition, the employees receive bonuses based upon company profitability. The profit share is a bonus, not the salary. Notice how this is different from the contract clause above? Except in cases of work-for-hire, a creator doesn’t get much, or any, money for the license, so the profit sharing becomes her whole salary. Deals like this are a big no-no.

This doesn’t mean you can’t participate in a product’s success, you just don’t do it through profit sharing. You do it through revenue sharing.

Revenue sharing divides proceeds as they come in, with nothing taken off the top. Each member of the creative team who has earned a share of the revenue receives it out of the gross, because each member of the creative team actually owns a piece of the property (even if they don’t control the property) by virtue of their creative contribution to it.

Graduated revenue sharing is a modified version of the revenue share, in which the production costs are accounted separate from the creative costs. This generally occurs in situations, like indie films, where the controlling party is cash-poor but is still investing her own money in the project, as well as investing creatively. The non-controlling parties invest as well, but only with their creativity. In this case, a dollar threshold is set. Before that threshold, the non-controlling parties receive diminished or no residuals, and after that threshold, they receive full shares in perpetuity.

There are some other legitimate variations on this later scheme, but one thing remains constant through all of them:
It’s all done on gross revenues. There is no “net.”

For the purposes of contract negotiations in the creative industries, there is never any such thing as “net.”

Why not? For two reasons:

1) Profit sharing inverts the business model.
2) Profit sharing gives cover to creative bookkeeping, which is an industry euphemism for “fraud.”

Inverting the Business Model
With clauses such as the one above, the burden of risk shifts from the middle man to the creator without compensating the creator for it. It’s the middle man’s job to take risks on creative properties, and he gets compensated handsomely for that risk when the gamble pays off. Shifting the burden to the creator (who has already maximized his risk exposure by creating a property without guarantee of compensation) is a snake’s move.

This kind of behavior isn’t just found in the creative industries. Illegitimate risk shifting was at the root of the recent mortgage crisis, and it’s at the root of the crash of a lot of businesses. The kind on display in the clause above is typical of how it happens in creative industries.

It amounts to the creator paying for access to the market, which is the bottom line of every single scam run on creative people by savvy operators without a healthy sense of ethics.

This is important: A creator does not pay for access to the market, ever, unless he is also a producer (in the “production company” sense of the word, which is how I use this word throughout this post).

The above clause tries to have it both ways. It tries to preserve the licensure relationship of the traditional model with regard to creative control and reward, but shift the burden of risk toward a co-producer type relationship.

As you can see from the phrase “incurred at [transmedia publisher]’s sole discretion to benefit the marketability of the [property]”, the clause above removes the creator from the production and marketing while making his income hostage to the business decisions of his customer.

If you’re looking for a co-producer’s relationship, you should make sure you share in the rewards and the control. Otherwise, stick to licensure. In no wise should you enter a relationship where the other party tries to have it both ways, while shifting the burden of risk on to you.

Which brings us to the way such arrangements guarantee that no creative property returns a profit: Creative Bookkeeping

Creative Bookkeeping: What is it?
Creative Bookkeeping is a euphemism for “cooking the books.” It’s an organized crime trick that got Al Capone sent to jail and allows businesses and individuals to cheat on their taxes and other financial obligations.

It boils down to the tried-and-true technique that traveling sales people everywhere use: ripping off one’s business partners (or boss) by padding one’s expenses.

There are a few ways this is done:

1) count ongoing overhead as a project-specific expense. Rent or property taxes on the office or studio space can get counted against the project on the grounds that, without it, the production company would have to go out of pocket to rent it for the project. The monthly salary of all employees who spend a few minutes or hours on a project can get billed against the project for the same reason.

2) Pad legitimate expenses in an untraceable manner. I use the word “legitimate” loosely, meaning “anything you can possibly get away with under the terms of the contract.” In the clause above, for example, the “office supplies” provision is a rat hole down which large amounts of money could be shoveled. How many paper clips, reams of paper, pens, pencils, computers, etc. does this project need? And how much do those supplies cost? And how much of an obligation does the office manager have to get the best possible deal on them? It doesn’t matter, because such expenses are untraceable, and they’re based on judgment calls. There’s no way to account for them. The Pentagon uses this very trick to hide funding for illegal black projects. If the Pentagon can get away with it despite dozens of GAO audits, your chances of catching someone out at this game are precisely zero.

3) Create ghost expenses. These are false billings from fictitious”consultants” that the books pretend are legitimate expenses. Of course, real people are easier to produce in a pinch than fictitious people, so it’s sometimes easier to pay real people a small fee to keep quiet, while paying them orders of magnitude more on the books.
Furthermore, the “consultant” could be a salaried employee, or even the producer himself, who takes a bonus on the books for “consulting” on the project. “Consulting” can, and does, mean anything the person doing the books wants it to.
After all, the clause above specifies that all expenses are legitimate “at the [transmedia publisher]’s sole discretion.” The person actually paying the expenses (the creator) doesn’t get a vote.

