“Net Profit Deals” Between Artists and Labels

In the past 10 or 15 years, many labels – mostly indie labels – have started signing so-called Net Profit Deal contracts with artists, rather than the traditional type of recording contract. Some major labels have also occasionally signed Net Profit Deals with artists, but only very occasionally, and less and less so as time goes by.

The Basics of Net Profit Deals

To give some context to Net Profit Deals, let’s first discuss the general terms of the traditional recording contract.

With the traditional recording contract, the artist is paid on a royalty per record basis, with the royalty per record being in the range of 13 to 17% of the so-called “PPD Price” (essentially the wholesale price). But the label is entitled to recoup all recording costs (and any prior cash advances to the artist) from those artist royalties. As a result, the artist doesn’t actually receive any royalties unless and until the total amount of artist royalties and prior cash advances exceeds all recording costs. And then, for any records sold after that, the artist is paid artist royalties. The record company pays all costs other than recording costs out of its own pocket – such as the costs of duplication, shipping and promotion – and doesn’t factor those costs into the calculations of artist royalties.

The new ‘360 Deals’ also calculate artist royalties the same way. Therefore, in the discussion below I will refer to the traditional recording agreements and ‘360 Deals’ together as “Royalty-Based Agreements.”

The basic idea of Net Profit Deals, on the other hand, is that after ALL expenses connected with the artist’s records are recouped by the label from record sales income, any net profits from that point forward will be split between the artist and the record label, with the artist usually getting in the range of 40 to 50% of those net profits.

Though this percentage is much larger than the 13 to 17% royalty range mentioned above for Royalty-Based Agreements, the artist in a Net Profit Deal is getting 50% of the net income from records sold (in other words, only what’s left after ALL expenses are paid).

Note: There’s one tricky thing to be careful about with Net Profit Deals: Sometimes a Net Profit Deal contract will refer to the artist’s share of net profits as being a “royalty.” But if the “royalty” is in fact a percentage of the net profits after ALL costs have been paid, then it’s really a Net Profit Deal and not a Royalty-Based Agreement, and so, the artist’s share should be in the 40 to 50% range mentioned above.

Advantages and Disadvantages of Net Profit Deals

Net Profit Deals create certain advantages and disadvantages for both labels and artists, as compared to Royalty-Based Agreements. But, of course the advantages and disadvantages of Net Profit Deals for artists are completely different than they are for labels.

Advantages and Disadvantages of Net Profit Deals for LABELS

Advantages (for Labels)

In most Net Profit Deals, the label doesn’t have to pay the artist anything until the label has recouped all costs fronted by the label. This is, of course, appealing to labels, especially in these days of declining record sales and the increased risk of losing money.

Disadvantages (for Labels)
The main disadvantage of Net Profit Deals for labels is on the back end – that is, if an artist’s records are extremely successful and the costs relatively low in comparison. In that scenario, the deal will be much less profitable for the label than a Royalty-Based Agreement would be.

Advantages and Disadvantages of Net Profit Deals for RECORDING ARTISTS

Advantages (for Artists)

Net Profit Deals can be attractive to artists, but for completely different reasons.

For one thing, if record sales are quite substantial and the costs involved relatively low, the artist will likely come out significantly better with a Net Profit Deal than with a Royalty-Based Agreement.

Also, to many artists the idea of an artist and label sharing any net profits seems inherently more fair and understandable than the voodoo economics of Royalty-Based Agreements.

Plus, some artists prefer the general feel of a profit split situation, which can feel more like a partnering relationship with the label than is the case with the traditional artist-label relationship.

However, the appeal of a ‘profit sharing’ relationship is somewhat dampened by the fact that even if the contract states that there is to be, for example, a 50-50 net income split, the label may actually be receiving more that 50% of the net income. This is because some labels deduct an “Overhead Fee” off the top, along with all other costs (i.e., recording, duplication, promotion costs, etc.). Then, whatever is left is divided 50-50. Put another way, the label is receiving an Overhead Fee off the top, PLUS 50% of the “Net Income.” (See the sample calculations below to see exactly how those calculations are done.) This is just one example of some of the subtle financial issues lurking under the surface with Net Profit Deals.

