Due diligence in game development: A guide to preparation and survival
With the growing popularity of video games, the game development industry is booming on a global scale. The outbreak of the coronavirus pandemic only accelerated this process. The unwavering demand for video games is generating an increase in interest in investing in entities involved in production and distribution of games.
In recent years the video game market has been rocked by many large M&A deals—to name just a few:
- Microsoft’s acquisition of the studio Mojang, responsible for Minecraft, for USD 2.5 billion
- Acquisition of ZeniMax Media for USD 7.5 billion (also by Microsoft), which has been the subject of a great deal of comment in recent months
- Codemasters’ acquisition by Electronic Arts for USD 1.2 billion.
Game development is also a major industry in Poland, as demonstrated by the successes of the native company CD Projekt, which in April 2020 became the largest public company in Poland in market capitalisation, overtaking such names as PKO Bank Polski, PKN Orlen, and KGHM.
Legal due diligence is the standard expected by investors, including stock-market investors, interested in acquiring companies from the game development industry. From the investor’s perspective, conducting this process can be crucial. The results can be provide the investor vital insight into the condition of the target, which can impact the financial negotiations or the valuation of the company.
How to prepare to find an investor?
As in other industries, an investment in an entity from the game development sector is usually preceded by a careful examination of the company. The legal risks identified during the analysis are often reflected in the negotiated value of the transaction and in the structuring of the transaction documents, or may lead the investor to withdraw from the project.
Instead of waiting for a potential investor to conduct due diligence of the target, a company seeking an investor can prepare for due diligence on its own, verifying key areas of its own operations, or can hire a professional entity to conduct vendor due diligence. This “self-examination” can identify any gaps or shortcomings and allow the company to make necessary changes in advance of a potential deal.
Due diligence can also be very useful in determining the list of activities that should be addressed or which the parties must remember about before the final closing of the transaction, such as obtaining the necessary corporate approvals on the part of the buyer and seller. An example would be the need for the seller to obtain approval from the shareholders’ meeting to sell the enterprise, as provided in the Commercial Companies Code. Or if the transaction will involves shares, it should be determined whether the articles of association require the company’s approval for the sale of shares. Failure to obtain such approval may render the sale contract ineffective against the company.
Due diligence typically covers financial, tax and legal aspects. In the video game industry, key areas will no doubt include issues of corporate law, intellectual property, and employment law.
Corporate due diligence of companies from the video game sector may differ depending on the type of company and the nature of the potential transaction. Apart from examining obvious issues, such as title to shares, review of financial documents, corporate resolutions, and the like, issues driven by the nature and size of the entity will also be relevant. Different issues will arise in the case of large listed companies, privately held companies, and startups still seeking the optimum business model.
Title to shares—important but often neglected
In transactions involving share rights in a company, it is vital to analyse the corporate documents, in particular the documents under which title to shares has been transferred.
First, the existence of the shares must be confirmed, along with the rights incorporated into the shares. Second, the legal title to the shares held by the seller should be verified. Confirming that the seller has the right to dispose of the shares is particularly important because, as a rule, such shares cannot be acquired in good faith from an unauthorised person.
The presumption of the correctness of data entered in the National Court Register does not carry consequences as strong as those provided by the warranty of public reliance on land and mortgage registers. In other words, to confirm that the seller holds legal title to the shares, it is not sufficient to merely examine the information disclosed in the National Court Register.
The form in which shares in a limited-liability company were acquired in the past should also be examined. Under Art. 180 of the Commercial Companies Code, this requires written form with notarised signatures. The absence of this form will render the prior transaction invalid if the contract was concluded on or after 1 January 2001 (before that date, ordinary written form was sufficient).
In the case of shares in a joint-stock company, it should be examined whether the shares that are the subject of the contemplated transaction were properly entered in the shareholders’ register (for a privately held joint-stock company) or in a securities account (for a public company). Failure to enter the acquirer in the shareholders’ register (or securities account) generally means that with respect to the company, that person is not regarded as a shareholder and cannot exercise the entitlements of a shareholder—e.g. cannot vote at the general meeting or enforce rights to a dividend.
Startup agreement—most common problems from the investor’s perspective
Companies arising under startup mechanisms, which have become popular in recent years, require a special approach during analysis of corporate aspects of legal due diligence.
Startups are often financed not by the originators of the company contributing their knowhow, but by investors who will wish to exit the company after it begins to generate a profit or beyond a specified investment horizon. In such companies, it is often the founders who are seeking a new investor willing to acquire shares or the entire enterprise.
In such situations, the party conducting due diligence must deal with article of associations structured in a manner typical for startups, and other documents governing relations between the shareholders, disposal of shares, and potential obligations arising under such agreements (such as an obligation to inject capital surcharges or raise the share capital at certain intervals).
The documents establishing entities of this type typically regulate comprehensively the relations between the shareholders. Sometimes it will not be possible for an investor to join such a company, if the articles of association contain provisions restricting the possibility of disposing of share rights or imposing a certain method for proceeding when taking decisions on ownership changes. This usually involves provisions on a right of pre-emption or priority, tagalong rights (which in certain situations may block an acquisition of shares in the company), or other provisions that cannot be changed without first holding a certain percentage of the shares.
Encumbrances on shares may discourage investors
Another challenge is financial leveraging of the newly created company’s capital. In such situations, the lenders often secure their interests through encumbrances on the company’s assets. This can generate numerous risks, e.g. when key intellectual property rights, which first sparked the prospective acquirer’s interest in the target, have been pledged as collateral.
