By Seyamack Kouretchian

New York Law Journal

June, 2002

In most video games, if you don’t react quickly and properly, chances are the bad guys will shoot you in the back and you will have to begin the game again if you wish to get to the next level.  Likewise, in real life, if you don’t understand the rules and know how to play the game, you can’t expect to get far before the bad guys get you.  Unfortunately, however, in real life, you typically don’t get a second chance to start over and avoid the bullet. 

For this reason, it is important that today’s new media attorney carefully understand the issues that will be faced should a favorite client wish to stop by and discuss a proposal it has just received from a video game developer to develop, market, and sell a video game based upon the client’s pre-existing content.  While once a very unlikely or remote scenario, as the video game industry continues to grow and capture market share from television and books, the odds of encountering any such deal continues to increase daily.

Consider the statistics.  Once a small cottage industry attracting only the attention of children and introverted technophiles, the video game business has grown up (though, maybe not matured) and burst into the commercial mainstream with splashy and highly sophisticated video games employing military-developed technologies.  These games, which can be based upon such varied content as literary works written by Tom Clancy, extreme sports figures like surfer Kelly Slater, historical figures like Julius Ceaser, and popular television and movie franchises, like The Simpsons and Star Trek, now target an ever-growing demographic base of 15 though 38 year olds.  A leading investment bank has estimated that video game sales will grow to $21.4 billion in North America alone by 2005-  up from $8.1 billion in 2000-  an estimate which may be considered conservative by anyone who happens to walk though the expensive booths that were set up by video game developers and publishers at the recent E3 video game industry trade convention in Los Angeles, California.    

Consider also last summer’s blockbuster “Tomb Raider” motion picture starring Angelina Jolie.  While the movie based upon a successful video game franchise generated some $300 million in total movie box office sales, when compared to the $700 million in total revenue generated from the sale of video games, it may be difficult to consider the moving anything other than a flop. 

To ensure that new media attorneys help their clients make it to the “next level,” it is important that they have at least a general understanding of the varied deals which make up the structure of the industry and game development process.  For example, under one possible scenario, an entrepreneur forms a privately funded company ("Production Co.") that acquires the license to exploit the name, likeness, and biography of a famous sports figure in video games across multiple gaming platforms, such as personal computers, handheld devices, and proprietary console systems.  Production Co. then retains a video game developer to develop the actual video game.  Production Co. thereafter retains multiple publishing companies to publish and distribute the finished game throughout various parts of the world. 

Another possible structure is where the publisher acquires the licenses, develops the games internally, and distributes the games through its expansive international distribution network.  Either way, it is worth noting that the manner in which games are financed, developed, published, and sold is quite varied indeed.

Whatever the form of the underlying game development and financing structure, nearly all video games based upon pre-existing content (such as Tony Hawk Pro Skater IV; Madden Football; or Star Wars: Bounty Hunter) begin with the execution of a Video Game License Agreement.  Since these agreements are often the starting point of any such venture, it is important that attorneys gain an appreciation of what to expect.

While Video Game Licensing Agreements are often custom-tailored to meet with the particular requirements of the content owner and video game developer/publisher, there are at least three issues that must be carefully considered in every such agreement: royalty rate calculations, intellectual property ownership, and artistic/editorial control.  Each issue will be separately discussed below.

Royalty Rate Calculations

            Regardless of whether one represents the licensee/developer or the licensor, the question of how royalty rates are to be calculated will often mean the difference between success and failure.  For the uninitiated, royalty rate issues may pose the most risk for disaster.  The hidden dangers lie in the fact that royalty calculations are inexplicably reliant upon the specialized nuances and operational aspects of the video game development, publishing, and distribution process-  a process that is neither intuitive nor apparent to even the most savvy of business people.

            Consider the fact that even a royalty rate based upon “gross unit sales” may prove to be too limited for the licensor.  This is because licensee/developers may actually obtain monies in the form of “development financing” from publishers.  While these monies are often paid to the licensee/developer during the development process to fund the development of a video game, they are also paid to secure for the publisher exclusive rights to publish the game in particular territories.  In this regard, they are actually in the nature of pre-sale revenue generated from the anticipated sale of units in a particular territory and, therefore, properly the subject of royalty calculations.  For this reason alone, it is extremely important that licensors completely understand the development, publishing, and distribution process.

Another potential area for oversight is the failure by either the licensor and/or the licensee/developer to appreciate how the game will ultimately be marketed and sold throughout the world.  If, after all, the game is to be marketed and sold through a variety of layers of publishers and distributors, then the ultimate royalty received by the licensor and/or licensee/developer is likely to be seriously affected. 