It is not always easy to determine in advance whether a Net Profit Deal will be more or less advantageous than a Royalty-Based Agreement. Comparing the economics of Net Profit Deals to Royalty-Based Agreements can be very confusing, and to a large extent is comparing “apples and oranges.”

The only way to really analyze the financial ramifications of a Net Profit Deal versus a Royalty-Based Agreement is to “spreadsheet it,” based on a ballpark estimate of what the total expenses will be and what the sales levels would likely be in your particular situation. When evaluating any kind of deal, it is always crucial to crunch the numbers.

That being said, those calculations can be difficult and problematical for an untested new artist with no prior record releases. But for artists with prior record releases, they can use the income and expense history of their prior records as an indicator of the likely income and expenses for their next record.

Disadvantages (for Artists)

Net Profit Deals also present certain disadvantages for artists, including the following:

Mechanical Royalty Issues

First, the mechanical royalty provisions of Net Profit Deals can be disadvantageous for artists who write some or all of the songs on their records. This can be best explained, though, by first describing the mechanical royalty provisions of Royalty-Based Agreements.

With Royalty-Based Agreements, artists who don’t record their original songs receive only artist royalties (at the 13 to 17% artist royalty rate mentioned above). But artists who do write songs for their own records are entitled to not only artist royalties from the label, but also mechanical royalties (“mechanicals”) for their original songs. Those mechanical royalties are calculated at a certain number of cents for each original song on an album, multiplied by the number of records sold, and are paid to the artist separately and in addition to the artist royalties.

Also with Royalty-Based Agreements, record companies are usually entitled to deduct and recoup recording costs from the artist royalties, but not from mechanical royalties. And since recording costs are recouped only from artist royalties – and not from mechanical royalties – mechanical royalties are not affected by recording costs and therefore start flowing to the artist much sooner than artist royalties.

With Net Profit Deals, though, mechanical royalties are handled very differently, usually in one of the following ways:

(1) With some Net Profit Deals, the label pays mechanical royalties to the artist, but treats those mechanical royalties as an advance to the artist, and will deduct the amount of those royalties off the top as a general expense – in effect later reimbursing itself for those mechanical royalty payments off the top from record sales income. Some labels, though, deduct the amount of those mechanical royalties from solely the artist’s share of the net profits (if any); OR

(2) In other Net Profit Deals, no mechanical royalties at all will be payable to the artist. Instead, the artist will receive only a share of net profits, and no separate mechanical royalty payments. In that case, the contract will usually say something like: “All monies payable to Artist hereunder shall be inclusive of any mechanical royalties which would otherwise be payable to Artist.” If this is the case, the artist will not have the cash flow from the mechanical royalties that are paid in the case of Royalty-Based Agreements. The resulting cash flow problem can be compounded by the fact that usually the label is spending money faster than it comes in, just to keep the momentum of record sales going. For these reasons, even if there may eventually be net profits from the record for the artist to share in, it will likely take quite some time before that happens. And in the worst case scenario – i.e., if net profits never materialize – the artist will receive ZERO money from the deal (i.e., no ARTIST royalties and no MECHANICAL royalties).

An important sidenote: If you are an artist considering signing a Net Profit Deal, you need to first discuss the pending Net Profit Deal with your publisher (if you are signed to a publishing deal), and with any co-writers outside your band, since the mechanical royalty provisions in Net Profit Deals may seriously affect their income from your record sales. You also need to clear the royalty provisions with any producers whom you have hired directly (as opposed to a situation in which the record company has hired the producer and has agreed to pay the producer separately from any monies owed to you as an artist).

If you don’t have those important discussions and work things out with those people, you will be jeopardizing your future relationships and business dealings with them.

