Term sheets: VCs versus record labels
It seems as though whenever something particularly wild happens in Silicon Valley, someone makes the comparison to Hollywood. Startup founders are like directors, pitching their companies/film scripts to VCs / producers inside a crazy world of connections and hype where no one really knows the winning formula, but everybody wants to get in on ‘the next big one’; so the story goes.
I don’t personally know all that much about Hollywood or the film industry at all. But I do have a little bit of experience with one of its counterparts: the music industry. Although my old band The Fundamentals never quite made it big, we did sign with a record label (Stomp Records / Union Label Group) back in 2012 to push the release of our first album. The discussion surrounding whether or not to sign and under what terms was a little bit analogous to an early-stage startup’s decision whether or not to take VC money- How much freedom will we have after we sign? Does signing with a label make us more legitimate? What do they bring to the table besides cash? Does this mean we’ll all instantly get rich? (Spoiler alert: no.)
Many others have discussed the similarities between VCs and record labels; see here, here and here. The common theme seems to be exploring the mismatch between artists/cofounders’ expectations and VC/record label reality, and how artists can best prepare themselves to enter contracts with favorable terms. For a good extended conversation on some of those dynamics, watch Mark Suster interview Chamillionaire if you have time:
In my opinion, the most interesting contrast between VCs and record labels has to do with contract negotiation dynamics. It makes sense that inexperienced cofounders and young artists alike both tend to go into contract discussions and only negotiate for what they perceive to be the upside scenario. Experienced entrepreneurs, on the other hand, know how to successfully negotiate for upside and for downside simultaneously, because they know what terms matter and what terms don’t. The key difference between a venture deal and a record label signing the extent to which the deal structure obscures the terms that are actually meaningful. Amazingly enough, the difference makes VCs look good by comparison.
Let me explain.
On a VC term sheet¹ the money discussion will ultimately boil down to two negotiation points: how does the VC make money if you’re a runaway success, and how do they limit the damage if you crash and burn. On a record deal, the two negotiation points are exactly the same- but are structured in such a way that they’re disguised inside other terms.
Imagine an overly simplistic, cookie-cutter VC deal that invests $2M at a $6M premoney valuation, with a 1x liquidation preference. It’s spelled out here what the VC’s upside (25% after conversion) and downside ($2M of preferred shares paying out first at a crappy liquidation) scenarios will be. It follows that the cofounders can see what’s in it for them in either scenario simply by subtracting off the VC’s take. Obviously this will get more complicated when you have multiple rounds of investment, down rounds, etc., but at least the upside and downside scenarios are more or less laid out as part of the deal structure.
On a recording contract, there are two principal ways the label can pay out money to the artist: as royalties, or as an advance. Royalties tend to be (disappointingly small) percentages of proceeds from album sales, often around 10-15%. Advances, on the other hand, are paid up front- but are then almost always recouped by the label out of royalty proceeds once the album ships. So if you sign a deal that includes a $50,000 advance, you won’t see a dime of royalty payments until you’ve sold $50k equivalent in royalties’ worth of music. That’s a lot of records. So why on earth would an artist sign a deal like this? Well, usually because they’re in debt from producing the album- most record labels no longer assume your recording costs, but instead make you pay for it yourself out of your advance.² How do labels talk artists into this kind of deal? By promising a bigger advance!³ Even worse, some labels will allow (and even encourage) artists to negotiate for a higher advance by giving up percentages on their royalty payments, usually at very steep exchange rates.
Imagine a simplistic but typical back and forth between an artist and a label:
Label: we’ll offer you a $20,000 recoupable advance and a 15% royalty rate.
Artist: I want a $50,000 advance.
Label: Ok, we’ll offer you $40,000 up front but with your royalty rate reduced to 12%.
If this agreement were phrased in VC deal terms, it would be as follows:
VC: We’ll offer you $2M at a $10M valuation and 1x liquidation preference.
Founders: $2M isn’t enough cash for us. We want $5M.
VC: Ok, how about $4M at an $8M valuation and a 2x liquidation preference.
That’s fucked! You would never see a founder in their right mind negotiate that way. But unfortunately, that kind of manipulation is par for the course in the music industry, because artists are often put in position where they feel they have to have the cash up front- they’re in debt, and they probably don’t have much choice. But then, the reduced royalty rate has two consequences: 1) it increases the number of albums the artist has to sell in order to pay off their advance (i.e. increases the liquidation preference) and 2) once their advance is finally paid off, the band makes less money in royalties from there on out (i.e. decreases the valuation). Sadly, artists are all-too-frequently duped into thinking that the royalty and the advance are two components of a balanced negotiation. The illusion is baked right into the deal.
Paradoxically, inexperienced artists often negotiate away their royalties in favor of an advance and then rationalize it as capturing the upside of the deal. How on earth do they think that? Because to them, at that moment, the advance money is the upside of the deal- it’s become the primary thing they negotiated for. They don’t see it as a loan because they’ve already committed that money to pay off their recording debt. No wonder being in a band is hard.
As far as I know, there are no good resources like Brad Feld and Jason Mendelson’s Venture Deals available for aspiring musicians. That’s a shame. It’s one thing to have a knowledgeable lawyer help with your negotiation; it’s another to actually understand the terms you’re negotiating yourself. [Update from Jason in the comments: he recommends All you need to know about the music business, by Donald Passman. I wish we’d known about this before! The resources we had consulted didn’t turn out to be that great.]. Of course, the music industry is changing so quickly that I probably have no idea what it’s like any more. But even so, I’m confident that no matter how badly musicians are taken advantage of by the industry, there will still always be kids with guitars making great music, waiting for their big break.
- For all of these examples, I’m imagining an equity investment, not a convertible note; I don’t know of any music industry equivalent for convertibles, maybe someone should invent one?
- This isn’t an accident; it’s very smart on the record labels’ part. Not only do they get better terms on the recording contract, they also don’t have to commit any money up front before recording. It used to be you could walk into a record studio with a good enough demo tape and you’d get signed; nowadays the burden of producing the first album has fallen largely on the artist. The more bands go along with this structure, the more leverage the label has in the future to tell upcoming artists ‘sorry, but that’s just the way we do things around here’.
- One tactic you see labels employ a lot is to assign two separate cash advances: one for the recording, and one as the ‘actual advance’. This helps to maintain the illusion that they’re paying for the recording process, like they used to, but you’re still also getting your cash bonus up front. Really it’s just smoke and mirrors.
Great analysis. The same fucked up economics and negotiation dynamics is true in the publishing industry, which is part of why we created FG Press – http://www.fgpress.com
Thanks Brad. I’m looking forward to watching FG Press shake things up, and maybe set off some warning bells in the music industry as well.
As a former musician I had the same frustrations. Donald Passman had a book years ago that was helpful to me, which was a bit of inspiration for the book we wrote.
Awesome, thanks. I wish we’d known about this. I’ll definitely be forwarding this along…