4) If you thought it couldn’t get dirtier, think again. The final common creative bookkeeping technique is to count overhead from other projects as applying to the most profitable project. Every production company and publishing house has its turkeys, and these turkeys really do lose money. Shifting a percentage of expenses from one of the turkeys (which has negative cashflow to spare) to one of the profitable projects protects a production company from being in the dangerous situation of showing much of a profit even on it’s biggest, most popular properties.

There are a lot of other arcane techniques bookkeepers use, but these are the four that are easiest for us laypeople to understand.

But why would anyone do this?

To hold on to the money. The creative industries attract high-risk gambler personalities, and gamblers like a sure thing. Just as people cheat at cards when then can, so they also cheat on the books when they can get away with it.

These tactics are not uncommon or rare: it happens frequently even in print publishing, which is arguably the cleanest game in this field (mostly because publishing now operates almost entirely on a revenue sharing model, not a profit sharing model, and due to decades of fighting by ballsy authors things like audit clauses are now standard). Make no mistake: The cleanest game in a dirty field can still get dirty–embezzlement and ripoff scandals are infamous; some, like the Ace Doubles Audit scandal in the 1970s, even make news in mainstream business channels. Creative bookkeeping is almost impossible to catch on an audit unless the bookkeeper is very incompetent or the auditor has access to independent inside information–like, for example, a court-ordered report from the print shop that they printed 10,000 units more than the publisher said they did–that is hidden on the books.

So Why Do People Fall For This?
Creators fall for this because, like producers, they can get greedy. Unlike producers, creators tend to be myopic, not thinking through the ways someone could cheat them if they put their minds to it. Often, new creators are happy just to have their work published, and they assume that since they created the thing, they get a piece of the profit, so they don’t look too closely at the fine print.

Other times, they take “net” because it’s what they can get, and the project is worth all the trouble of the inevitable lawsuits. Often, they’re getting something out of the project that’s more important than the money.

Peter Jackson did this with the Lord Of The Rings films, and eventually won the litigation. He also had some very good lawyers and investigators. J. Michael Straczynski did this with Babylon 5, because he wanted to tell the story enough that he was willing to knowingly take the risk that Warner Brothers would screw him (which they did, royally). In both cases, these men did deals that wound up with themselves ahead even in the case they got screwed: they didn’t just get theoretical royalties out of it, they got salaries up front, and they got reputations that have given them enough power to never have to take a bad deal again.

Sometimes, in situations like that, it’s worth it.
Most of the time, it’s not.

But Why Should I Care?
A lot of you reading this series are authors, and might be wondering “If publishing is the cleanest business, why should I care?”

Well, just because it’s the cleanest business doesn’t mean it isn’t filled with sharks and snakes, it just means that there are fewer in the publishing world because publishing is a non-monolithic, lower-margin business. But there are other reasons, too — SFWA, MWA, RWA, and similar associations worked long and hard to flush a lot of the snakes out of the business, and that’s one of their principle ongoing utilities.

You should care because, if you do well, Hollywood may eventually come knocking at your door for film rights, or Silicon Valley might do the same for video game rights.

You should care because your properties are exploitable for any number of transmedia applications, and this is one of the places where the real money comes from in the writing business.

You should care because many of the new companies coming up in the publishing world, particularly those poaching podcasters and other online new media artists, are writing contracts based on the Hollywood model.

I’ve seen a few of them. In this post I’ve quoted one that an ANMAP member handed me last week for comment. These contracts are out there, and the more you get into graphic novels, games, film rights, and other spinoffs, the more you’re going to run into them.

You should care because this is where your living comes from. If you’re a content creator, your rights and residuals are all you have. Protect them.

There’s an old saying in Hollywood: “1% of gross is a thousand times better than 100% of net.” That’s because net is almost always $0, no matter how much money the project generates.

In the creative arts, “nothing but net” means one thing, and one thing only:

Nothing.

Next time: The Market Awareness Principle

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12 Comments

  1. Thank you for this. Your knowledge and expertise in these areas is greatly appreciated. Hopefully through educating up and coming authors and other creatives with articles such as this good writers won’t end up with bad deals.

  2. Pingback: Think Contracts Don’t Matter? at Literary Abomonations

  3. Pingback: Think Contracts Don’t Matter? at Literary Abomonations

  4. Very comprehensive post. As you know Kris Rusch, and others, have been talking this last while about royalties and the concerns with e-book royalties specifically. I don’t believe these concerns stem form “snake oil” types in publishing. I think it’s the result of publishers not having a true understanding of the impact of e-books and how they’re distributed. And how these distribution channels have changed. I don’t think this new round of controversy is intentional more than its good business.

