Raising MoneyFinancing the EarlyStage Venture

[ LiB ]

Raising Money/Financing the Early Stage Venture

If you are a start-up, now that you know how much money you need to make your pitch build (or your full build, if you want to self-publish or try for the higher royalties of a finished game), it is time to raise it. Raising money for a company is never easy, and the high rate of failure for game developers doesn't make it much easier. On the other hand, the industry has the glow of expanding and generating profits all through the recent recession , which has given it some cachet in the public and investing audience. Furthermore, a game company is something that everyone with a console or a PC can relate to, which is always helpful when pitching.

This section will help you answer three core questions of financing your company:

• Who might fund you?

• What materials should you prepare to make your pitch?

• How do you take the investment into your company?

The practice of institutional equity financing is not currently common in the game development industry, but given the escalating cost of production and the rapid expansion of financing solutions and groups seeking to fund game development, it makes sense for developers to have a passing knowledge of the price of institutional money. This is discussed in the "Equity Investment Term Sheets" section.

Sources of Funding

Technically speaking, there are several sources of funding available for start-up companies, but practically speaking, an early-stage developer is only likely to shake fruit from one of four trees: friends and family, publishers, angel investors, or a game-focused financing entity.

Friends and Family

Professional investors all say that they don't bet on business plans or projects: they bet on people. Who knows you better than your friends and family? At the same time, remember that family and money mix only a little better than nitrogen and glycerine. The relative ease of raising money from people you know can be outweighed by the stress: If the company falls on hard times, will you feel like your friend looks at you funny if you buy a new sofa for your apartment? Will Uncle Mike get drunk at Thanksgiving and growl at you about where his money's going? Furthermore, it's hard enough to start a company and try to make it succeed without the added stress of knowing that the hopes of your loved ones are riding on you as well.

NOTE

TIP

If you decide to raise money from friends and family, do it by the books. Show them your plans, explain that it's quite probable they will never see their money again, discuss whether they want the investment structured as equity (ownership) or a loan, and have a lawyer dot the i's and cross the t's. Set expectations low and keep the transaction at arm's length.

Advantages: They love you and want to help you; they are less likely to try to take over your company; if you hit hard times, they'll probably be more flexible about a workout (see the "Getting Into and Out of Trouble: Remedial Actions: Workouts" section later in this chapter).

Figure 3.2. These are advantages and disadvantages commonly associated with different forms of capitalization; your experience may differ .

Disadvantages: The pressure! The guilt! If your company is having trouble, you'll want your family and friends to be a refuge from your business trouble, not a constant reminder of it. Also, most friends and family aren't what are known as "value-added investors," those investors with experience, knowledge, or contacts that can help the company as much as cash.

Publishers

Most start-up developers self-finance a pitch build to showcase their skills and use that to get a publishing deal (either developing that IP or another game that the publisher needs made). The publisher will fund the development of the game with a development advance (recoupable against royalties), payable in installments over the life of the development, which developers often use to keep the company's lights on and maintain a reasonable cash reserve. The publishing deal is covered in Chapter 6, "The Publishing Contract."

NOTE

NOTE

Publishers generally don't want to hear that their milestone payments are covering your overheadtheir idea is that the milestone payments should be going directly into the game costs. If you are in a financial position where you are using mile stones to cover basic expenses, it may be best to keep that to yourself.

Advantages: Financial freedom (a publisher won't take a chunk of your company); publisher commitment (if someone at the publisher took a $4 to $8 million dollar bet on your company, you can be sure they'll see to it that marketing puts some muscle behind the release); publisher advice (if you get good external producers , they can be wise counselors).

Disadvantages: The publisher is taking on most of the risk, so it will take most of the reward (if any). Unlike other investments, which give the money to the company in one or two lump sums, which can earn interest, the development advance is paid over time and is contingent on performance of certain duties . Many developers speak of late milestone payments being the norm, and a constant battle to get paid taking time away from work on the game. If there is a hitch with a milestone, a developer can run into a cash crunch.

Angel Investors

Angel investors are wealthy individuals who like to find deserving young companies to support. The ideal angel is one with industry-specific experience and contacts who can advise the company as well as provide capital. Most angels have business experience (whether industry-specific or not) and can be a huge help in guiding new entrepreneurs through the hoops of running a company.

