With 2018 coming to a close we’ve decided to look back at our most popular blog posts of 2018.   Interestingly, all of these posts are on the subject of capital raising/financing, which should be of no surprise to anyone who works in the technology sector!  Now, onto our most popular posts from 2018:

1.  Priced Rounds

In our most popular post we discussed the benefits to priced financing rounds, rather than convertible instruments, for early-stage financing rounds.  We also cautioned that some investors prefer convertible instruments and others will reject a priced round valuation but accept the same valuation (or higher) as the cap on a convertible instrument.   At the end of 2019, I still prefer priced rounds for early-stage investments but only if a Common share is on offer.   I am not fond of preferred share priced rounds prior to a company’s Series A financing (I’ve seen this more than normal in 2018) as this is too early a point in a company’s life for such a complex financing structure and the additional restrictions that often follow.

2.  Things Every Startup Should Know Before its First Financing

In the runner-up post, we laid out four things every startup should know before embarking on its first financing: (1) know your investment structure; (2) have your investment documents ready; (3) don’t treat investor interest as commitment; and (4) be realistic in the timeline for closing the investment round.  I’ll add a fifth: know all your outstanding equity obligations and clean them up before starting the round.  Put another way – all those equity offers you wrote yourself can’t be ignored and need to be cleaned up before the first financing begins.

3.  Video Game Profit Sharing Structures

Finally, in third place, was our post detailing three common structures for video game studio profit sharing: (1) draft a profit sharing agreement; (2) create a separate company for each game; or (3) issue shares to profit share participants.  While clients came to us with numerous structures for profit sharing in 2018, all went the profit sharing agreement route due to its flexibility.

That’s it for 2018.  Stop by again in 2019 for more posts on the law of startups and video game studios, from a Canadian and US perspective.

Startups often email me to assist with a financing expected to close a few days later.  Eager to get the deal going, I ask about deal structure, such as type of investment, investor rights and size of round, only to learn that structure has yet to be determined and no firm commitments have been made by investors.  While there is nothing wrong with these details being TBD, it benefits startups, their investors and legal counsel to fix as many deal terms before expectations of closing take root as until the above is set in stone, there is not deal.

Before beginning your first fundraising round, consider the following:

1.  Know your structure.  Fixing the structure for your investment round is critical and shows investors that the company is sophisticated.  Options include a priced round, convertible notes and SAFEs.  There’s nothing worse than pitching to an interested investor and being unable to answer questions about the round’s structure.
2. Have your Documents Ready.  Be ready to close your lead investor quickly if they are ready to move forward with the investment.  While investment documents may be negotiated further, having the documents ready shows professionalism and speeds the transaction toward close.
3. Don’t treat Interest as Commitment.  Until investors move beyond expressing interest and into reviewing and negotiating deal documents there is little merit to their interest.  In my experience, converting investor interest into investor commitment is much more challenging than expected and you don’t want to plan the company’s direction over the next year based off expressed interest only to find out that you can close 1/2 the amount expected.
4. Be Realistic in Closing Timeline.  Attempting to close a round in a few days only happens if the above points have been addressed by the company.  Legal counsel can prepare documents as quickly as the client requires but investors won’t move quickly until they know the investment structure and previously received draft documentation.  With this in mind, set a realistic closing timeline.

Closing your first financing is daunting.  By keeping in mind structure, documentation, investor commitments and setting realistic closing time-frames you will put your startup in a better position to successfully close the round.

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.

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.