Things Every Startup Should Know Before its First Financing
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:
- 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.
- 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.
- 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.
- 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.
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.
You Need a Streaming License
Streamers are increasingly important to the success of indie video games and our clients often encourage streaming as a way to increase exposure without substantial expense. However, recent streamer controversies illustrate the need for developers to include an explicit streaming license and code of conduct within the game’s End User License Agreement (EULA) with broad grounds for termination.
What is a streaming license? A streaming license expressly grants users a license to stream the video game but makes it clear that this license can be revoked at any time, without notice or compensation. Without this language, substantial ambiguity remains concerning the scope of the license and impact of termination. Consider the following example:
DEVELOPER grants you a license to publicly display the Game on online video streaming websites, such as youtube.com and twitch.com, and social media, such as tweeting a GIF. DEVELOPER may terminate or modify the scope of this license at any time without notice or compensation and will not be liable to you or any third party for any loss incurred relating thereto.
You can also draft the license to fit your company’s particular needs. For example, the streaming license could prohibit monetization of the stream.
Do you have a Code of Conduct? In addition to a streaming license, we recommend that the EULA contain a user code of conduct that prohibits certain conduct, such as profanity, nudity etc. Breach of this code could provide a basis for terminating a user’s streaming license, although not the only basis.
Can’t I just use the DMCA? Yes, a Digital Millennium Copyright Act (DMCA) claim is the quickest way to secure removal of a stream and a clear streaming license (with termination language) provides a clear basis for making the DMCA claim. Without a streaming license, unnecessary ambiguity remains concerning the impact of termination (for example, could liability follow if you terminate a lucrative stream that was previously permitted?).
In sum: It benefits your streaming community to receive a clear streaming license and to understand the basis upon which the license can be used and revoked. While you can remove an offensive stream without such a clause (under the DMCA), ambiguity does little to benefit your company or streaming community.