Advantages: Raising money from angels can be a relatively quick process, since there is only one person to deal with. Most angels are content to advise, but do not necessarily want to control the company, and generally do not demand as much ownership of the company as institutional investors like venture capitalists.

Disadvantages: Angels probably don't bring the same knowledge about the industry and development process as a publisher or game industry financier. Unless you know where to find them, you may be prohibited from soliciting them under the federal and state securities regulations (see the "Financing Vehicles: Regulation of Investments" section that follows ).

Industry-Specific Financiers

As the game industry has matured, the risk (read: budget) of each development has increased and the financial industry has emerged with some models to address these risks. Investments have generally been in projects more than in companies. Two emerging models, both based on Hollywood film finance, are production companies and completion bonds .

Production Companies

Production companies position themselves between publishers and developers and function in a similar fashion to Hollywood film production companies. The production company solicits pitch-es for new games , usually new intellectual properties, and identifies a few promising projects. The production company funds the early stage development of those projects, terminating the projects that don't pan out and procuring financing and distribution for the projects that look most promising after prototype development. The production company is usually compensated with a share of the game's royalties, which will vary based on how it splits the cost of development with the publisher.

Advantages:

• Opportunity to get original IP developed.

• Intensive help and oversight by the production company.

Disadvantages:

• The developer probably won't see any royalties before the production company recoups its investment plus a premium.

• The developer may have to give up important IP rights to its games.

• Intensive oversight by the production company.

• The publisher may not put as much marketing muscle behind a release in which it has no other sunk costs.

Completion Bonding

Completion bonding is also known as film-style financing because it is a common financing method for film productions . How it usually works:

1. The developer, DevCo creates a special purpose entity, which we'll call GameCo.

2. GameCo contracts with the publisher to deliver NewGame on a specified date.

3. GameCo contracts with the bank for a loan to pay DevCo to do the actual game production. The loan is backed by the publisher's promise to pay the full amount of the loan to GameCo (who will then pay it to the Bank) on delivery of NewGame .

GameCo procures a completion bond from a specialized bonding company to insure the bank's loan against the risk of GameCo's not finishing the game. In other words, the completion bond is like an insurance policy that gets triggered if GameCo does not deliver the game. Without the bond, if GameCo did not deliver, the publisher would not pay GameCo, and the bank would lose its money. With the bond, GameCo gets the money from the bonder and repays the bank.

What's in it for the bonder? The bonder will charge a fee, from 2 to 10 percent of the game's budget. To manage its risk, it will aggressively investigate the project and the company, and will oversee the entire production. It may or may not require the developer to put up collateral for the bond.

Figure 3.3. Completion bonding.

Advantages for developer:

• Payments are more likely to be on time because the bank, not the publisher, pays.

• The bonder can act to balance power between the publisher and the developer.

• A project that would not have been funded directly by the publisher may get a chance with a completion bond.

Disadvantages for developer:

• Expensiveeven though the publisher will usually pay the bonding and loan fees, which range from 3 to 10 percent of the budget, these fees will probably be recouped from developer's royalties.

• Generally requires a prototype before a bonding company will issue a bond.

• The bonder may require the developer to put up collateral.

• The publisher may not put as much marketing muscle behind a release in which it has no other sunk costs.

Pitch Materials

When raising money, you need something concrete to show your goals, your talents, and your ability to execute a project. Pitch materials are the first project that potential investors see, and they judge your ability to execute a development project based on what they see in your pitch. Does it look completed? Are there typos in written material? Does it look as good as it possibly could (it should be in color and bound, with some kind of protective cover)? Is it well organized and clear? Is it thorough, or does it gloss over difficult sections or topics? Is it playable ? Does it convey why someone will spend $25 to $60 on this game?

NOTE

TIP

Many developers worry about having their ideas stolen during the pitch process. It may be difficult to get a prospective investor or publisher to sign an NDA pro tecting your confidentialitytheir position is that there are only a few basic plots and most pitches are so similar to one another that they would be made too vulnerable by NDAs.You can obtain some measure of protection by documenting your presentation and mailing a copy to your attorney by certified mail and instructing her not to open it (clearly, you should con sult with her first).

