Introduction: A Game of Risk
There is nothing simple about starting your own company. There are major risks and potential financial burdens that you will step into if you decide to set out on your own. Being your own boss takes discipline, financial responsibility, and serious determination. However, it is also potentially rewarding and, in some instances, even lucrative.
The games industry is a high risk and high stakes business. Setting out on your own in a risky industry obviously requires careful thought and a realistic assessment of your goals and needs. You should first ask yourself whether you are financially, emotionally, and personally able to handle of consequences of lean and difficult times ahead. There are several business planning books on the market that start with checklists that provide a quick and dirty risk assessment. However, how much of a risk it is to you depends primarily on your own experiences, abilities, and resources.
This article is not meant to convince you to set out on your own. Quite the contrary, it will probably scare many people away. The rewards may be slow to come, if they come at all. Some of the resources provided below can be helpful to those who pursue game development as a hobby and would like to sell their product. The bulk of the information is dedicated to providing information to those who are seriously pursuing the independent production and release of their games.
This article is the modification and adaptation of several blog articles written over the course of a month. I'd like to thank the folks at GameDev.Net for giving me the opportunity to share this with you.
Part I: The Building Blocks
The first part of this article concerns decision making. In the early stages of business planning, you have to put together your business team, settle on an entity type, choose a name, and determine how your business will be structured. These are the first steps you should take when formulating your business strategy.
Building your Business Team
Developers take great care in deciding who will code, design, and manage projects. At least equal care should be taken when deciding who you want to help you run the business portion of your business.
Your Lawyer
Developers want entertainment attorneys. Why, you ask? It is much harder to break attorneys in non-entertainment industries out of the habit of negotiating unfair clauses. Entertainment lawyers are experienced in working within the confines of a bad deal, because they understand how leverage has worked to manipulate every facet of the entertainment industry. Publisher/developer deals are inherently unfair, and the people who understand this best are those who have also worked with record deals and studio deals. Good entertainment attorneys will be able to squeeze the best deal possible for a client out of what will ALWAYS be a bad deal. Entertainment attorneys also work well with many contracts and issues,, including intellectual property licenses, work for hire licenses, and NDA's. This doesn't mean that you have to hire an entertainment attorney--especially considering the number of sleazy entertainment attorneys out there.
A bad attorney is worse than no attorney at all, so the practice area is less important than your lawyer's commitment, ethics, and willingness to learn. What do you need in a lawyer? You need someone with a very strong understanding of all of the Intellectual Property issues that arise in gaming. You want an attorney with transactional experience, one who can take apart a contract and explain it in plain English. You also want an attorney who can write the kind of contract that specifically applies to your transaction. It should be noted that law schools don't spend a lot of time teaching students how to deal with contracts. Law students are practically force fed litigation in most ABA accredited schools, and they only learn about contracts when they get into practice.
Most importantly, you want an attorney who cares about what they are doing. A good attorney will always take the time to find the best answer if she does not know it off hand. Similarly, a good attorney will learn about the industry her clients specialize in by taking the time to read about the industry, the issues, and the kinds of transactions involved. Good attorneys don't rely on their gut, and they don't give simple one word answers. It is not the attorney's job to make decisions for you. Instead, it is the attorney's job to lay out the array of possibilities ranging from worst case scenario to best, and provide counsel on what actions will lead to the best case scenario. A good attorney leaves the final determination to the client and consults the client when doing anything on behalf of a client.
Look for someone who cares about your work as much as you do. Your attorney should always return your phone calls by the end of the business day, even if it's just to schedule a time to talk. Any time you're deciding on an attorney, make sure you get references. Ask for a list of their past clients, if available. If not, ask for the names of other attorneys who are able to vouch for the one you are interested in hiring.
Be careful about hiring your friends. Get everything in writing and make sure you get a copy of the fee arrangement, regardless of how well you know the person. It is also important to make absolutely sure that your attorney has a reputation for discretion and confidentiality, ESPECIALLY if you are hiring an entertainment attorney. A lot of very prominent and successful entertainment attorneys have a very bad habit of disclosing proprietary and/or confidential information about cases and transactions they are working on to increase their own personal leverage and clout. It's important that developers in particular stay away from this kind of lawyer. Also, check out a recent article by Tom B. for how to train your attorney -- this should be required reading once you've found an attorney you want to work with.
Your Accountant
The responsibilities of your accountant are no less rigorous than the responsibilities of your lawyer. Your accountant is your financial guru and unless you have a background in accounting yourself, someone you must trust implicitly. As with your lawyer, your accountant should have a good grasp of your industry and the kinds of transactions you will be engaging in. Your accountant should also be aware of some of the tax issues that may come up for digital distributions and brick and mortar distributions (sales tax, VAT tax, etc.). As with a good lawyer, it's important that your accountant cares about your business and has a reputation for honest business practices. Once again, you will probably want to get references.
