Working with early-stage startups and game studios, we are often involved in key company decisions, such as a first hire.  Lately, with many of our clients growing their teams, we’ve been fielding questions concerning the scope of employment agreements.  Below are a few recommendations:

1.  Consider a less strict intellectual property ownership clause.  From the outset, I must stress that the company needs to own employee work product.  However, there are different ways to define what constitutes “work product”.  The most contentious IP clauses grant the company ownership of everything created during employment, at home or at work.  These broad clauses are often at odds with the creative nature of the industry, where employees work on personal projects outside the office, which do not relate to the employer’s business.  For example, making indie games outside of working at a AAA studio.  Further, such broad clauses can drive away prospective employees.  While each company’s needs are different, a carefully crafted IP clause can ensure company ownership of work product while encouraging employee creativity in a manner that does not jeopardize such ownership.
2. Non-compete clauses are useless (in many jurisdictions).  There seems to be an infatuation with non-compete clauses among early-stage founders, perhaps because there is a presumption that the clause will protect the company’s interests.  It won’t.  In many states (California, for example) non-compete clauses are unenforceable against employees (excluding senior management).   If you’re asking a junior dev. to sign a non-compete, it’s probably unenforceable.  If non-competes are enforceable in your jurisdiction, the clause must be carefully crafted – as a broad clause will be found unenforceable.   In my opinion, I always exclude non-compete clauses unless there is truly a reason for the clause and I believe there is a reasonable chance it will be enforceable.  In most cases, a standard confidentiality clause will provide the company sufficient protection.
3. Law overrides employment terms.  Employees may be entitled to overtime, paid vacation etc., the terms of which are set by the laws of your jurisdiction.  As a result you, can’t force an employee to waive the rights to which they are legally entitled.  For example, an employee agreeing to be paid a flat wage when the employee is also entitled to overtime is not legal.  When hiring an employee, be sure that the employment terms are consistent with applicable laws.  When you start introducing startup employment trends (unlimited paid vacation, for example), further caution is needed to ensure that the trend reconciles with the legal requirements of your jurisdiction.  Tip:  speak with your legal counsel.

In addition to the above considerations, we recommend that you have your lawyer draft an employment agreement template that reflects your legal needs.  In doing so, you can address the above concerns and create an agreement that will serve your company needs as the team begins to grow.

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.

In addition to the legal, accounting and immigration reasons I raised in support of initially incorporating in Canada, I wanted to revisit this question and point out the various incentive programs only available to Canadian companies:

1.  BC EBC Tax Credit.  This tax credit grants investors in eligible business corporations (EBC) a 30% refundable tax credit for their investment (up to $60,000 annually).  This program is only available to BC or federally incorporated companies.  BC angel investors quite like this program and it can often serve as an incentive for investment – an incentive that is lost should you incorporate in Delaware.

2.  Industrial Research Assistance Program.  Otherwise known as IRAP, the program provides companies with non-refundable funding under 4 different arms, including grants that can cover substantial portions of your company’s labour or R&D costs.  This program is only available to provincial or federally incorporated companies.  Again, if you incorporate in Delaware you lose access to IRAP funding.

The above are two examples among many programs, both federal and provincial, that require recipients to be Canadian companies.  When choosing where to incorporate, consider the benefits that are available to Canadian companies that are lost if you incorporate a Delaware company.  While I’m not averse to incorporating in Delaware, I am averse to incorporating in Delaware for the sake of emulating other successful U.S. startups without considering the costs/benefits of this decision.

As I concluded two years ago:  incorporate in Canada first.  If your jurisdiction of incorporation needs to change this can be easily accommodated in the future.

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.

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.