Business Plan

Writing a business plan is actually a great exercise for any company. It forces you to examine and quantify every one of your worst fears about the company, which has the effect of making them slightly less intimidating. It gets all of the founders discussing core strategies of the company. It vets problems that you might not have seen otherwise . It also sparks inspiration for problem solving in other areas.

NOTE

CAUTION

Remember to mark the business plan CONFIDENTIAL AND PROPRIETARY at the top of every page and 200 X [ Company name ]. All Rights Reserved.

Your business plan may need to be tailored to one of two purposes: a plan to raise money for the company as a whole, including all future projects; or a plan to raise money for a particular project or property development. Publishers generally do not need to see your company's business plan.

The business plan should include long-range goals, but is likely to be anchored around a proposal for a particular game, whether a developer-originated IP, or some other IP to which the developer has acquired rights.

If you need a business plan to show to investors, you should plan to prepare a full document of around 20 to 40 pages, not including design documents. If it is for internal purposes, or if your potential investor requests "an executive summary," the document can be a few pages, plus team bios, design documents, and budgets .

Market

Describe the market, both for games in general and for the kind of game(s) you are looking to develop. Break the market down by genre and platform, and take into account worldwide sales. The industry is tracked by several entities, making it relatively easy to find this data on the Web. If you are looking toward licensing your technology or content, describe the market for those assets.

Product

In a sense, you have at least two products: game development services and the particular game you are trying to get funded. The most important product description for your game development services is in the section about your team, but the services you offer should be introduced in this section. Here is where you can describe your game brieflythe design document will bear it out more fully. If you plan to develop any proprietary technologies for licensing elsewhere, describe those as well. Discuss what differentiates your product and any sustainable competitive advantages you may have, including development tools.

For an original IP, describe any licensing plans including sequels, franchises, strategy guides and hint books, as well as other media.

Team

This is the most important part of your plan. List all of the members of your team, released games and sales of those games, genres, and platforms they have worked on, software they have worked with, and companies where they have worked. Give a history of the team as a whole in addition to each member specifically , in other words, how long the team has worked together, how many games they have released together, and so on.

Competition

Your competition falls into two categories, both of which should be discussed: competitors in the game development service business, and competitors for sales of the kind of game you are trying to make. Describe your competitorsboth developers and games in the genre and on that platform competing for the same demographic. Remember to include internal development studios as well as external. If you do some digging around, you may be able to find out which major pub-lishers have similar releases coming out around the time you believe your game would be completed. If you are developing a technology, describe other products on the market and in development, what their market share is, and how you plan to compete .

Costs

Insert a detailed budget for development of the game with notations on underlying assumptions. If you are pursuing investment in the company, not just in a game, break out company overhead and discuss expansion plans (like a second team), if any. Be somewhat realistic to maintain the credibility of your numbers .

Revenue

Take a deep breath , because this will feel like a shot in the dark. It is okay if your revenue numbers end up being wrongwhat is important is that they are logical and you can defend them to a publisher or investor. For internal or investor purposes, you will be looking at company revenue from development advances and royalties. Revenue for the company is easy if you will be funding the game through a publisher: you will be receiving development advances in the amount of your product budget. Given that so few games actually show royalties every year, your wisest bet may be to note this fact and include data about the market in which you may, if you beat the odds, participate. Don't forget to include revenue from international markets.

NOTE

CAUTION

Federal and state securities laws have anti- fraud provisions preventing the use of mislead ing or inaccurate information to sell securities. This includes information found in a business plan, so be very accurate and conservative in your descriptions and have an attorney help draft and/or review the document before it is sent to potential investors.

Pre-Production Documents

Your pitch will need a set of pre-production documents. Keep two things in mind when drafting these presentation documents: (i) you will probably not have the opportunity to present them in person to many of the decision- makers ; and (ii) they are your first opportunity to show a publisher how organized and thoughtful you are.

The greenlighting process for a game may go something like this: U.S. product development to U.S. sales and marketing to International sales and marketing, then back to U.S. executive committee.

Figure 3.4. Books are indeed judged by their covers.

What does this mean for you? It means that your documents must be extremely terse and written in the publisher's language. If you excite someone in product development, give them documents that make it easy for them to get sales and marketing and international excited, too.

In addition to hard copies of the documents, provide your publisher with some kind of access to electronic copies of the pitch documents, perhaps on a password-protected Web site.