Your Business Manager
For many small developers, the business manager is also the lead developer or the project manager or the CEO of the company. That being said, your business manager is responsible for the day to day business of your company. This includes payroll, hiring and firing, enforcing business practices that protect proprietary information and trade secrets, managing documentation and data, marketing and advertising for your company, and negotiating deals with third parties for SDKs, manufacturing and distribution, game engine licensing, and licensing your own products to others. If your development team is the pumping heart of your organization, your business manager is the brain that keeps the rest of the body of your business moving. Ideally the business manager is the person most invested in the success of your business, as she is the person most responsible for the business's success or failure.
Your business manager should be a voracious reader. She should read all of the primary trades both online and off (PC Games, Game Developer, GDNet, IGDA white papers and articles, the Byron Report, news sites and blogs). She should also read books about business management. Because she's the business manager of a development company, she should read books and articles specifically designed for the governance of those kinds of companies. She should understand the development process. She MUST be able to make tough decisions, such as firing or disciplining individuals for bad conduct. In short, your business manager should be an intelligent hard ass who lives and breathes your company's business. She can be less of an obsessive hard ass if your company is in a position to delegate some of her duties to others, but typically it's good to have someone who is just that committed.
Once you've formed your business team, you and your team should decide how best to approach your business's formation. This requires selecting the appropriate business entity and identifying possible investors.
Selecting your Business Entity
Distinguishing between the alphabet soup of business entities is difficult in and of itself. Knowing the difference between LLC and Inc. is sometimes fairly complex. However, simply knowing what these letters mean is of little use. You need to know which entity will work best for your business. Below are some of the traits of the most common business entities and how they can benefit and/or hurt your work in the game development area.
- A note on "pass-through"--for tax purposes, pass-through means that you aren't being taxed twice for profits earned by your business. Pass-through taxation is when your business profits pass through the business and are taxed on your personal income tax. I say this now because it comes up several times in this discussion and it's an important point when you're picking your business.
Sole Proprietorship
If you're just starting out and you're working out of your apartment, you are probably a sole proprietorship. A sole proprietor is an individual who owns their business. There is no liability shield and for tax purposes your business profits pass-through. As a sole proprietor, you'll have a DBA (Doing Business As) that can be your name, your game handle, or something you made up. To register with your state/municipality as a sole proprietorship, you can visit your state's Secretary of State website. Many states put the forms for most of the business types you need on the website as a service to you.
A sole proprietorship is useful when you are simply selling your services as an independent contractor. If you're a freelance programmer or designer, you work independently and you don't need anything more complicated than that. If you actually start selling a product you will probably want to convert to another organization type-- being personally liable for products is a bit of a scary-dangerous business in the event of a civil suit.
Why bother organizing as a sole proprietorship? First, it enables you to deduct business expenses in the same manner as corporations, partnerships, and LLCs. You can deduct things like operating expenses, marketing costs, travel expenses, and some of the notable "write offs" like business lunches. You can also deduct some of your start-up costs and some of your computer/equipment expenditures connected to making your business profitable. Second, it makes you look more professional when you have a DBA. Third, it can protect you in other ways, too.
Let's look at an example. Say Duke is a freelance contractor /DBA/ Duke Nukem, Sole Proprietorship. He's offered work by a small development firm. There is no written contract in place, just an oral agreement that he will do the work for a certain amount of cash. Duke writes unique programming code for the benefit of the development firm.
Who owns the copyright to the code? If Duke is an independent contractor, he does. If he is an employee, the developer does. Duke really, REALLY wants to be an independent contractor in this scenario because he wants to be able to use and sell the code in the future. Being a sole proprietorship and having a /DBA/ supports Duke's contention that he is, in fact, an independent contractor. Otherwise the developer would have a stronger argument supporting the contention that Duke was an employee at the time he wrote the program code.
Having a sole proprietorship has its benefits if you're working on your own. It's worth registering yours.
General Partnership
You don't really need to do much to have a general partnership. If there are two or more people doing business together and no contract is in place, it's assumed to be a general partnership. General partners share in all profits AND losses of the partnership. General partners are also personally liable. Individual partners are taxed through pass-through taxation based on an equal distribution of profits and losses, unless an agreement is in place that splits the liability/profits otherwise.
A good example is when two or three good friends come up with a game. They design it, program it, and come up with a demo. They do this without any understanding of who owns what, assuming that they'll all benefit equally when they sell the product. That's a general partnership.
A lot of people advise against general partnerships. I'm not one of those people. I'm of the belief that when people are personally on the hook for both profits and losses, they will probably be more committed to the venture. It honestly depends on the people you're working with and how well you trust/know them.
