The Two Questions I ask new Startups and Studios

Each week I meet with prospective clients that are excited to be launching a new startup or video game studio.  Regardless of the differences between these clients, I inevitably end up asking two important questions at the start of every meeting:

1.  Have you incorporated?

Many clients incorporate without legal counsel, which I have no problem with.  However, by incorporating without a lawyer, prospective clients are often left with a few problems that I am attempting to unearth and that I know will need to be remedied:

A. The company’s paperwork is incomplete.  While a company exists once the filings are made with the state/province/federal government (if a federal, Canadian company), there are a number of resolutions, registers, receipts and other documentation that a company requires in order to have a complete minute book.  The preparation of the foregoing is the bulk of a lawyer’s work incorporating a company and will need to be prepared, especially if the company aims to raise capital as this documentation will be requested as part of standard due diligence.

B.  Too few shares were issued.  If you incorporated a company with 1, 10 or 100 shares, too few shares were issued and should be split or additional shares issued.  This avoids fractional shareholding in the future (imagine offering someone .25% and 10 shares are issued to date) and also makes equity offers to prospective employees more appealing (10,000 shares appear more attractive than 1 share, even if the same percentage ownership results).

C.  Too many share classes created or the wrong share classes created.  I always ask clients their reasons for a particular share class as both client and lawyer should understand the reasons behind the company’s structure.  Since most startups are incorporated with a single, common, share class, I push prospective clients to explain and even justify other classes.  Additionally, if a preferred share class exists, what are the rights and restrictions associated with this class?  Inevitably, no preferred rights and restrictions were specified,requiring the creation of these rights or restrictions or, more likely, deleting the preferred share class.

2.  Have you Transferred IP to the Company?

Clients mistakenly assume that the company they incorporate automatically owns the intellectual property they create.  While someone may be a shareholder (even the sole shareholder) or a director, this does not automatically transfer ownership of intellectual property created by such person(s) to the company.  Indeed, without a contractor, employment or assignment agreement in place, each founder remains the owner of the intellectual property they create.  As a result, the company may not own a core asset and cannot be in a position to license that asset to third parties.  Additionally, by asking this question I am often told about contractors who created intellectual property for a founder or the company without an agreement in place, which will also need to be corrected.

Based on these two questions, I am often able to obtain a full picture of a company and its history and put in place the key documents required to address any issues unearthed.   If you are embarking on a new venture be sure to keep these two questions in mind – doing so may prevent future legal headaches (and fees).  Or, you could read my suggestions on corporate structure and IP assignments here and here.

Video Game Profit Sharing Structures

Our video game studio clients often come to us with plans to split game profits among the team members but require advice on the form this split should take.  Three main approaches exist for structuring your video game profit share:

1.  Profit Sharing Agreement

The most common approach is the Profit Sharing Agreement.  This agreement is between the company and each person participating in the profit share and sets out the profit sharing terms and contains key terms such as:

  • How profit is calculated.  For example, revenue received by the company from sales of the game minus publisher royalties, platform fees, certain operating costs etc.
  • What constitutes the “game”.  Does the game include DLC, HD/upscaled/remastered versions, sequels etc.?
  • Adjustment of each person’s percentage if future participants added. 
  • What is the profit sharing duration?
  • Is there a cap on payouts?
  • Termination upon acquisition of the company or the game, perhaps with a lump payout.
  • What happens if the company receives investment?

The benefit to this approach is that the participants are not shareholders in the company and, as a result, do not have a say in how the company is operated or a right to receive payouts from future games developed by the company.  However, the parties need to ensure that the agreement is thorough in its scope as any ambiguity or overlooked scenario could create major headaches in the future.

2.   Create a Separate Company for each Game

Under this approach, a separate company is created for each game you develop, with the commonality being that the main company you incorporated (the studio) is a majority shareholder (51% and up) in each of these separate companies.  For example: Studio Company owns 66 2/3% of Game 1 Company.  The separate company would receive profits from the game and distribute them to the shareholders based simply upon their shareholding (although more complex special rights and restrictions could also be put in place).  Intellectual property for each game may rest with the separate company or the main company.  Profits from the game would be distributed as a dividend to the shareholders.

This approach works well if each person is expecting an interest in the company developing the game with the benefit that these persons cannot participate in future games developed by the main company (which may be unrelated to the current game).  However, when pursuing this approach, it is important to obtain tax advice to ensure that distribution of the profits between the companies is structured efficiently.