    Corporations are legal entities, just as people are, but corporations are without a conscientious, and their sole reason for being is to create wealth.

    Excellent point about net versus gross. I’ve seen these kinds of wordings in contracts before and turned and ran.

    Nice post. I’m going to share it with other writers.

  5. Russ–

    Glad you found it useful. I don’t believe that most people in publishing are snakes–however, the increasing prevalence of undefined “net” in contracts (or, worse, contracts like the one I was quoting above) is exactly the kind of sea change that allows snakes and sharks to flourish. I’ve got no problem swimming with sharks, I just like to wear my chainmail for the occasion. And I don’t really blame sharks for their nature–but I think that people who are going to swim with them should know what behaviors to beware of.

    And, of course, as I cover elsewhere in this series, a lot of times the best of intentions add up to exploitation through lack of diligence and business sense, which can leave valued friendships and professional relationships in ruins. The end result of either a shark in the water or a very sweet-hearted ignorant person in the water can be pretty ugly.

    Thanks for sending others this way–and for coming by yourself!

    For others who are reading, if you’re in publishing you should read the three posts called “Royalty Statements,” “Royalty Statements Update,” and “Sea Change” on Kris Rusch’s blog at http://www.kriswrites.com. This stuff is becoming even more important as publishing restructures.

    -Dan

  6. Came over from Dean Smith’s site.

    This is a great post. When I used to be a regular on a certain writers’ site (and I still go there from time to time), I learned very quickly from reading thru various threads that any publishing contract that specified royalties based on net was a MAJOR red flag. In a best case, this was due to the owner being uninformed or misinformed; at worst, the owner was a scamster who knew exactly why he/she was doing (separating the writers’ wallet from his pocket).

    As to gross vs. net, Jimmy Stewart was one of the first (if not THE first) actors to get a percentage of the gross on his films (smart); made a ton of dough. As to “settling for” net, I’m reminded of the old comedy routine where the comedian(s) win a huge lottery, but because of taxes and dubious fees…they end up owing the government money!

    Most informative post. Thank you for it.

  7. Pingback: New E-Publishing Opportunities….or not? « Michael Kingswood's Writing Blog

  8. Nancy —

    I remember that old comedy routine–would that it were mere parody! In the music business, it’s not uncommon for very successful artists to wind up *owing* money to their record labels. The contract will obligate the band to pay *all* expenses for their recording, their touring, etc. plus all the company’s expenses, including the cost of the bookkeeper that cuts the checks to the artists.

    Because these expenses are incurred on a deferred basis, there is, naturally, a finance charge, and a service charge, and subtle inflation all the way around on the books. By the end of the album, the band can wind up in debt to the record company, which (naturally) hasn’t taken any of the risk on, because they convinced the hungry artists to assume it all themselves. Steve Albini has an example of how this works here, and it’s not the worst one I’ve ever run into.

    I am seriously concerned about recent changes in the book business, such as the quotations in my above blog post (which came from a publishing contract) and the agencies turning themselves into holding/publishing companies, that writers are going to start winding up in the same situation–not just getting ripped off, but living the business equivalent of a sharecropper’s existence. Living in a company town is no picnic, but I wonder how many of the current living generations are familiar enough with them to recognize the setup when they see it.

    Thx for the info about Jimmy Stewart–you might be right that he was the first to get gross as a contract player. I think though–and I’m not certain about this–that Charlie Chaplain got gross at United Artists. Of course, he also owned the studio, so it’s not exactly the same thing. But perhaps there’s a lesson in that, too 😉

    Thank you for stopping by!
    -Dan

  9. It seems to me that the most reasonable arrangement is for the creator to collect a license fee for each month the publisher/studio/whatever has the license, plus a small percentage of the gross, plus a percentage of the net. This should protect the creator and provide incentive for the studio to honestly create a successful, profitable product, or cut their costs by releasing the license on the rights. As you point out, so many of these contracts pay the studio to do a bad job and rip off the creator as much as possible.

    Doc

  10. Thanks for the post, will need that in the near future. Came over from Kris and Dean’s blog posts.

  11. Thank you for the very informative article! Could you point us to where we can see examples of *good* agreements? I am personally interested in graphic novel contracts (I am the artist, adapting someone else’s story.) It would be very helpful to get a good point of reference.
    Thanks again.

    • Unfortunately, I don’t have any on hand at the moment. If anyone does have such a resource, please do link it here or email it to me and I’ll make a fresh blog post about it.

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