Your pitch documents should include:

• Sell Sheet. This is a one-page dossier on the game that helps sales and marketing do their jobs. Include your name and logo, genre, platforms, release date, target demographic, a two-paragraph synopsis of the game, unique selling point, and competitor games.

• Team Bios. Limit these bios to the vital statistics: names , released games and sales of those games, genres and platforms they have worked on, software they have worked with, and companies where they have worked. Give a history of the team as a whole

  NOTE

  NOTE

  Use as little text as possible and as much art as possible when drafting these docu ments. Only include infor mation that will make a publisher's pupils dilate remember that yours is one of hundreds and hundreds of submissions received.

  in addition to each member specifically, that is, how long the team has worked together, how many games they have released together, and so on.

• Design and Technical Specifications. These should be stripped-down versions of your internal design and technical documents with enough specificity to show that you have thought through your execution plan.

• Bible. This document gives a visual tour of the product, with art showing the major characters and other visual elements like backgrounds, weapons, vehicles, and so forth.

Pitch Build

Some visual, at least modestly playable manifestation of your game is a requirement, especially for new teams and companies. A publisher is more likely to be impressed by technology than by art, but a more art-intensive demo has the advantage of taking less time to create.

Financing Vehicles

Once you have people willing to give your company cash, how do you take it in, and what do you give them in return? Your two options are equity and debt, discussed in the following sections.

Equity

Equity is ownership of the company. Equity in a corporation, LLC, and partnership are called stock, membership interests, and partnership interests, respectively. These are discussed more fully in Chapter 2, "First Steps."

This section will address the different terms involved in an equity financing. Note that these issues are more likely to come up in a later financing for more money: the first financing, often

Figure 3.5. These are a few of the many flavors of securities.

called a seed round, is usually a small initial offering of common stock to insiders like friends and family or hands-off angel investors. As mentioned before, venture capitalists are unlikely to ever beat down a developer's door because generally the profits are not sufficient or predictable. However, as the development industry matures and different business models are explored by developers, the returns offered by those projects may be more interesting to investors.

Investors may have different needs from the founder- employees , and may require special instru ments (types of investment). When an investor wants to share profits, but is not as interested in controlling the company, the company can issue different kinds or classes of equity that do not have the same voting rights as other classes. For instance, an LLC owner can be a managing mem ber who has control over daily business and whose approval is required for certain actions, or a regular member, who may be more or less passive, depending on how the LLC operating agreement is written. A C-corporation may issue different classes of stock to investors that don't have the same voting rights as those held by founder-employees.

On the other hand, some investors want a preferred return (also called a liquidation preference ), meaning that in case the business has to liquidate, the investor will be repaid before certain other equity investors. This can be achieved in a corporation by issuing preferred stock, which has certain rights by law and as written in the company's charter documents (see Chapter 2). Other entity types simply need to draft specific purchase agreements and other documents to achieve this end.

Equity Investment Term Sheets

Institutional investors usually want preferred stock because it receives a liquidation preference and it can be customized with a host of rights giving them more control over the company. The rights given to the investor will vary depending on the investor's investment objectives and relative bargaining power. These rights can be tailored by various agreements, such as a purchase agreement, investor rights agreement, or charter documents, to fit just about any needs. The investor's demands may differ based on the investor type, objectives, and sometimes even on geography (the West Coast East Coast thing continues, to say nothing of U.S. versus Europe versus Asia). Your investor's wish list will be set out in an offer, also known as a non-binding term sheet, which may include any number of the following terms:

NOTE

NOTE

Tax and securities law may make it necessary to create a separate class for investors.

NOTE

TIP

As with a publishing contract, "price" is only one small issue and what looks like a great deal can be hollowed out by other terms of the contract. Get your lawyer involved ASAP in any investment discussion.

• Type of Offering. What is the amount and type (preferred stock? convertible preferred?) of securities being offered? For the first round of institutional financing, this may be called "Series A Convertible Preferred Stock" or "Series A Preferred."

• Valuation/Capitalization of Company. How much is your company worth, before and after financing? What percentage of the company is represented by the Series A investment? How many shares/options/other securities are outstanding? Sometimes the parties will attach a cap table that shows the breakdown of stock ownership before and after the round.