Take, for example, the case where a licensor has agreed to accept a ten percent royalty rate on revenue received by the licensee/developer from unit sales.  If the licensee/developer then enters into an agreement with a publisher to distribute the product in consideration for a payment to the publisher of a royalty equivalent to seventy percent of gross unit sales, then the licensor will actually be receiving only three percent of the unit sales (the licensor receives ten percent of the thirty percent that is paid to the licensee/developer by the publisher). 

To make matters even worse, it should be noted that some publishers distribute products through sublicenses with third parties in territories where they do not have a distribution network.  For example, a U.S.-based publisher may actually be distributing a game in Australia through a distribution agreement it has with an Australian distributor.  If the U.S.-based publisher receives a fifty percent royalty from the Australian distributor, then the licensor can expect to receive a royalty equivalent to only one and one-half percent, and not the ten percent that it believed it was entitled to pursuant to the terms of its Video Game License Agreement.  When one considers how quickly a seemingly lucrative royalty rate can be reduced to pennies, it should become obvious why a failure to understand the development, publishing, and distribution process can be a recipe for “game over.”

While there are multiple ways of minimizing the royalty reduction that may result from such multi-layered licensing scenarios, a preferred method for a licensor may be establishing different royalty rates for different territories.  In this manner, a licensor may seek to be paid a greater royalty rate in those territories where the licensee/developer is forced to sublicense the publishing of the game through a third party.

It may also be appropriate in certain limited circumstances to establish a minimum royalty rate based upon a pre-established wholesale price.  While such royalty provisions can prove quite dangerous to the licensee/developer, they may be appropriate when the development costs are extremely low.  The parties must also consider a game’s typical lifecycle, which begins with an initial release, than moves to an “add-on release” stage where, for example, new levels for the same game are independently sold.  Thereafter, the game’s price is reduced and/or the initial release is bundled and sold together with the “add on release.”  As the game enters the end of its lifecycle, it may be re-released as a “special edition” with an included strategy guide and/or additional new “add-on” features or, in certain circumstances, it may even be bundled with titles from the same developer and/or publisher and sold at an even more reduced price.  These various stages, which can span the course of several years, will need to be carefully considered before either party elects to adopt a royalty rate based upon a minimum, pre-established unit price.

Another issue to consider when examining royalty rate calculation provisions is whether the royalty rate should escalate as sales goals are met.  For example, a royalty rate of ten percent may be subject to an incremental increase once the game sells 200,000 units.  This increase may continue at whatever intervals a licensor and licensee/developer are willing to agree upon until a final “maximum” royalty rate is reached.

The parties should also consider different royalty rates for each different platform on which the game is ultimately developed.  For example, a ten percent licensor royalty rate may be perfectly appropriate for a game released for play on personal computers, while a six percent licensor royalty rate may be more appropriate for the same game if released for play on proprietary handheld devices or gaming consoles.  These different royalty rates are often the function of the increased costs associated with releasing games on proprietary handhelds and/or consoles since license fees will typically have to be paid to the manufacturer of these proprietary devices. 

Finally, when examining the royalty rate provisions of a Video Game License Agreement, it is imperative that all parties understand those costs which may be offset against revenue.  A licensee/developer may insist that deductions be made for returned units, while a licensor may insist that revenue not be offset by foreign taxes and/or insurance, shipping, manufacturing, and/or marketing costs.  Whatever the final decisions are as to how revenue may be offset, it is critical that all parties truly understand how the video game is to be developed, published, and distributed internationally when considering which line items are appropriately offset against royalty revenue.

Intellectual Property

Since video games are nothing more than digitally-generated audio and visual elements that are perceived and manipulated by the individual player through the use of a machine (be it a personal computer or a Sony Playstation), the issue of who owns the intellectual property that makes up a video game is often times the subject of a fairly emotional discussion between the licensor and the licensee/developer.  On the one hand, licensors believe that anything based upon their original work of authorship (i.e., any derivative work) is and/or should be their sole and exclusive intellectual property.  On the other hand, licensees who spend millions of dollars and thousands of man hours toiling over the architecture and “look and feel” of a particular software-generated interactive environment are often equally emphatic about their claim of ownership over the resulting intellectual property.  How this issue is ultimately resolved is typically a function of leverage and an understanding and appreciation by all parties of the different layers that make up a video game.

For example, even a simple mystery game based upon the fictional character Sherlock Holmes will contain multiple layers of intellectual property.  The most obvious are the characters that a player may encounter during game play, such as Sherlock himself, his trusted partner Dr. Watson, and the newly-created villain, Vaidaio de Vice.   Then there is the game’s trademark, the storyline of each mystery, the artwork of every visual element in the game, the music, voices, and other audio elements of the game, and the game’s general “look and feel.”  Underlying all of this visual and audio interactivity is the literal source code upon which all of these audio and visual elements are displayed, as well as the internal logic that runs the game on the specific platform.  This source code may itself be comprised of pre-existing and/or newly-created software programs carefully stitched together in such a manner that a player can seamlessly interact with a virtual environment of digitally-generated polygons as she proceeds to solve the mystery and get to the next level. 

