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September 19, 2005

Audit Rights - Use Em or Lose Em!

Filed under: Game Law Articles — Tom B @ 3:43 pm

I was approached a few weeks ago about doing this regular monthly article for Gamasutra and thought it would be a good thing. So, then I began mulling over what sorts of topics would be fun for me to do and of value to the readers. Well, with all that’s been going on lately such as Hot Coffee and the Jack and Hillary show, I was tempted to use the opportunity to rant on about lawyerly things like the Bill of Rights (the first ten amendments to the U.S. Constitution) and the potential impact these present issues can have on free speech - or possibly a rant about the desperate need for our industry to make a conscious effort to present games as a valid “art form” just as the film industry has done with its commercial medium. These are, for sure, issues I have something to say about and that I believe need to be voiced… but instead I decided to save my rants for future articles, and make my first one about helping developers deal with one of the more knotty business issues they face - royalty audits.

Audit Basics

Most publisher contracts contain a provision that provides developers a right to periodically audit the publisher’s financials related to their game in order to verify that the royalty credits and payments due the developer are properly calculated and accounted for. The audit is usually at the developer’s expense. But, typically, if a discrepancy of more than 5-10% is discovered, the cost of the audit is paid by the publisher. This protects the developer from any mistakes on the part of the publisher in determining the “net proceeds” from which royalties are set or inadvertent miscounting of units sold. It seems really simple, and certainly sounds like a good thing for any business to do. There are few, if any, developers who would sign a publishing contract without an audit provision - at least none of my clients would.

Here’s the odd part… the exercise of audit rights by developers is, in reality, fairly rare. I have asked developers about this. Even in cases where they felt that they were due royalties, I have had developers express a strong reluctance to exercise these rights, because they think that to do so might create the perception that they didn’t trust their publisher. Of course, this is not really a matter of trust - it is a matter of business sense. The continuing failure of developers to routinely exercise their audit rights creates a void into which the most lax accounting practices can easily fall on the publisher’s end.

You see, if developers don’t enforce their audit rights, there is no incentive for the publishers to use the necessary high degree of care in determining the appropriate royalties. This level of care takes time, and time is money. So, if no one is going to audit, why bother? Not surprisingly, any slop usually lands on the publisher’s side of the balance sheet. If any accounting errors do occur, it is unlikely that they will result in a higher net revenue figure or more units sold.

Let’s be serious here. Developers fortunate enough to make a game that puts them in a position to receive back-end royalties should be sure that they get every single dollar they are entitled to, because it is an all too rare occasion. Sure, for most developers, it’s a buyer’s market and there are more developers looking for publishers than there are publishers looking for developers. So this may not seem like an easy decision, at least politically. But it sure is a simple financial one. Audits cost several thousand dollars. Compared to the budgets of most games, it is a small price to pay to make sure that you are getting everything you are due.

Besides, it seems to me that the only publishers who would be offended by a developer enforcing its audit rights are probably not ones you should be doing business with in the first place. Developers can do worse than have publishers believe that they are competent business people willing to enforce their contractual rights. For example, they could be viewed as incompetent business people that are easily taken advantage of.

The 6 Million Dollar Game

I was on a panel discussion recently at the Microsoft Meltdown in Seattle where we were discussing publisher deals. This was a pre-contract through gold master sort of discussion, and prior to the presentation, I asked that we go past the delivery of the game and include audits in our discussion. I almost forgot about it, but one of the panelists, a top-tier developer, reminded me about this last topic of discussion as we were about to close. I soon found out why he remembered because numbers like these are hard to forget. At first I was a little surprised to hear him say that his studio always audits every publisher deal. Why? Because when they audited their first major deal they found 6 million dollars (yes…that’s $6,000,000.00) in royalties due them that had not been paid. Apparently, the issue there was the manner in which the publisher had been calculating net proceeds rather than the number of unit sales. But, whether it is the methodology or simple accounting of units sold, an audit should reveal any errors.

Sure, there are only a few games that hit numbers like that, and there are only a few developers in the top tier. But mid-level independents that live from one game to the next are even more thinly capitalized, and for many, a few hundred thousand dollars in inadvertently omitted royalties could make the difference between success and survival.

Audits Make Business Sense

Like a close friend of mine who does product acquisition for a major publisher says about dealing with a publisher, “It’s not my job to protect your financial interests and if the developer does not have the business sense to ask, then I’m not going to offer.” Just as this basic business principle applies to the negotiation of publisher contracts; it also applies to developer audits. If you don’t ask, they will not offer. So, while the exercise of your audit rights is certainly an expense, it can often be money well spent.
Review your contracts so that you are well aware of what your audit rights are and how to exercise them. Then, any time you are in a situation where you believe that you have reached, or are rapidly approaching, recoupment of advances under your publisher contract, you should consider calling an audit. Unless and until developers start asserting their rights in their business relationships with publishers, they will continue to be perceived as business softies who are easily taken advantage of, and this isn’t helping your business, or, indeed, anyone else’s.


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