Audit Issues

There’s another potential disadvantage of Net Profit Deals for artists: It is much more difficult and cumbersome for artists to do a royalty audit with Net Profit Deals than with Royalty-Based Agreements. In the case of Net Profit Deals, the only way that an artist can know whether they have been paid the proper amount is by verifying ALL income and ALL expenses that the label incurred. On the other hand, in the case of a Royalty-Based Agreement, the artist needs to verify only the income received and only certain limited kinds of expenses (primarily just recording costs and independent marketing and promotion costs), and not all expenses.

Audits can be very expensive, easily costing around $10,000 to $20,000 (and often much more, particularly in the case of major label artists having substantial sales) and hence are not an affordable option for many artists. Even so, it is still wise for artists to try to make sure that their Net Profit Deal contract provides strong audit rights and contains a clause stating that if the label’s accounting statements are off by a certain percentage, the label will then be obligated to reimburse the artist for any audit costs incurred.

Merchandising

Frequently in Net Profit Deals the label will have the right to create and sell at least one new T-shirt for each record released during the term of the deal, and sometimes other merchandise as well. Those T-shirts (and other merchandise) are then sold from the label’s website and perhaps through retail channels as well. The band then shares in the net profits from those sales.

However, the label’s sale of such merchandise can reduce/cannibalize the artist’s sale of his or her own merchandise. And since merchandise income is such a big part of surviving on the road, any band entering into a Net Profit Deal needs to either try to avoid giving the label the right to sell such merchandise, or at the very least, negotiate the best possible contractual rights and protections in regards to any such label-created merchandise.

“Overhead Fees” (aka “Administration Fees” and “Marketing Fees”)

From an artist’s point of view, the “Overhead Fees” mentioned at the beginning of this chapter are of questionable fairness, since even without an Overhead Fee a label is usually entitled to receive at least 50% of any net profits. Overhead Fees are basically a device to allow the label to take a little bigger piece of the pie. Sometimes they can either be removed entirely from the contract, or the Overhead Fee percentage reduced, when the deal is being negotiated.

Some Sample Calculations: Comparing Royalty-Based Recording Contract Royalty Calculations to “Net Profit Deal” Calculations

For purposes of these sample calculations I am just plugging in some sample (and admittedly very random) numbers here. Certainly all of these numbers will vary substantially from one artist-label situation to the next.

Also, to try to keep things as simple as possible, I am not factoring in any numbers for such things as income from the digital distribution of single songs or income from licensing masters for films and TV shows. I’m also not taking into consideration the fact that major labels generally spend substantially more on recording costs, marketing etc. than do indie labels. Also, I am drastically oversimplifying how royalties are calculated in the case of Royalty-Based Agreements.

In short, I’m not necessarily trying to base these calculations on realistic estimates of what either an indie label or major label would spend, since those numbers are all over the place from artist to artist and label to label. Instead, the sole purpose of these sample calculations is to show the procedure for calculating how the artist is paid in the Net Profit Deal scenario versus the Royalty-Based Agreement scenario, using the same set of numbers for both deals.

So now the fun begins:

ROYALTY-BASED RECORDING CONTRACTS: A sample calculation of the royalties payable to the artist):