• Dividends . Dividends are cash distributions paid out to shareholders. Different classes of securities may have different rights to receive dividends. The Series A Preferred may or may not receive the same dividend payments as the common stock shareholders. The investor may ask for the right to receive a set annual dividend that is only payable if the company liquidates (if you're thinking this sounds a lot like an interest rate, you're right). Dividend rules are usually established in the incorporation documents.

• Optional Redemption. The investors will want the option to force the company at some point in the future to buy the investor's shares. The customary requested price equals the original purchase price of the shares plus any declared but unpaid dividends.

• Conversion. Investors who buy preferred stock often want the right to voluntarily convert, at any time, into shares of common stock (which has more upside potential) at some conversion ratio . The conversion ratio usually starts at 1 share of preferred for 1 share of common, but can be adjusted for dilution (see the following Anti-Dilution section).

• Liquidation Preference. In the event of a liquidation, winding up, or, in some cases, the sale of the company, preferred stock can grow big long fangs. A preferred investor can negotiate for the right to choose its compensation in a wind-up: it can elect to convert into common stock, or receive its original purchase price and then may even share any remaining proceeds pro rata with the common stock, among other possibilities.

• Anti-Dilution. If the company issues certain classes of stock at a price less than that of the investor's preferred ("cheap stock"), the investor's stock may have anti-dilution protection , which is a kind of purchase price protection. If shares of cheap stock are issued, normally that would dilute the value of the investor's stock. Same numerator, bigger denominator = diminished value. Anti-dilution protection adjusts the numerator to protect the investor's ownership proportion.

  There are various formulas for anti-dilution protection, with weird names like "full ratchet" or "weighted average." Beware of "full ratchet"if triggered, the investor gets to buy the number of shares it could have purchased with its initial investment if the stock were sold at the cheap stock price. Think of it like retail returnables: Your mom buys you a full-price sweater at the Gap in December. It's too big, and you take it back (with the receipt) in January. Not only do you get to exchange it, now you can get the sweater in two other colors because it's on clearance sale. Good for you, not good for the Gap.

• Board of Directors. How many seats on the board will the investor be able to elect with its class of stock? How many directors can the common stockholders elect? Will the board have audit and compensation committees , and who will sit on them? These provisions will most likely appear in a voting agreement, a stockholders agreement, and/or the company by-laws.

• Voting Rights. The investors may want their stock to have special voting rights and approvals , such as the right to veto even an overall majority of the stockholders on certain key issues like amendments to charter documents; redemption or repurchase of any stock; large acquisitions by the company of stock or assets of another company; grants of exclusive rights to any intellectual property or exclusive distribution rights; payment of dividends; or a sale, merger, liquidation, or change of control transaction. Also known as protective provisions , these rights will be listed in the charter.

• Information Rights. This requires the company to deliver to the investor certain periodic financial statements and the right to inspect the books of the company. This would appear in the investor rights agreement or the purchase agreement.

• Preemptive Rights. Under this provision, if the company proposes to do another round of financing or otherwise issue more stock, with certain exceptions, the company must first offer such equity securities to the investor (and the founders, if they can negotiate this) on a pro rata basis (based on their initial investment). These rights can be waived, and sometimes a new investor will require such waiver . This right would appear in an investor rights agreement or a stockholders agreement.

• Right of First Refusal/Tag-Along/Drag-Along. This is a right of the investor's preferred stock to, at its election, purchase the founders' shares before they sell them to a third party (with certain exceptions, like family trusts, and so forth). The founders may get this right as well. A tag-along right is a way to give the investors some liquidity by allowing them to participate in a sale by the founders to a third party on a pro rata basis. In other words, if a third party agrees to buy 10 shares from a founder, and the Series A investors own half of the company, the Series A investors could elect to sell 5 of their shares and the founder would sell 5 of his shares to the third party. A drag-along right is where a majority of the shareholders, or a majority of the preferred, want to sell the company to a third party and can force the holdouts to sell their shares as well. These provisions will probably appear in an investor rights agreement or a stockholders agreement.

• Expenses. In many cases, the company is responsible for its own legal fees as well as those of the investors! And the investors' counsel does most of the drafting. In addition, the company may be responsible to the purchasers for consultant expenses (technology experts, accountants , and so forth) incurred in due diligence. This will appear in the stock purchase agreement.

