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Home   >   Analysis and Opinion   >   Analysis   >   5 (Avoidable) Legal Mistakes Made By Games Companies

5 (Avoidable) Legal Mistakes Made By Games Companies

By on October 19, 2010

This week, we have a guest post by Andy Moseby of law firm Kemp Little. He argues that thinking about legal issues early can save massive financial headaches later.

$400m for ngMoco; $400m for Playfish; over $760m for Playdom. It’s hard to ignore the numbers and it’s no wonder that many of the games developers we see have a clear exit strategy and an even clearer dream of appearing in next year’s Rich List, says Andy Moseby.

Picture of Andy Moseby

In every transaction, there are two sides. A seller wants to maximise the price on an acquisition. The buyer – from a legal point of view anyway – wants to protect the value of business it’s buying.

Due diligence – the laborious exercise of providing all financial information, corporate history and commercial arrangements to a buyer – is key to this. But it’s also a way in which the purchaser can chip away at the price. If skeletons lurk in the closet, you can guarantee that a thorough due diligence process will drag them out into the open, and suddenly the luxury yacht in the Caribbean has to be scaled back to a dinghy in Margate.

Many of the issues revealed during the due diligence process are understandable. They come from a time when the company was starting out or focussing on generating income rather than spending money on legal niceties. But time and again, the same things crop up, and they have a habit of slowing the acquisition process down, leading to extra costs and pulling management away from running the business, or resulting in the sellers receiving less than they anticipated.

Here is my short guide of the five most common legal pitfalls. For anyone who has already fallen into these traps: don’t worry – far better to identify and fix them now, than trying to do it in the midst of a sale under the watchful gaze of a buyer.

1. Tax and Structuring

There are many different reasons to look at clever financial structures for your intellectual property. There may be attractive industry-specific tax breaks. You may be able to off-shore your intellectual property in a country with a low tax rate on IP income or attractive R&D incentives.

If you are going to pursue this strategy, not only should you carefully assess the commercial reasons for doing so, but you should also make sure the tax breaks apply to what you’re developing.

It sounds like common sense, but control of IP can be key. In an industry where IP is frequently licensed in or owned by publishers not studios, developers need to fully understand the parameters of tax credits, especially as many tax incentive regimes have only recently been established (and their application criteria barely tested).

Even where IP portfolios have been successfully established off-shore, mistakes can easily be made. We have seen cases where deals have collapsed or been severely delayed simply because the developers have failed to put in place licences to the on-shore group businesses exploiting that IP.

To put that simply, they didn’t have the right to use their own intellectual property.

These decisions go to the heart of how your business will ultimately be structured (and how attractive it can seem to a buyer), and can be extremely difficult to unwind at a later date.

2. Giving Shares to Founders or Early Contributors

Let’s say you set up an independent developer. A couple of fabulously talented creatives have just left large publishing houses and want to join. You don’t have a huge amount of cash – and neither do they – so you issue them a bunch of shares for nothing. To incentivise them further, you put in place a vesting mechanic whereby the number of shares they retain if they leave the business increases over time to reflect their valuable contribution to the business.

This all makes commercial sense, but can lead to a significant tax headache.

Under established, but not particularly well-understood, legislation, HMRC will treat the shares as if they were paid in place of salary. They will look to tax the shareholders under the income tax regime at the time the shares are issued. When any restrictions attaching to those shares fall away (for example, each time the vesting mechanic operates) there is a further income tax charge, even though the shareholder won’t have received any financial benefit of the shares at that point.

So whenever a director or an employee receives shares in your company, they may have a hefty income tax bill to pay.

It gets worse. If a shareholder sells his shares, HMRC swoops again. If he is a higher-rate tax payer, he could be paying 50% tax on part of what he receives for his shares rather than the lower capital gains charge.

Not only that, but the company will be primarily liable for any income tax charge through PAYE and will also have to pay National Insurance contributions.

Issuing shares by way of certain tax efficient share option schemes, such as an Enterprise Management Incentive (EMI) scheme, can help, as can entering into what is known as a section 431 election. These allow any gain to be charged under the capital gain regime (provided any income tax charge on any undervalue is paid up front). This should be done within 14 days of issuing the shares, but if this hasn’t happened it is worth speaking to your advisers. Elections can sometimes be entered into later if share restrictions can be removed.

3. Establishing Ownership and Use of Key IP

A buyer wants to know that a company owns its key assets. It will be keen to see that proprietary technology, know-how and branding is adequately protected and able to be exploited by the company.

It will also want to see that all those working on your IP have effectively assigned ownership over to the company. Whilst this happens automatically for employees (provided they created the technology or code during their course of employment) it will need to be expressly provided for in any agreement entered into with consultants, contractors or freelancers.

Similarly, if you are reliant on any third party IP, such as a game engine or middleware, what happens if the company providing it goes bust or terminates the licence? Make sure your key contracts allow you access to the relevant code on insolvency, and be able show any buyer you have a back-up plan.

4. Open Source Software

Even five years ago, if a large corporate buyer came across a target business using a significant amount of open source software, alarm bells would ring, and a whole raft of indemnities and warranties would be added to the purchase agreement.

Despite the fact that key legal concepts surrounding “copyleft” and what constitutes a derivative work still haven’t been decided with any degree of certainty, these days buyers take a more pragmatic approach. Sensible use of OSS is applauded, but ideally a buyer would want to see a considered OSS governance policy.

Knowing what OSS you are using, where it comes from, where it is being used and ensuring that your business complies with its OSS licence obligations can prevent a sale being put on hold (or a buyer losing interest) whilst you are effectively forced to complete a full OSS audit.

5. Surround Yourself with the Right Network of Advisors and Contacts

Look to build good working relationships early, but recognise when it might be time to call in the specialists.

Don’t underestimate the effect appointing the wrong advisers can have on a transaction. Okay, so it won’t necessarily kill the deal, but ask anyone who has been through the process and has had to explain to advisers at every meeting how their business works, who has been unable to speak to the partner they met at the start of the deal and been passed around a series of juniors, or who has had a nasty surprise when the bill arrives: it can turn a buoyant exit into a stamina-sapping war of attrition.

Conclusion

In the excitement of setting up a business, many legal issues naturally get overlooked. It is worth stopping for a moment and considering whether any of these mistakes have been made in your business.

Fixing the issue now, rather than waiting until the middle of an acquisition discussion can save costs and help the deal run smoothly.

Andy Moseby is a corporate partner at Kemp Little, a leading UK technology and digital media law firm

About Andy Moseby