One thing that tempts musicians into signing a record deal is often the promise of the advance that comes with the deal. This is especially true of up and coming acts that have been slogging through on their own dime, and making a whole lot of financial sacrifices in the process. "An advance!," they say, "we're going to be rich!"
Well, not so fast. The first, A+, number one thing to remember about an advance is that it is an ADVANCE. It's an advance against royalties you'll (hopefully) earn on future record sales, and the label is going to want to be paid back. In fact, they'll keep your sales cash until they are, and that holds true across multiple albums and advances. That's because record label advances are cross-collateralized - a very important concept to master, so learn more about that here.
So, there's your warning about getting too hepped up about advance cash. But for what you really want to know - how do record labels decide how much they will pay you as an advance?
The answer is that it is part art, part science. For your first advance - the advance for the first album you record with a label as part of a multi-album deal or for the only album in a single album deal - the label will consider a lot of different factors. Indie labels in particular will consider how much they can afford to pay you and still have enough cash left over to actually spend on promoting your release - and if you're working with an indie, opting for a small advance in exchange for a bigger promo spend is the right choice for you in the long run.
Major labels will consider things like how much they plan to spend on promotion plus how many copies they think they can sell of your release so that they actually recoup your advance and still make some extra money on top. Of course indie consider sales potential as well, but for many indies, it's a pure cashflow issue. Even if they think you can sell millions, they can't pay you the advance to cover that.
That's the art part. Labels consider your sales potential, often based on what you've accomplished before, plus plans for touring, feedback received on your music and other such things - but it's still a gamble - they don't know if the advance is going to be too small, too big, or just right (though you can count on them trying to err on the side of "too small" unless you are the subject of an intense bidding war). The science part comes in with the advance formula associated with multi-album record deals. These formulas aren't included in all record deals, but if you're signing with a major in particular, a good lawyer can insist that your contract includes a formula. How these work is by setting out mathematical equation for determining the advance for each album in a multi-album deal. This equation usually puts the advance as a percentage of royalties earned on the previous album. There is also usually minimum and maximum payout amount stipulated in the formula. The percentage is computed using sales from within a specified territory during a specified period - for instance, sales in the US for nine months after the album release. The formula is applied to each release, so album two sales will determine album three's advance, album three's royalties will determine album four's advance, and so on.
The beauty of the formula for everyone is that it rewards good sales and conserves when sales have dropped.
The best thing to understand about advances, however, goes back to the beginning - this isn't free money. It's more like credit. Take what you need and wait for your sales to come in - it will put you in better control of your career.