• Exclusivity. The investors may ask for exclusivity for a certain period while they conduct due diligence and draft the appropriate documentation. This will be in the term sheet and will be one of the only binding provisions in it.

Not all of those terms will appear in a term sheet, and you should try to negotiate a lot of them away or at least make them more favorable. On the other hand, depending on the investment climate, you may be stuck with those terms.

Once you've got a signed term sheet (almost always non-binding), you are one step closer to getting financed. As long as no skeletons jump out of your company's closet during due diligence, most reputable investors will try to stick to the term sheet. Be aware that the deal is far from closed: many issues that were vague or ignored in the term sheet can be sticking points when your lawyers are negotiating the definitive documents with the other side.

NOTE

NOTE

Demanding investors, particularly those interested in control of the company, must be scrutinized very carefully . First, your legal bills for creating new classes of equity and negotiating the terms can spiral. Second, a powerful outsider can make you feel like you're not quite in control of your destinyand for most entrepreneurs, that's what makes the pain worthwhile. On the other hand, if you are working with a rep utable and knowledgeable investor, you would hope that they would be working for the success of the company and your inter ests would be somewhat aligned.

Debt

There are two main differences between debt and equity: debt usually does not participate in the success or upside of a company, and it receives payment priority (is repaid before other claims) in case the company runs into bankruptcy. Debt is a great idea for family and friends and angel investors who are willing to extend unsecured loans.

There are basically two kinds of debt, secured and unsecured . Secured debt is backed by some kind of collateral (an asset, like a car) that the creditor can take or sell if the debtor cannot satisfy the loan (ever see Repo Man ?). Your mortgage, for example, is secured by the home: if you default, the bank will take the home and sell it to satisfy the debt. Unsecured debt is not backed by an asset.

Because unsecured debt is riskier for the creditor, it usually carries higher interest rates than secured debt. However, any kind of debt will usually be "cheaper" for the company than equity: because it has payment priority and is less risky than equity, debt investors are satisfied with lower returns on their investments.

Depending on the risk/return objectives of a lender, some loans and debt instruments (sometimes called notes ) may be issued with warrants (options to buy stock at a set price) or be convertible into equity upon a future event.

Figure 3.6. Here's someone you won't want to meet.

Because debt instruments are securities and securities are governed by federal law, be sure to work with an attorney when issuing debt instruments to comply with securities laws and other applicable laws.

Regulation of Investments

After the stock market crash of 1929 and the ensuing Great Depression, Congress and the states enacted laws regulating the sale of securities. Securities can include stocks, LLC interests, bonds, warrants, options, and other instruments issued by a company. The main federal laws are the Securities Act of 1933 and the Securities Exchange Act of 1934. Every state has its own laws regulating securities, called Blue Sky laws because they are designed to prevent unethical companies from promising and selling the blue sky above. Companies selling securities must comply with both the federal laws and the laws of any state where it will be offering or selling securities.

The goal of these laws is to ensure that purchasers receive enough accurate information to make an informed decision. The Securities and Exchange Commission ("SEC") requires that sellers of securities, known as issuers , register the sale, known as an offering , and provide a detailed prospectus containing all sorts of information about the issuer. This process is long and expensive (well into six figures), so the government created exemptions to these rules for companies raising smaller amounts of money.

In general, small offerings may qualify for an exemption if they are:

• Private offerings

• Limited offerings (less than $5,000,000)

• Only offered to qualified investors

• Only offered to investors residing in the same state as the company

NOTE

NOTE

Even if your offering is exempt from regis tering with the SEC, you must still obey federal and state anti-fraud laws by avoid ing making any untrue or misleading state ments or omitting any material facts in connection with the sale.To minimize the risk of an SEC action and/or shareholders' suit, work with your lawyer throughout the process to be sure you comply.

Investments in a typical start-up game development company will most likely fall under an exemption, as it is likely to be selling securities to private investors or investment funds, and the amount of investment will be less than $5,000,000. But the penalties, such as fines and recission rights (paying back the investors' money), can be onerous, so work with a qualified corporate attorney to ensure your offering is exempt.

NOTE

NOTE

While it won't be covered in depth here, note that you probably won't need to register stock offered to the company's employees, directors, general partners , and officers of a company; these offerings are generally exempt under Rule 701.

[ LiB ]