Famous Last Words August 2011

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DISCLAIMER: This column is intended for general educational and entertainment purposes and is not legal advice. Every situation is unique. Anyone entering into a contract should have a lawyer who can provide counsel.

Jim Charne, Attorney at Law

August, 2011
Famous Last Words
By Jim Charne, Attorney at Law

Should All Studio Personnel be Stockholders?

Dear Jim:

We’re a small team, a start-up, a new company. 

We started with just three of us, and are now we’re up to ten.

There’s a strong sentiment in the company that all staff should share in the success of the studio; and the best way to provide for that is to issue shares to everyone.

I don’t mean that everyone would be equal in that regard.  But we want to be fair and generous and that seems to be the best way to get everyone to be “all-in” in moving the company forward.

What do you think?

-- New Studio

Dear New:

It is not uncommon for game developers to want everyone included in the financial growth of the studio.  After all, game development is a very demanding collaborative process, team members spend lots of time together, and developers come to rely on team members in many ways throughout development.

There’s nothing wrong with sharing profits with employees; but making stock grants is not a particularly good way to do so.

We’ll look at why; then consider alternatives.

1.  Issuing stock is a securities transaction that may be subject to federal and state regulations.  It’s not as simple as issuing more certificates.  Securities are subject to intense regulation by the United States Securities and Exchange Commission and various state-level agencies.  Before you were to do this, it is critical that you consult with a lawyer who does securities work.  In my own practice, I stay away from securities work because it is a very specialized, highly regulated field with potentially severe consequences if not done right.  I did not study it, am not current on the rules and regs, and know when to call in reinforcements!  It is strongly recommended that before you undertake any such issuance of new shares, you must hire an experienced securities lawyer who can guide you along the way – and keep you out of trouble.  When my own clients want to do this, I make a referral for the work.  It is not cheap.

One other consideration for the recipient of free company stock, under any incentive or other plan, is that it may create an unwanted tax issue for the recipient!

The stock that is received has value because it represents an interest in a going business.  Receipt of stock for free may be additional compensation subject to tax in the year it is received.  Since the shares are non-tradable securities of a small company, they cannot be sold or traded to generate cash to pay the taxes.  While it may feel great to get those shares, they could be a headache come April 15.    

2.  In a small business, it is generally not regarded as a good idea for people who are not active in the business to hold stock.  (Of course that does not apply where you have investors who have put up hard, cold cash for their shares.)

Over time, people move on, may be fired for many reasons (performance related or not), find a better job, have a falling out with colleagues, etc.  It is not a favorable situation to have these people continue as shareholders.

In effect, at the time they leave, they no longer contribute to the growth of the company.  So if a person who is a stockholder were to leave, and two years later, the company is the developer of the next Sims, or Halo, or Grand Theft Auto, or World of Warcraft, the departed stockholder has, in effect, received a free ride to this much greater valuation of his or her shares.  In my view, that’s not fair to the continuing employee-shareholders who have built that value in the company.  

A further consideration is … do you really want a departed employee-shareholder to have a voice in company affairs?  Departed shareholders must get notice of all shareholder meetings, can vote as shareholders, and those votes can influence company policy and plans.  Do you really want ex-employees (maybe now competitors) to have that power?

One way to handle this concern may be to write and adopt a Shareholder Agreement.  Once adopted, no one would be permitted to acquire any shares unless he or she first signed and agreed to be bound by the Shareholders Agreement.

Among the provisions in a Shareholders is a requirement that a recipient sell back his or her shares to the company using a valuation formula applied as of the day the person leaves.  The Agreement would provide a process to calculate the value; and frequently, that value can be paid in increments over a period ranging from five to ten years.

The idea is not to put the company in financial distress by having to repurchase shares.

A good Shareholders Agreement contains many other provisions that can be of great value to the company and all the other shareholders.  Your attorney should be able to help you put such a document together, and explain all its terms and the reasons they are there.

3.  An alternative to issuing shares to employees is to adopt a Phantom Stock Plan.  Phantom shares are not real company stock; but rather “make believe” interests that are treated as stock in the event the company goes through a “liquidity event.”    Holders of phantom rights have no voting or control rights and do not participate in shareholders meetings.  The grant is a binding contract between the recipient employee and the company.  Interests in the phantom interests are generally paid out only upon the occurrence of a “liquidity event.”  A “liquidity event” is generally limited to an IPO, sale, or merger of the company.  The phantom shares may be structured to vest over a period of years (their purpose is to retain talent!), and they lapse and are recaptured by the company if the employee leaves employment for any reason (voluntary or involuntary) before a liquidity event.

Since the phantom payout comes from money or other consideration that would otherwise be paid to the stockholders of the company, I always recommend a unanimous vote of the stockholders to approve and adopt the program.  Without that, there is always a risk a stockholder would complain that deductions were being taken from his or her share or proceeds from whatever deal triggered the payout under the phantom plan.

Your attorney can prepare a phantom plan.

In the end, all of these are complicated and truly require involvement of your lawyer.  But they get you where you want to go in terms of sharing the growth in value of the company with selected employees.

A final alternative that is the simplest and easiest, is to share that growth through a cash discretionary bonus plan.  It does not get anyone equity, but when there are profits, a nice bonus check feels mighty good when cashed or deposited!   

-----

Jim Charne practices law in Santa Monica, CA (www.charnelaw.com) where he represents developers, designers, composers and other clients in the games industry.  Jim has been a frequent speaker at GDC and Practicing Law Institute games industry programs, is active in IGDA from whom he received a coveted “MVP” Award at GDC 2006, and is a member of the Advisory Board of G.A.N.G.  On October 19, 2011, Jim will chair a one day program in San Francisco, offered by the Practicing Law Institute, titled: “Representing the Games Industry Client 2011.  Jim served as President of the Academy of Interactive Arts and Sciences from 1998 to 2001.

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Famous Last Words is intended for general educational and entertainment purposes and is not legal advice.  Every situation and circumstance is unique.  Anyone entering into a software-related contract should have an experienced lawyer who can provide counsel throughout the process.

©2011 Jim Charne.  All rights reserved.