Creating the next blockbuster game tends not to be cheap. Some businesses 'bootstrap' and aim to survive off revenue alone, but many seek external financing across a range of models.
The UK games market has seen a number of high profile exits in the last few years at valuations that have caught the attention of investors not only in the UK but also, increasingly, from overseas, including private investors and venture capital firms from the US. This has bolstered the UK market as it continues to compete with the traditional tech strongholds like Silicon Valley for funding opportunities.
Businesses may consider:
Do shareholders want to dilute their control of a company to raise funds, particularly when third party investors are likely to have different motivations?
If a game is unpopular, revenues may not be as high as expected and a company may be unable to repay its debt. In a worst-case scenario, a company could be placed in administration.
Publisher funding for the games industry
For many years, the games industry has relied on publishers to fund developers. This has a number of benefits:
- security of funding as developers and publishers are unlikely to terminate their agreements;
- publishers support developers of all sizes; and
- developers benefit from a close relationship with publishers and this dilutes some of the risk associated with taking a game to market.
However, publisher funding is based on a 'milestone' system (i.e. funds are given when certain development milestones are met) and this raises some concerns including:
- the risk that publishers have too great an impact on creative decisions by setting the milestones;
- milestones may constrain game development and prevent exploration of different ideas; and
- if milestones are not met, a developer may be unable to pay for all expenditure, particularly payroll.
Alternative sources of finance
While publisher funding is the main source of financing, there are alternatives available:
A small number of banks lend to developers and publishers. Lending is usually structured by milestone payments, as with publisher funding, but there are likely to be fewer creative constraints. Banks tend to lend against distribution and would require a guarantee against the game being delivered to market.
Similar to film finance, investors lend against a particular game and take a share in the revenue. In some circumstances, games are grouped together (known as "slate financing arrangements") to mitigate the risk of a particular game flopping.
A new funding source where a large number of people invest in a project through an online platform. There are various types of crowdfunding , but the gaming industry may be interested in a royalty-based system where investors give money in return for a fixed share of revenue.
A games business, like any technology business, will require funding to fuel its growth cycle as it aims to achieve international expansion and potential exit (usually by trade sale or IPO). Along this journey the business might expect to start with seed money from family and friends when bootstrapping isn't enough, then perhaps angels for initial outside capital, before pitching to VCs and institutional money when looking for larger rounds at higher valuations to achieve the blockbuster exit all founders are chasing.
Once a developer or publisher takes outside investment, the founder team will need to walk the tightrope of managing the business, keeping investors happy and looking for the next funding round, while all the time building the company, its titles and achieving a critical mass of players.
Typical investment structures
Incoming investors will typically subscribe for shares in the business and, at the same time, enter into a shareholders' agreement to govern the relationship between the shareholders and the ongoing running of the business. Convertible debt is another common method used to invest, although this is less popular for early stage businesses as this structure doesn't generally work for SEIS tax relief (see our article on Tax and tax breaks). The parties are free to negotiate the terms of the investment and all manner of complexity can be built to achieve particular objectives or protect certain interests, however, simplicity is usually the best course of action.
Typical issues to consider on investment:
When investing in a games business, the key assets are likely to comprise intellectual property (IP) and, possibly, player data. Ensuring that the business actually owns or has the right to use the IP that is central to its titles or platform is key — this could mean code itself but also, possibly, brands and images licensed in from third parties. The right to leverage player data will also be key to value and an investor will carefully examine the privacy policies used by the business as well as its notification and general compliance under the Data Protection Act 1998 (see section in TW Play Guide on Leveraging player data).
Corporate diligence is also necessary to confirm the actual ownership of the company and that there are no legacy disputes between the shareholders or third parties (such as employees, consultants or developers) regarding their equity stake in the business, for example, claiming they were promised shares for the development of game concepts, code or other IP.
The specific terms of the investment should always factor in tax advice at a personal level for the investor. As described in our article on Tax and tax breaks, SEIS and EIS relief are very attractive to UK investors but where there are foreign-based investors, corporate investors or offshore structures, their circumstances need to be weighed against those of the existing shareholders and co-investors. Keeping an eye on the exit event is also key to ensure that any eligibility requirements are not overlooked when negotiating the investment terms.
Investors will invariably invest in the parent company if there are subsidiaries in other jurisdictions. For games businesses that were founded outside the UK, but which wish to attract UK investors, an investment round is often the time to restructure by interposing a new UK holding company. While the same position used to hold in the US (US investors requiring a US holding company), it is becoming increasingly common for US investors to invest directly in a UK games business rather than requiring a 'flip' to the US.
Care is needed when investing in companies that started in less familiar jurisdictions. The diligence matters described above will be crucial as each country will have its own laws, for example, around IP ownership.
When negotiating any investment agreement, a key point will be control and decision making. This can be cut many ways but once there are multiple shareholders, it is likely that a concept of an 'investor consent' will be used to act as a check on the company, in addition to protections baked into the company's articles of association. For example, investors will want to ensure that pre-emption rights will apply on new funding rounds to avoid dilution of their shareholdings (usually on the basis that each investor would need to participate to follow their money). "Drag-along" and "tag-along" rights are also often used to enforce a sale once the requisite majority is met and to ensure minorities are not left behind.
Vesting and employment
Investors might be investing in a games business largely because of the calibre of the management team. Provisions that make the founders' shares subject to staged vesting provide a neat way to ensure that the founders actually "earn" their shares and don't walk away. The use of "good leaver" and "bad leaver" concepts add a layer of complexity but are a helpful way to ensure fairness (although what is fair is likely to be viewed differently by management and investor).
Ensuring the management have suitable employment contracts is important to make leaver provisions workable and, therefore, an investment round is generally a good time to regularise employee terms and set salary expectations. An investor will also want to make sure that the management / founders are subject to appropriate non-compete restrictions in the market.
The term sheet for an investment will likely include an agreed option pool allocation. Options, and particularly the tax favourable Enterprise Management Incentive (EMI) options, are a great way to incentivise employees and attract new hires. Advice is needed to make sure any option grants are carried out properly and that the company is in full compliance to ensure both talent and company achieve the planned tax treatment.