ARTIST ROYALTIES (Royalty-Based Recording Contract): $10 = The WHOLESALE price per record (the price at which a label’s record distributor sells records to record stores and other retailers) (x) 14% net artist royalty rate =$1.40 artist royalty (for each record sold) (x) 30,000 records sold                              = $42,000 in artist royalties   (minus) $20,000 in recording costs (recouped/deducted/pocketed by the record company from the artist’s royalties) (minus) $10,000 (50% of a total of $20,000 spent by the label on independent marketing and promotion costs). (Normally the label is entitled to recoup from artist royalties 100% of the amount given to the artist for tour support, and 50% of the money spent on independent (outside) marketing and promotion costs (as opposed to the cost of the label’s own staff doing marketing and promotion). __________________________________________________________________ SUBTOTAL= $12,000 in ARTIST royalties MECHANICAL ROYALTIES (Royalty-Based Recording Contract) for the artist’s original songs: Normally on top of the artist royalties mentioned above, the label also pays songwriter/publishing royalties (“mechanical royalties”) to the artist (and the artist’s publisher, if any) for songs on the artist’s records written by the artist: If there are 10 songs on the album and the artist wrote all ten songs, the artist/songwriter is typically paid as follows: Six and 83/100 CENTS (6.83 CENTS) per song, for each record sold. (Explanation: In most recording contracts, the artist/songwriter is not paid the full so-called “statutory rate” provided for by the U.S. copyright law, but instead 75% of that amount. Currently the statutory rate is nine and one/tenth (9.1) cents per song for each record sold. The 6.83 CENTS mentioned above equals 75% of this “statutory rate” of Nine and one/tenth cents per song for each record sold. x 10 songs = 68.3 CENTS in mechanical royalties per album   (x) 30,000 albums = $20,490 in total SONGWRITING/PUBLISHING ROYALTIES HENCE, THE COMBINED ARTIST ROYALTIES AND MECHANICAL ROYALTIES (under a Royalty-Based Agreement), USING THE ABOVE NUMBERS, WOULD BE: $12,000 – Artist Royalties $20,490 – Mechanical Royalties $32,490 TOTAL Received by Artist

Now, compare those numbers to the following Net Profit Deal calculations.

NET PROFIT DEALS: A Sample Calculation of Artist Royalties (assuming that the contract does not require the separate payment of mechanical royalties to the artist) ARTIST ROYALTIES (based on a wholesale price of $10 per record received by the label from its distributor): 30,000 records sold @ $10 per record = $300,000 GROSS INCOME received by the label from its distributor.

(minus) $20,000 recording costs (this is reimbursement to the Label for those costs) (minus) $30,000 in duplication and printing costs (calculated at $1/per record) for 30,000 records (minus) $20,000 (i.e. 100% of the $20,000 in costs incurred by label to advertise, market, promote the record. (This is reimbursement to the Label for those costs.) ____________________________________________________________________ $230,000 SUB-TOTAL ____________________________________________________________________ (minus) a $45,000 “Overhead Fee” deducted and pocketed by label (based on 15% of the $300,000) ____________________________________________________________________ $185,000 SUB-TOTAL

½ of this amount is payable to Artist = $92,500 ½ to the Label = $92,500 (IN ADDITION TO the $45,000 “Overhead Fee” deducted and pocketed by the Label), for a total of $137,500 to the Label

Remember – these are only sample calculations. Any significant changes in the numbers plugged into these calculations would have a large impact on the final totals in these calculations.

Also – and this cannot be overemphasized – the above calculations should definitely NOT be interpreted to mean that an artist will always come out better financially with a Net Profit Deal than with a Royalty-Based Agreement. Every situation has its own unique numbers, and which type of contract is better will depend on the exact numbers that are used. This is one reason why it is so important for artists to do – IN ADVANCE – the best possible income/expense projections for their particular situation.

By the way, if a record is a big flop it won’t really matter much which kind of deal was used, since in either scenario there will usually be no artist royalties owed to the artist, and no net profits for the artist to share in. The one exception to this general comment is the fact that under a Royalty-Based Agreement (and some Net Profit Deals), the artist (wearing his or her songwriter hat) will have received at least some mechanical royalties along the way. But if the record is a really big flop, mechanical royalties will be minimal anyway, no matter what kind of contract has been signed between the artist and the label.

Other Typical Deal Points

Despite the various differences between Net Profit Deals and Royalty-Based Agreements, there is a certain amount of overlap between the two. This is because many of the issues that need to be addressed in a Royalty-Based Agreement also need to be addressed in a Net Profit Deal – for example, how much the recording budgets will be, who will be in charge of the artist’s official website, and many other issues.

Here are some typical deal points found in both Net Profit Deals and Royalty-Based Agreements:

The “Term”

In both Royalty-Based Agreements and Net Profit Deals, “the Term” means the period of time during which the artist is obligated to record for the label. Usually at any time during the Term, the label has the right to drop the artist, and at that point “the Term” ends.