Often carrying out the transaction will require the consent of a third party who has lent money to the company to finance its operations.
Intellectual property issues
The development and production of a video game can be a venture spread out over multiple stages, taking several years and involving many different people. Undoubtedly it is the end product that draws the investor and leads to the decision to enter negotiations with the target. But understandably, it is vital to confirm that the company is fully entitled to the game it is producing, or in colloquial terms, that it owns all the rights to its own game. This is not always obvious or unambiguous, particularly when work on the game may have begun informally.
From a legal point of view, nearly everything that arises during the process of developing a game may be regarded as intellectual property. This includes for example graphic designs, musical arrangements, the game universe, including characters and narrative, software, name, logo, and many other solutions prepared for the purpose of developing a video game.
With respect to the concept for the game, ideas as such are not protected, and thus are not the subject of intellectual property rights. Only in certain instances, protection may extend to a certain expression of the concept for a game. The form of expression of the game concept may be protected if it has a creative, individual nature.
The company should hold the rights to the game. If the game was created for example by the founders before the company was established, they should transfer the rights to the company, so that it can exploit, elaborate on and dispose of the game (through sale or licence). Alternatively, the rights should be bought out by the originator who wishes to continue the work on the game.
Polish law requires an agreement transferring economic copyright to be made in writing and to set forth the fields of exploitation, i.e. the manner in which the work can be used, or else the agreement will be invalid. Transfer of economic copyright in the form of terms agreed through email correspondence, or by issuance of an invoice, will not be effective because the requirement for written form will not be fulfilled.
Absent a contractual transfer of rights, the rights will remain with the creator, and the company may be treated at most as a non-exclusive licensee, but that is not a desirable situation, as it creates major risks for the investor (e.g. it is doubtful whether the company, as a non-exclusive licensee, can further elaborate on the game).
It is also important for the company’s situation to be properly secured with respect to acquiring intellectual property rights in relation to employees or freelancers with whom the company cooperates on the basis of civil contracts.
Although there is plenty of awareness within the game industry that it is necessary to secure intellectual property rights, unfortunately it remains all too common to find improper provisions in contracts, resulting in invalidity of the contract or raising serious doubts as to the scope of rights acquired by the company. Copying and pasting provisions from the Copyright Act does not always ensure a broad acquisition of rights.
Other problematic issues during due diligence from the investor’s point of view include for example claims for infringement of third-party rights (e.g. use in the game of elements of works by others, or other intellectual property rights) or neglect of trademark registration procedures (e.g. for the name or logo of the game) in key territories for distribution of the game.
Various employment issues are checked in due diligence, such as the use of external service providers, working time, and contracts with key employees, particularly in terms of non-competition and confidentiality clauses.
Outsourcing is very popular in the production of video games. Developers often use external entities, such as voice actors, script writers, musicians, graphic artists, and programmers. Considering how long it takes to develop a game, it can be difficult to determine the status of persons who have been providing services for a long time. Often the nature of the services they provide differs little from the work performed by staff hired under employment contracts. For this reason, grounds may arise for deeming the relations with such service providers to be employment, which is risky as it entails the possibility of reclassification of existing contracts and the need to pay social insurance contributions in arrears.
Another problem faced by the game development industry is the “crunch”—the period of intense effort in the runup to the launch of a game. This phenomenon can have legal repercussions, but also can drive down staff morale or even result in the departure of key personnel.
It may also be necessary to review contracts with key employees and contractors cooperating with the company in terms of non-competition and confidentiality clauses. The period for which such clauses are in force requires particular attention, along with whether the clauses remain in force after the end of the parties’ cooperation—this can be vital to protect the potential investor against the departure of key staff after the investor acquires the company.
Due diligence covers the entire company and all areas of its operations, and describing all of them is beyond the scope of this article. If the article were to address all areas and issues that deserve attention, the article could grow as long as a typical due diligence report, which could run to dozens of pages.
Apart from the issues mentioned above, companies seeking investors should verify the data protection rules they apply (including cybersecurity) and examine the contracts to which they are a party.
Publishing, licensing and other agreements related to the company’s cooperation with contractors (suppliers and customers) may contain provisions commonly known as change-of-control clauses. These provisions address the parties’ mutual rights and obligations in the event of a possible change in ownership structure. These clauses typically contain provisions under which a change in a party’s ownership structure requires the consent of the other party or gives the other party a right to terminate the contract early. It is thus vitally important to be aware of such provisions, as they can block or greatly hinder the company from finding an investor and carrying out the transaction.
Due diligence is an organisational and legal challenge for the target and for the investor. Good preparation by both parties greatly facilitates the process. That is why it is worth considering conducting vendor due diligence, to catch problematic issues early on and as far as possible to mitigate the related risks.
When seeking an investor and preparing for the transaction, it is worth remembering about:
- Verification of corporate issues, including the need to obtain approvals to carry out the transaction
- An inventory of intellectual property rights, and confirming that the company holds full rights to intellectual property
- Employment, data protection, confidentiality, and cybersecurity issues
- Proper preparation of documentation for the due diligence process, such as redacting personal data from documents, drawing up a complete set of the contract forms used by the company, and compiling insurance policies, safety certificates, and the like.
We hope that this miniguide helps readers prepare for the due diligence process and makes the due diligence itself run more smoothly.
Michał Pypka, Jan Kaźmierczak, Maciej A. Szewczyk, attorney-at-law, M&A and Corporate practice, Wardyński & Partners