Revisiting “Should I Incorporate my Canadian Startup in Delaware?”

It seems Canadians are still wrestling with whether to incorporate their startup in Delaware.  I wrote about this question back in September 2014  and since then the post has racked up over 1,000 views.  Back then, I concluded with this piece of advice, which I still stand by:

Don’t lock yourself into Delaware before you know where your investment comes from.  Based upon the cost and complexity of operating a Delaware startup from Canada, I recommend that you incorporate in Canada at the start.  Where a future U.S. investor requires you to incorporate in Delaware (or another state) your legal advisors can assist with this transition.  Conversely, Canadian investors may prefer to invest in a Canadian company!

Tip:  your product/service is important, not the place of incorporation.

Incorporating a Video Game Studio

We represent a number of indie video game studios and are often asked what legal structure should be used when incorporating a video game studio.  Fortunately, the legal structure we recommend for most indie video game studios is simple and cost-effective to put in place.  [Press Start]

  1.  Incorporate.  The studio should be an incorporated company (and not a sole proprietorship, meaning doing business personally).  By incorporating you ensure that the company, and not you personally, would be the liable party should legal issues arise in the future.  We do not recommend a partnership as the split of a partnership could tie up game IP and prevent release.
  2. Create one class of Shares.  The company should have a simple structure comprised of a single class of common shares without a cap on the number of shares that can be issued (otherwise called an unlimited number of shares).   If you are incorporating in the US where an unlimited number of shares is not possible, set a high cap such as 10,000,000 shares.
  3. Issue a few million shares per founder.  Don’t stress about the number of shares to issue – more is better!  Issue at least 1 million shares per founder as this avoids fractional shares should you issue shares in the future and looks better visually if you are trying to recruit people to the company.  The shares should be purchased for a nominal amount, ex. $0.00001/share.  Remember, ownership percentage is what matters and owning 1/10 shares is the same as owning 1,000,000/10,000,000 shares.
  4. Consider reverse vesting shares.  If you are offering shares to a few team members who need to prove their value by, for example, meeting development milestones, then consider reverse vesting the shares issued to those team members.  Reverse vested shares are issued to the team member up front but can be forfeit (entirely or in part) if the team member does not meet certain milestones set by the company, such as a time or development milestone.  By reverse vesting shares you ensure that the company shareholders have earned their shareholding and, without, someone could walk away and keep their shares!
  5. Assign IP.  The company will be licensing the video game to end-users and, in order to license the game, needs to own the game.  By assigning all intellectual property that you have in the game to the company you ensure the company has sufficient rights to license the game.

The above is a simple to understand structure that works for many indie video game studios with a small shareholder base.  By starting with a simple structure you can also easily modify the structure in the future should the studio take off and your legal needs shift.

Shameless plug:  Voyer Law offers a flat fee legal package just for indie video game studios.  Click on legal packages for more information.

Fully-Diluted Calculations

Congratulations, you received a term sheet!  While the main terms, such as valuation, are certainly important, there are numerous less noticeable terms that can have just as great an impact.  One such term is “fully-diluted”.

What is a fully-diluted calculation?

A fully-diluted calculation assumes that all options, warrants and other rights to acquire stock have been exercised or converted, regardless of whether they are actually vested or exercisable at the time of the offering.

Let’s illustrate the impact of a fully-diluted calculation compared to a funding round without full dilution.

Startup has issued 1,000,000 shares and 100,000 options.  None of the options are vested.  Investor desires to take 10% interest in the company.

Not fully-diluted:  Startup will use the number of issued shares only to calculate the 10%  and will issue investor 111,100 shares (representing 10%).

Fully-diluted:  Startup will use the total number of issued shares and options to calculate the 10% and issue the investor 122,200 shares.  However, since none of the options are vested, and may never vest, investor actually acquired a present-day interest of 10.89%.

While the above example seems benign given the .89% difference, that percentage could be worth a large sum if the company exits in the future.  What if you are selling an almost controlling interest in the company, perhaps 23.5%?  In that case, a fully-diluted calculation could result in a sale of a 25%+ (and controlling) present-day interest depending on the number of outstanding options etc.  In other situations, an investor may request that the entire option pool (even if no options have been granted) be factored into the fully-diluted calculation – in the case of a 12% option pool, this term would have a substantial impact.

In sum: while you may not be able to avoid a fully-diluted calculation in a term sheet, it’s important to understand its impact and to negotiate with that impact in mind.

Publishing Video Games in Germany

Germany has strict rules governing video game content that large studios and indies need to comply with before publishing or advertising a game in Germany.  Breaching these rules is costly as fines may total $550,000 USD in addition to (in some cases) constituting a criminal offence.  Often, the laws result in modified video game content just for the German market (see: Half-Life, Wolfenstein).

By factoring these rules into development you can facilitate a smooth release in Germany.

1. What Content is Unlawful in German Video Games?

It is unlawful to display violations of human dignity, propaganda material of unconstitutional organizations (especially Nazi symbols), glorify violence and war as well as certain pornographic content.  See Article 4 for the full list.

In addition, it is unlawful to provide content that has the potential to impair the social and emotional development of children if you don’t take precautions to shield children from the content. Depending on style and presentation, games that cover violence, sex or drug use can fall under this category.

2. Does my Video Game Violate German Law?

If you’re unsure whether your game violates German law, there are two ways for your game’s content to be reviewed:

A.  You can have it pre-assessed by the German certified self-regulation organization USK.  The organisation offers basic initial assessments at a flat rate equivalent to $330 USD. You can also apply for an official rating which will prevent your game from being put on the “index list” of restricted content allowing for legal certainty before launching. This assessment entails a test run of the game and costs up to an equivalent of $1,320 USD. For a yearly fee equivalent to $3,300 USD, you can also become a USK member, which includes customized child protection solutions and a certain degree of protection from fines and other administrative measures.

B.  If your game is sold through certain marketplaces (Google Play, Nintendo eShop and Windows Store), you can obtain classification via the International Age Rating Coalition. This system is free to developers and allows you to rate a game using a complex questionnaire.  As of October 2016, IARC will be recognized as an official age classification system by German authorities.

3.  Wont Somebody Please Think of the Children!

As mentioned above, for some games, child protection measures have to be taken.  Examples of such measures include:

A.  tagging your website with an age restriction label; and

B.  restricting game distribution to adults, for example by using an age verification system.

Content that is deemed specifically harmful to children may only be made available to adults in closed user groups.  In addition, if you act as a website provider, it might be necessary to appoint a “Youth Protection Representative” to ensure compliance.

While these requirements are not minimal, it’s important to take them into account if you plan on Germany constituting a portion of your game’s market.

Thanks to guest writer Dominika Wiesner, a German trainee lawyer  working in our office this summer, for her work on this blog post.