3.  Issue Shares in your Company to Profit Share Participants

Under this approach, a special class of non-voting share (the profit share class)  is issued to the profit share participants and contains a dividend right to receive a portion of game profits, which would contain similar terms as described in approach 1 above.  This approach is similar to approach 2 above except that no separate company is created.  However, additional terms are also required, such as:

  • Share retractability:  this allows the company to repurchase the profit sharing shares in the future.
  • Voting trust:  this takes control of some or all of the voting rights of the non-voting shareholders  (see non-voting shareholder’s limited voting rights).

The problem with this approach stems from the fact that the profit share participants may only be involved in one game but the studio may continue on to make other games, which the profit share participant should not receive a financial benefit from.  Further, by being a shareholder (without detailed share rights and restrictions), the shareholder may be able to participate in profits from future, unrelated titles, benefit from sale of the company and/or exert their rights as a shareholder to participate in the company’s direction.  To alleviate these problems, complex terms and agreements are likely needed (see retractability and the voting trust) to ensure that the profit share shareholders only benefit from the game they worked on and have a limited right, if any, to participate in the company’s direction.

As a first step, it’s critical to recognize that your profit sharing agreement needs to be documented in writing.  Second, you must reflect on the relationship you desire with the profit sharing participants (duration, scope of their involvement etc.) and analyze that relationship relative to the features of each of the above approaches.

Priced Rounds

As part of our day-to-day practice, we advise clients on different structures available for early-stage financing rounds.  As part of these discussions, convertible notes and SAFEs are inevitably raised by the founder yet the concept of a priced round is rarely raised and sometimes not even understood by the founder.  Priced rounds were the common approach to financing startups at all stages for over 25 years and are slowly making a comeback, which should be to the benefit of founders.

Understanding the Priced Round.  Priced rounds are simple:  the company and investors agree to a company valuation and the investors purchase shares in the company at this valuation.  Conversely, convertible notes and SAFEs are premised on the parties NOT agreeing to a company valuation, which is answered at a later date when a priced round occurs (typically the series A round) and the convertible notes or SAFEs convert.

When are Rounds Priced?  These days, priced rounds first arise during the Series A financing, where preferred shares are sold to investors.  At this stage convertible notes and SAFEs usually convert.  However, as advocated for in this post, any round can be priced including angel and seed rounds.

What are the Benefits to a Priced Round?  The company knows exactly what % of the company is being sold in the round and the founders know exactly how much they are diluted.  In a convertible note or SAFE financing there is some uncertainty as to how much of the company is actually being sold as these instruments typically convert on a fully diluted basis including the increase in option pool size required by the Series A investors yet the increase in the option pool is unknown until the Series A round.  Additionally, priced rounds eliminate the confusion surrounding how numerous convertible notes and SAFEs, with different caps and conversion terms, convert (these calculations are difficult to understand, even for sophisticated parties).

We encourage our clients to explore priced common share rounds when considering the structure for their next early-stage investment round.   Admittedly, some investors prefer convertible notes and SAFEs and others will reject a priced round valuation but accept the same valuation (or higher) as the cap on a convertible note or SAFE.  While priced rounds may not work in all situations there is no harm in floating this as a possible investment structure.  Indeed, sophisticated VCs, such as Fred Wilson of Union Square Ventures, agree that pricing rounds may be in the best interest of startups and their founders and should be explored rather than avoided.

Real World Items in Games

When creating realistic video games, developers often desire to render real-world items digitally but neglect considering rights held in these items.  A failure to investigate rights held in real-world items is not limited to smaller studios as major developers (ex. Activision) have been sued for using real-world items in their games, such as AM General’s Hummer and certain firearms.   To assist in avoiding these issues, consider the following steps when inserting real-world items into your game:

  1.  Check to see if the item you are adding to the game is based on a real-world item.  For example, modes of transportation, firearms and luxury goods in games could all be based off a real-world item.
  2. When purchasing assets from marketplaces be sure to ensure that the asset creator has not  infringed the rights of third parties.  This has been an issue on the UE marketplace leading to an audit of most firearm asset packages.
  3. If your item is based on a real-world item, determine the rights held in that item.  For example, the design could be covered by a design patent while the name or logo could be trademarked.
  4. If there are rights held in the item be sure to secure a license from the rights holder before proceeding, otherwise you risk litigation and will be running afoul of most representations and warranties contained in publishing and platform agreements you sign.

In many cases, it’s cheaper to design your own items rather than seeking a license for real-world items, which may not be granted.  Take the GTA series and its use of cars of its own design – it’s doubtful that an automaker would license their rights to a game in which the same car is used to commit (digital) criminal offences, including murder.

If you are in doubt whether the particular item or its name is protected, be sure to contact your legal counsel before spending time integrating it into your game.