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.

Anti-dilution protections are frequently granted to investors and forgotten by founders until their friendly lawyer brings it up.  In many cases, anti-dilution protections are reasonable but in other cases can impose a substantial burden on the company, even impacting the appeal of the company to future investors.

Generally, anti-dilution protections protect an investor from the dilution of the investor’s interest.  When VC’s speak about anti-dilution they are usually referring to price-based anti-dilution protections, which protect from a decrease in share price in a future financing (known as a “down-round”) by, ultimately, increasing the number of shares issued to previous round investors.  This down-round protection is seen in Series A financings and Brad Feld has a great post covering the details.

What is FAR less common, and almost universally viewed as inappropriate, is an absolute anti-dilution clause.  This type of dilution protection guarantees the investor a certain percentage of the company, usually for a fixed time.  For example:

Startup hereby agrees to issue additional shares of Common Stock (for no additional consideration) to maintain Investor’s ownership interest at 10% of the total capital stock (calculated on a fully-diluted basis, including all options, warrants, convertible securities and other rights to acquire capital stock).

In the above case, the investor maintains a 10% interest in the company without a need to make additional payments.  What if the company sells shares to a new investor?  New shares are issued to the previous investor.  What if the company issues options to employees?  New shares are issued to the previous investor.  The absolute anti-dilution clause is viewed as inappropriate as it protects the investor against ALL dilutive events, including those every investor expects to occur, rather than a limited set of dilutive events, such as a down-round.

The absolute anti-dilution clause also runs the risk of rendering your company less appealing to investors.  An investor may reconsider an investment knowing that they will be immediately diluted by the previous investor’s absolute anti-dilution clause.  This is especially the case if the new investor is increasing the company share price and, in turn, the value of the previous investor’s shares.

I usually encounter these absolute anti-dilution clauses in connection with an accelerator program investment.  In this scenario, clients tend to accept the terms as acceptance to the program is viewed as worth the cost (which is a reasonable position to take).  Nonetheless, it’s important for companies to understand the impact of absolute anti-dilution clauses and to weigh the pros and cons of any investment in light of an absolute anti-dilution clause before proceeding further.

Startups commonly raise money through one of two instruments: (1) Convertible Note; or (2) SAFE (Simple Agreement for Future Equity).  While these instruments are common, founders need to understand the basics of each instrument and the points of negotiation available.  This overview is part 1 of a 4 part series that, in future instalments, will cover negotiating each type of instrument and consider an alternative to these instruments.

Why use a Convertible Note or SAFE?

The Convertible Note and SAFE allow a startup to raise money without determining a value for the company.  Many early-stage companies do not or cannot determine a company valuation, especially those companies that are pre-launch, yet need to raise money.  These instruments are used to raise money but kick the question of valuation down the road until a future round values the company, otherwise known as a “priced round”.  Among startups, a priced round typically occurs with a Series-A financing, which involves issuing preferred shares to investors.

It’s important to understand that, under either instrument, equity is not initially issued to investors.  Instead, the instrument converts in the future into equity once the company raises a priced round, thereby establishing a company valuation at which the instrument can be converted.

NOTE – It is possible for startups to raise in priced rounds from day 1, a topic I will discuss in the final part of this series.

What is the difference between a Convertible Note and a SAFE?

A Convertible Note is a debt-equity instrument and, accordingly, charges interest while a SAFE is an equity instrument.  The interest element to the Convertible Note was part of the reason for the shift to SAFEs as this element created, in some situations, unnecessary legal issues.

From a negotiation standpoint, the instruments vary in the different elements commonly subject to negotiation.  A Convertible Note involves, at a minimum, discussions around: cap, discount, interest and maturity date .  Conversely, a SAFE usually involves one point of negotiation: cap.  This single point of negotiation has led to increased use of the SAFE over the Convertible Note.

These instruments also differ in how they convert.  A SAFE only converts upon a preferred share financing round (a priced round), which usually is a Series-A financing.  If a preferred share round does not occur then the SAFE remains unconverted and no shares are issued to the SAFE holder.  Conversely, a Convertible Note converts upon either a priced round (may not be preferred, depends on the note) OR at its maturity date.  As a result, a Convertible Note will always convert while a SAFE may not.

NOTE – there are additional points that can be negotiated on both Convertible Notes and SAFEs, for example, a discount or preemptive rights.

What is a Cap, Discount, Interest and Maturity Date?

Cap:  the maximum value at which the instrument converts into equity.  If the priced round values the company below the cap, the instrument converts at the priced round value (perhaps with a discount) and if the priced round values the company greater than the cap, the instrument converts at the cap value.  For example, if a company raises a priced round valuing the company at $12 million and a SAFE has a $10 million cap, the SAFE converts at a $10 million valuation.  It is possible for Convertible Notes and SAFEs to be issued without a cap, meaning that they convert at the priced round valuation, perhaps with a discount.

Discount:  discount an investor receives on conversion of the instrument, which may only occur upon particular conversion scenarios.

Interest:  Convertible Notes have a debt element and, accordingly, charge interest to the company issuing the note.  Interest is calculated into the total value of the Convertible Note upon conversion.

Maturity Date:  the date on which a Convertible Note must have converted by and, if no conversion has occurred, the note automatically converts on the maturity date.

Overall, Convertible Notes and SAFES are similar in the goal each instrument tries to achieve: raising money without determining a company valuation.  While similar in goal, each document has its own negotiation points, which will be covered in our next blog posts.  Stay tuned!

Many founders I speak with are concerned about where their startup is incorporated and how this could impact fundraising opportunities in the United States.  In reality, this concern is unfounded.

Any sophisticated investor considers the product/service, team, market potential and other commercialization factors before, if at all, considering where a startup is incorporated.  In some circumstances, an investor may request that the startup alter its jurisdiction of incorporation but whether or not they proceed with the investment is determined 90% by quality of the company over jurisdiction of incorporation.  As relayed to me by Canadian founders, “if an investor passes because you’re a Canadian company, that’s not the real reason for passing“.

Where an investor requires your startup to be incorporated in the U.S. there is a simple process for creating this structure that I discussed in a previous blog post – The Canadian-U.S. Swap: Moving an Early-Stage Startup to the U.S.

Canadian founders should focus on building a compelling product/service and not waste energy worrying about minutia of incorporation.  Sell investors on your company and any issues concerning where your company is incorporated can be worked out between your legal counsel and investors.