Peter Alhadeff, Berklee College of
Barry Sosnick, Earful.info, Five Towns College
Editor’s note: The following is presented as a comment on the paper Are Music Recording Contracts Equitable? An Economic Analysis of the Practice of Recoupment (Theo Papadopoulos, Victoria University, MEIEA Journal, vol. 4, no. 1, 2004).
The relation between an artist and a label is potentially conflictive from the start. A label advances money for a recording project with the hope of recouping it later. Even if the artist sells, he or she will not collect artist royalties before the label reaches the breakeven point. In practice, breakeven can be fuzzy, and cause more tension.
Professor Theo Papadopoulos of Victoria University in Australia recently explored such issues in the seminal paper Are Music Recording Contracts Equitable? An Economic Analysis of the Practice of Recoupment.For Papadopoulos, a label’s fixed or “establishment” cost per release includes the recording advance, the budgeted marketing campaign, music videos, payment to independent promoters, retail product placement, and tour support. The variable cost per release depends on the marginal cost, and the article shows the following simplification for marginal cost:
Marginal Cost = MPC + DIST + RA + RM
MPC is the marginal production cost, DIST is the distribution cost, RA
is the artist royalty, and RM is the mechanical royalty. A label’s total cost function for that release is:
Total Cost = FC + VC
where FC is the fixed cost and VC is the variable cost. At a production quantity Q, total cost becomes:
Total Cost = FC + MPC*Q + DIST*Q + RA*Q + RM*Q
In Papadopoulos’ elegant formulation, total cost is an expression of a disbursement that includes payment for an intellectual property component. This is the sum of the mechanical royalty and the artist royalty. A label tries to minimize this cost as it tries to maximize profit. It cannot avoid payment of the statutory mechanical rate but the artist royalty is another matter. Settlements over artist royalties can bring the label into conflict with the artist and raise the issue of contractual equity. Specifically, Papadopoulos asks at what point in the product cycle should a label consider the advance to the artist as paid from artist royalties? He then considers various scenarios.
Papadopoulos’ analysis hinges on the definition of total cost, and therefore fixed cost. In fact, Papadopoulos’ own treatment of the recording advance, a key element of his work, leads him to underestimate a label’s breakeven point.
Papadopoulos is correct to describe the recording advance as a fixed cost. However, it is wrong to consider the sum handed to the artist at its face value. The label is parting with a sum of money that would otherwise be earning a steady stream of interest payments if invested elsewhere. When a label signs an artist, this opportunity cost of lending money is very real and has to be included as an additional fixed cost. When a business parts with a given sum of money P, it expects to earn a future sum A, which is greater than P. If the money were put in a fixed interest bearing investment that paid an annual rate i for N years then,
A = P(1+i)N and I = A-P, where I is interest earned
In the case of a label, it makes a recording advance P and it is potentially surrendering an interest earning I on an alternative investment that pays a rate i. The true cost of the loan to the label of its recording advance for artists who are not going to break even must therefore be close to P+I.
This is the majority of artists. This expression, which can be approximated by calculating the future value of the recording advance, is the relevant number for inclusion in a label’s overall fixed cost.2 The fixed cost for artists that will break even, on the other hand, should include the loss of at least one period of unearned interest on the recording advance.
The above reasoning is standard in financial breakeven analysis, and we conclude that a financial breakeven method is better suited to depict the label–artist relation than accounting breakeven.3 It is interesting that this fundamental point is largely absent in any discussion of the equity of contracts in the recorded music trade. Like Papadopoulos, the existing literature proceeds as if there is no premium attached to liquidity. Cash, of course, is expensive. If artists were able to self-finance their musical projects, the cost of drawing from their own funds would be measured by the amounts they put down and the interest earnings they would forego—not just the temporary drop in their bank balances.
A label takes a risk when it signs an artist and the artist–label relationship is full of uncertainty. At the very least, future earnings need to compensate earlier disbursements. To deal with this, Papadopoulos introduces an exogenous stand-alone risk factor that he adds to the artist’s total cost function. A label, he argues, is a multi-product firm in which not all of the artists in its roster will recover the recording advance. The label will budget for this loss, which he calls λ. Papadopoulos would then allocate the value of λamong the roster of artists.
The simplification makes sense, but begs many questions that we will address in future work where we hope to quantify the label risk factor in more depth and establish a statistical basis for analysis. Papadopoulos certainly opens up for discussion the issue of intra-artist equity and good art-ist–label relations, as he makes clear that the breakeven point for successful talent appears much later than otherwise would be the case. The implication is that successful artists are ultimately financing less successful ones.
We generally agree with the above. However, we are inclined to be less optimistic about the practical application of a new business model for risk sharing presented by Papadopoulos in the latter part of his paper. He suggests that artists agree to apportion royalties to defray the potential losses from λ, helping the label minimize the cost of artist royalties. By definition, the only contributors to such royalties would be successful artists, and there may be little reason for them to do much more than they are doing now.
1 Theo Papadopoulos, “Are Music Recording Contracts Equitable? An Economic Analysis of the Practice of Recoupment,” MEIEA Journal 4, no. 1 (2004): 83–103.
2 In practice, labels do not give the artist the full advance upfront. The equivalent treatment would be to consider the loan as an annuity, and the relevant cost would then be the future value of that annuity.
3 See Harold Vogel for a comparative discussion of entertainment company buyouts: Entertainment Industry Economics (Cambridge University Press, 2001), pp. 27–29.
The authors wish to acknowledge Don Gorder, Chair of Berklee College of Music’s Music Business/Management Department, for his useful comments. Participants at the 2005 MEIEA Conference, including Keith Hatschek and Steve Marcone, also provided valuable feedback.
PETER ALHADEFF is a founding faculty member (1992) and Associate Professor in the Music Business/Management Department at Berklee College of Music. He is the former Editor of Recording Magazine en Español, a part of Music Maker Publications (MMP). Also with MMP, he has been the Associate Editor of Músico Pro for the last ten years. Alhadeff’s music business articles include publications by the Recording Academy’s Grammy 2000 and Grammy Latino. He has served on the faculty of the Institute of Latin American Studies (ILAS) and King’s College of the University of London, the Inter-American Bank at the Instituto Di Tella, and the University of Buenos Aires. Alhadeff, who has a doctorate from the University of Oxford, has published in refereed economic journals and books, including the St. Antony’s/Macmillan Series, and is the author of Algebra de Vectores y de Matrices (Editorial Tesis, Buenos Aires, 1989).
BARRY SOSNICK is the president and founder of Earful.info, a provider of strategic marketing and risk management solutions to the recorded music industry. He is also on the faculty of Five Towns College, teaching classes in music marketing and public opinion research. Mr. Sosnick was a senior project leader with the prestigious political polling and market research firm Luntz Research Companies, where he guided political, legal, and marketing strategies for Fortune 500 companies, elected officials, and a foreign government. He was an equity analyst, most recently with Fahnestock & Co. (now Oppenheimer & Co.), where he provided research on the home entertainment and consumer electronics retailers, and assisted mergers and acquisitions, and public and private financings. He co-authored research with music business graduate students from the University of Miami entitled The Changing Recorded Music Industry, presented at Loyola University New Orleans to the Music and Entertainment Industry Educators Association (MEIEA). He presented to MEIEA, at the University of Miami, a paper entitled A Capital Budgeting Approach to Understanding Artist–Label Relationships, co-authored with Peter Alhadeff, an economics professor at the Berklee College of Music. Sosnick is a frequent speaker and panel member at universities and industry conferences, including the National Association of Recording Merchandisers (NARM). He also serves on the MEIEA advisory board.