While it is conceivable that a licensor may have enough leverage to obtain ownership of virtually every aspect of the finalized game, unless the licensor also financed the development of the game, it is more likely that the licensor and licensee/developer will divide the intellectual property between themselves in the most obvious manner- the licensor retaining ownership of all environments, plot elements and game characters, whether new or pre-existing, as well as all images displayed on the screen and the sounds produced during the course of game play, including all possible combinations and sequences thereof;  and the licensee retaining ownership of all of the computer software, which can include the systems and/or tools used to develop the game, as well as the proprietary engine or base software used to run the game. 

If the parties do not intend to work together on any subsequent release based upon the original game, then the issue of ownership of intellectual property can prove in hindsight to be a costly issue indeed.  After all, unless the game is expected to undergo a major overhaul in any subsequent release, the licensor will be seriously hampered if it is required to find another licensee/developer to independently develop a similar game engine.  Likewise, the original licensee/developer may be hampered in its ability to exploit its proprietary game engine if the engine is so intertwined with the original or newly created content that to completely separate them is simply impossible.  For these reasons, the parties may both be better off if they agree to grant each other certain rights of first refusal should either party later wish to develop a sequel.  Of course, great care should be taken in ensuring that such rights of first refusal are crafted to protect against abuse by the other party.

Rights to ancillary intellectual property rights, such as film and movie rights, merchandising rights. and product tie-in rights (such as pay-per-call phone tip line rights and/or the rights to produce and sell related strategy book guides), should also be carefully considered by both the licensor and the licensee/developer.  After all, a successful game can drive the sale of merchandise based upon content that would otherwise be collecting dust.  Likewise, a video game that is otherwise only worthy of collecting dust can find itself enjoying brisk sales if the content upon which it is based is popular.  Creative methodologies, such as, but not limited to, the restrained use of rights of first refusals can be used to address if and/or when one party may be entitled to any such ancillary rights. 

Artistic/Editorial Control

Artistic and/or editorial control of a game is likely to be another area where licensors and licensee/developers are likely to focus upon when entering into a Video Game License Agreement.  As with the issue of intellectual property right ownership, the issue of who should maintain final control over the artistic and editorial elements of a video game can prove to be a difficult issue to resolve.  This is due to the fact that, in most cases, licensors believe that they are best suited to develop a game that is based upon the work that they originally and successfully created and exploited.  After all, licensors will claim that they, and only they, truly understand their audience and are able to ensure that the final game is both true to the original material and a natural extension thereof. 

By comparison, licensee/developers are equally confident that they alone are the most capable at developing a video game that a player will find intriguing, fun, and worthy of hours of their recreational attention.  They will claim that they, and only they, truly understand the target market of gamers and are able to develop a product that caters to the expectations of today’s scrutinizing and growing gaming audience.  In support of this fact, licensee/developers may refer to the fact that while several top motion picture studios have video game development divisions, these divisions have yet to successfully compete with those companies that focus strictly upon developing and/or publishing video game products.  In this regard, licensee/developers will likely note that often times the studios will actually grant video game licenses to third-party developers and publishers and not their own internal video game divisions.

While this issue can be resolved in a variety of manners, it is not uncommon for the licensor of a well-known and more recent work to maintain artistic and/or editorial control over the final video game.  Specifically, the licensor will typically maintain final approval rights over the “look and feel” of the images displayed on the screen, the sounds produced during the course of the game, plot elements, and any new characters, environmental settings, and/or devices that may be created.  The licensor may also obtain approval rights over all packaging and marketing material in order to ensure that its original work is consistently represented across multiple media.  Of course, where the licensor maintains such approval rights, it is imperative that the licensee/developer maintain control over all other aspects of the game, such as, but not limited to, game play and overall design, roll-out and product lifecycle schedules, marketing strategies, promotional plans, and the like.  The parties may also wish to consider utilizing focus groups as a back-stop measure to ensure that decisions made by the licensor over the objections of the licensee/developer will not harm the product’s ultimate success in the target market.

Conclusion

While numerous other issues will need to be carefully considered and addressed by counsel when negotiating a Video Game Licensing Agreement, the three primary issues discussed above are likely to be the most critical for ensuring success.  To best address these issues and avoid a mistake that leads to “game over” for a client, it is imperative that counsel be familiar with the specific structure surrounding how the game is intended to be developed, published, and distributed internationally.  Additionally, counsel should consider a host of other factors, such as the implication of future technologies, the prospects that a party will be acquired, and/or the prospects that a party will go bankrupt, when negotiating Video Game Licensing Agreements.  After all, as in the virtual world of the interactive gaming adventure, in the world of Video Game Licensing Agreements, disaster may be lurking just around the next corner. 

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