Mergers & Acquisitions: Key Considerations for Video Game Transactions
Mergers and acquisitions (M&A) in the gaming industry are off to a great start in 2021. This is building off of record-breaking success for M&A deals in 2020 as a result of the COVID-19 pandemic. Investment in the gaming industry, particularly among publicly traded video game companies, reached a new high in 2020, up 77% from 2019.
Consumer spending on video games has also increased significantly, creating profitability for companies like Sony, Nintendo, and Microsoft. In this era of increased profits, these companies are able to purchase smaller video game platforms like ZeniMax, which is being acquired by Microsoft.
However, not all skies are blue in the world of video game companies. One of the main concerns in this industry is that smaller studios will lose their identities by merging into a large conglomerate. As rapid expansion continues with the popularity of games like Fortnite and Minecraft, M&A transactions have expanded through acquisitions of smaller studios, narrowing the market for startups and other small businesses.
Still, both the smaller studios and the major platforms can benefit from M&A transactions. However, there are a few industry-specific legal issues to consider when creating the best agreement to make a video game M&A deal happen.
General Considerations for Investing in Video Games
When looking for video game companies to purchase, larger companies look for excellence in design and production, as well as the ability to create new intellectual property (IP). They also look for games that have the potential for unique monetization mechanics and growth for many years post-launch of the platform.
Further, they also look for shared company values, the creation of diversity within game-making teams, and people who add to collaborative and innovative cultures within the larger conglomerate.
The central components surrounding all of these criteria are business development and maintaining business relationships. Those looking to invest in the games market should consider these criteria broadly.
Below are some specific considerations for buyers considering becoming investors in the video games and esports industry.
Corporate Structure and Shareholders
Disentangle Complex Shareholder Rights
Since video game companies usually begin as small startups, they are financed in various ways during their early stages, including raising seed funds from venture capital investors in the form of equity or through various debt vehicles such as loans and option rights.
This diverse funding results in complex shareholder structures with complex rights that are stipulated by shareholder or other agreements. Under these complex structures, shareholders may have redemption rights in these documents or the right to sell their shares if another shareholder sells their portion of the shares to a buyer.
When a smaller company is merged into a larger organization, parties should disentangle complex shareholder structures early in the M&A process to ensure the buyer receives the intended economics in the smaller company.
Put Limited Warranties in Place
After fundraising rounds with venture capital funds, investors from these funds will want to make sure their returns are maximized. To do this, buyers should look closely at the terms of the merger or acquisition. In particular, investors will look to ensure that limited warranties are given. These include basic warranties for the title and some capacity warranties. One key point that investors will want to confirm in the transaction is that no business warranty is given.
Consider Founder Rights and Retention
The first employees a buyer generally want to retain are consider the founders of the company. The buyer will likely want to tie the founders into the business for the first few years to ensure continuity as well as knowledge transfer for all essential components of the business.
One way to incentivize founders to continue with the company is to provide them with compensation based on predetermined metrics that must be met at a later date for them to receive the remaining portion of the proceeds from the sale of the company, commonly known as an “earnout.”
Another way to bring the founders on board is to provide the founders with equity in the company based on the structure of the deal in some form of “equity roll” from the founders into the buyer.
Understand Your Human Capital Needs
Talent Acquisition and Retention
Buyers also generally wants to retain the employees of the company. First, it is crucial to keep the deal confidential early on, but employees will need to be made aware of the sale of the company at some point, and they should do it carefully. The timing of the disclosure is something that can be negotiated between the buyer and the seller.
In most deals, employees are given options to incentivize them to stay with the company and reward good performance. This may include giving the employees equity in the company as well as certain vesting and acceleration provisions to encourage retention. Additionally, the buyer could provide incentives to key employees, such as developers, who are crucial to the value proposition of the business. Other key employees could include programmers, engineers, and management staff.
Further, in the video game industry, employees are often given stock options as part of their compensation. When the company is bought out, parties must ensure that employee stock options are considered as part of the M&A deal by either compensating the employees for their stock options or having the buyer assume the existing options so that they continue on.
Talent acquisition is a key employment issue in video game M&A deals. Buyers should tread carefully, making sure they provide employees with appropriate incentives to stay but not too much compensation if they leave.