But even after the end of “the Term,” the label is entitled to continue selling those albums recorded during “the Term” and to continue owning the copyrights in those albums, usually for as long as those copyrights will remain in effect (i.e., for many years, and in most cases for much longer than the artist will be living). There are some exceptions to this, but that’s the general idea.

From an artist’s point of view, it is crucial that the recording agreement, if at all possible, contains clauses creating a clearly defined exit strategy in case the deal is unproductive or if the label fails to perform its obligations. The contract should, if at all possible, specify what the artist’s rights will be if an album has been recorded but doesn’t get commercially released, or if it goes out of print, or if the label ceases to have bona fide national distribution (if the label is an indie label), or if the label defaults on certain other obligations stated in the contract.

The “Territory”

Both Royalty-Based Agreements and Net Profit Deals typically allow the record company to sell records worldwide, though not always so. Sometime the “Territory” is limited to certain countries.

Marketing and Promotion Issues

In either a Royalty-Based Agreement or a Net Profit Deal, the artist should seek the right to approve (or at least the right to be consulted about) major marketing and promotion decisions, and to have the contract guarantee that the label will spend at least a certain specified amount of money each year for marketing and promotion.

Sometimes the contract will also provide that if the label fails to make these guaranteed “spends,” the label will not be entitled to exercise any options for follow-up records.

These kinds of clauses can be hard to obtain sometimes, especially without significant negotiating leverage.

But even if the label agrees to such clauses, there’s also an issue of what an artist without a big bank account can realistically do to legally enforce any such spending commitments by the label. First, there’s the legal expense. Secondly, when an artist sues his or her own label, it almost always seriously damages the artist’s relationship with the label, which in turn affects the artist’s career negatively. Nonetheless, if possible it’s still better to have those spending commitments included in the recording contract than for them not to be there.

Approval Rights

Both Royalty-Based Agreements and Net Profit Deals usually contain other clauses relating to the artist’s approval rights – for example, whether the artist has a right of approval over the studios and producers to be used, and over the label’s issuance of licenses to third parties allowing the use of the artist’s music in film and television productions, commercials, compilation records, computer games, etc.

Accountings

The agreement normally requires the label to regularly provide (usually semi-annually) artists with an itemized accounting for record sales, along with payment of any monies (if any) then owed to the artist.

Net Profit Deals and Joint Venture Deals – What’s the Difference between Them?

Sometimes the terms “Net Profit Deals” and “Joint Venture” are used almost interchangeably. But those terms have different meanings, even though in both cases there’s a sharing of profits between the label and artist (rather than the artist just receiving royalty payments from the label).

In the case of Joint Ventures, the label and artist jointly create a new legal entity (like a corporation), which will own the Joint Venture assets (for example, the masters which will be recorded). The Joint Venture Agreement will spell out the responsibilities of each of the parties and will state how the expenses and income of the Joint Venture will be allocated between the parties. And so, a Joint Venture is more like a formal partnership between the label and artist.

But with Net Profit Deals, on the other hand, there is no new legal entity created, and the label and artist don’t have the kind of extensive legal entanglement and joint ownership associated with Joint Ventures. Instead, the parties have more the kind of relationship which labels and artists have traditionally had.

Some labels (major labels more so) occasionally sign Joint Venture Deals with artists. But Joint Venture Deals are infrequent even with major labels, and even then, are generally used only for already-successful artists.

Net Profit Deals with major labels are also unusual and are more the province of indie labels.

Conclusion

Unlike the traditional kind of recording contract, which has been around for a long time, Net Profit Deals have become common only in the past 10 or 15 years.

As a result, there are not yet the entrenched deal terms and standard parameters with Net Profit Deals that you find with Royalty-Based Agreements. With Net Profit Deals, there is often a fair amount of improvising done during the negotiations, in terms of determining how the deal will be structured and exactly what terms will be included in the contract.

For any artist considering entering into a Net Profit Deal – particularly if being offered a Net Profit Deal by one label and a Royalty-Based Agreement by another label – it is essential that the artist and his/her representatives crunch the numbers and evaluate carefully all of the various financial, legal and logistical issues involved.