Employees vs. Independent Contractors
A related issue buyers should consider early on is whether the service providers and employees of the company are properly categorized as employees or as independent contractors under employment law. This distinction is important because misclassification of employees can result in tax issues and penalties for the target. Further, the workforce composition (employee v independent contractors) will impact how the buyer should handle talent retention, and post-deal integration.
Risk Associated with “Crunches”
Another employment issue specific to the video game industry is the concept of “crunches.” Video game developers often engage in crunches close to deadlines when projects need to be finished. These intense work periods could be categorized as illegal overtime work that can result in severe penalties and criminal liability.
To avoid this, companies must compensate their employees for overtime hours worked, and this issue should be preemptively addressed in the M&A transaction.
Intellectual Property (IP)
It will be crucial for the buyer to ensure that they acquire the intellectual property rights in addition to the business. Video games and their creators are central to video game studios. Most all of the parts of a video game, such as code in a video game, are considered intellectual property. This can include the design, music storytelling, technology source code, and other components.
Take Inventory of All IP Rights
One common pitfall in poorly drafted agreements is who becomes the owner of all intellectual property rights, including licenses. Buyers should take inventory of all IP rights, such as usage rights and editing rights, and make sure that the M&A agreement includes all of the rights they desire.
Sellers Should Register Intellectual Property
The seller should also aim to register all intellectual property with the government. This will allow the buyer to conduct IP searches for patents, trademarks, and copyrights, as well as to make sure that all of these are in order. If there are issues with IP registration, then these can be resolved before the completion of the deal.
Employees and Intellectual Property
Employment processes also play a role in intellectual property protection. The buyer should check to make sure that all employees have signed agreements that give the intellectual property rights of the video games and source codes to the seller.
Buyers should also confirm that all employees have signed confidentiality agreements to protect trade secrets. Conducting this due diligence will ensure that any missing agreements are completed prior to the sale.
Overall, intellectual property is a primary issue in video game mergers and acquisitions. Proper due diligence will ensure that intellectual property rights are given to the appropriate party once the transaction is complete.
Contracts and Third-Party Agreements
The creation of a video game typically involves input from many third parties, such as publishers, distributors, creators, and platform holders. The relationship between the video game studio and these third parties is generally governed by some form of contract.
These contracts highlight the terms of the business agreement for the work to be completed by a third party. The buyer should review all of these third-party contractual agreements to ensure that none of these agreements violate the law or raise legal issues.
Another key consideration in video game M&A is to review the licensing agreements. The buyer should review these agreements to determine whether the buyer will be granted the appropriate licenses and that the transaction will not violate any previously granted licenses.
Further, seller’s documents such as leases, vendor agreements, and loan documents should be reviewed by the buyer's legal counsel to determine if these need to be assigned to the buyer, are subject to enforcement by the other party, or have provisions that could delay or prevent the transaction from occurring. If issues arise regarding these contracts, the buyer and seller should work together to determine how to proceed so that the buyer has the appropriate contracts in place when they take over or acquire the business.
Planning the due diligence process prior to the transaction or as early as possible can shorten the deal timetable by making it more efficient and controlled. A well-organized process with room for input from the buyer's legal advisors will allow the due diligence process to expand as needed over time. If the seller is aware of any issues that may impact the transaction, they should be proactive by providing the buyer with this information so that the issue can be discussed during negotiations.
Countries around the world have varying regulations regarding data collection and storage. The collection of user data is a key component of video game development and maintenance for both traditional video games and mobile games. It is also subject to complex rules and regulations, such as the European Union General Data Protection Regulation Law and the California Privacy Act.
Many countries also have increased regulations for video games that are targeted toward children. As a result, one point of due diligence in the video game merger or acquisition is to check for regulations in the state or country where the product will be deployed. Monitoring changes in these regulations will ensure that products comply with local laws that may raise issues for the transaction.
If last year was any indication for future trends, video game M&A transactions will likely continue to increase in frequency. These transactions are both profitable and complex. Buyers should pay close attention to potential changes in the company culture and workforce to ensure a smooth transition. Integration may also result in a change in governance structures, such as the implementation of rules, procedures, reporting obligations, and more.
Indeed, because of their complexity and relative novelty, video game M&A transactions have specific risks to the industry. Still, potential investors can protect themselves from certain increased risks with proper due diligence. An experienced legal team can help address risks and avoid any pitfalls in the transaction.