If you do go the partnership route, it is important that you get everything in writing to spell out:
- How profits will be split;
- How liability is split;
- Who owns the rights to what (all partners own products of partnership equally on behalf of the partnership unless an agreement states otherwise);
- When approval rights are required from the other partners (spell this out, as approval isn't required when one partner enters into a contract on behalf of the partnership);
- What happens when one person quits;
- What happens when a person dies (estate planning);
- What happens upon dissolution of the partnership;
- How to bring in new partners;
- And anything else that may come to mind.
Limited Liability Company (LLC)
First, a note on Corporations. Corporations are separate entities, and therefore profits may be double taxed. In other words, instead of profits from the business passing through to your personal tax return, the corporation's profits are taxed independently (both income and employer payroll taxes). Your salary, which is taken from the corporate profits, is also subject to taxation (both income and employee payroll taxes). The profits are therefore taxed twice. However, shareholders (i.e. owners) of a corporation are in no way personally liable for the losses of the business. If the corporation can't pay a creditor, that creditor cannot turn around and require payment from the individual shareholders beyond what has been invested in the business.
An LLC has all of the tax benefits of a partnership or sole proprietorship (business profits are only taxed once) but it also provides the liability shield available to corporations. This means that the members are not personally on the hook for debts owed by the business. It's important to note that individuals are still personally liable if they personally guaranty a loan or commit fraud. There's also a legal doctrine called "piercing the corporate veil." Treating your business like your own personal piggy bank (in legal parlance, "commingling funds") and failing to observe common company practices (common practices include having routine business meetings with minutes, maintaining business documents, keeping your business license up to date, properly reporting business earnings, etc.) can cause you to lose your limited liability.
An LLC obviously has a lot of advantages--you get all of the protection of a corporation and fewer tax headaches. However, it also requires a lot more work. Registering your LLC can cost you quite a bit and you will need to have several documents (Articles of Organization, Operating Agreement, registration forms, etc.) drafted before you can even get the proper license. As a small business, however, LLCs have several attractive qualities because they require fewer corporate formalities. Also bear in mind that "pass through" taxation is the default tax treatment for LLCs. One other major benefit of an LLC is that you are able to elect tax treatment. You can be taxed as a sole-proprietorship/partnership and be subject to income and self-employment payroll taxation, or you can elect to be taxed as an S Corp or as a C Corp. As the relationships of the members (similar to partners--members operate the organization) are determined by the operating agreement and Articles of Organization, it's important that you work out the same factors you needed to consider when forming a general partnership before you start the registration process. It's too costly and too time consuming to mess up, and as with all things in business, your goal is to do it right the first time.
Corporations
Corporations are a separate and distinct entity from the people who run it. A corporation can enter into contracts, incur debt, and be subject to judgments. Corporations consist of a board of directors, shareholders, officers and employees. A corporation's primary obligation to its shareholders (i.e. owners) is to make money. If you incorporate as a business, it is imperative that you are able to maintain traditional corporate formalities. This may mean holding annual shareholder meetings, having your officers elected by your board of directors, complying with your Articles of Incorporation, having regular board meetings with the minutes recorded, and maintaining financial documentation that in no way implies impropriety or commingling of funds. Failure to comply with traditional corporate formalities has fairly serious consequences. First and foremost, it may lead to the piercing of the corporate veil. This means that the individuals who run the corporation may be personally liable for judgments and debts against the corporation. As the primary function of a corporation is to prevent personal liability, this is a big deal. These requirements are overwhelmingly concerned with record keeping. While it isn't necessary to record every minor decision the corporation makes, major decisions with written consents from the board of directors may be necessary.
It may also lead to the dissolution of your corporate status. Considering the expense associated with incorporating your business, this is something you will want to avoid.
The advantage of a C-Corp. (traditional Corporate status) is that you can have several shareholders and investors, which means you may be able to raise to more working capital. You may also issue shares and distribute dividends. However, it is important to note that your income from your C-Corp will be double taxed. As an officer of your corporation, you will be paid a salary as opposed to a share in the company's profits. Your salary is subject to all of the standard employment taxes, such as FICA, social security, and federal and state income taxes. However, your corporation's profits will also be taxed separately, so any income you earn from dividends or disbursements will be taxed as separate income.
S-Corporation
For tax purposes, an S-Corporation is a federal tax classification that permits the entity to not be subject to an income tax (similar to a LLC). Instead, all profits and losses pass through to the shareholders and are taxed on their personal tax returns. The election to be treated as an S-Corp is based almost entirely on tax treatment. The fees associated with being treated as an LLC in some states (such as CA) may turn out as greater than they would be if you elected S-Corp treatment.
In an S-Corp, instead of members (as you'd have in an LLC), you have shareholders. Those shareholders are subject to a pro rata tax, to be claimed on their personal tax statements, based on profits earned by the business. This means that shareholders are taxed based on the number of shares they own in the business. A majority shareholder will be responsible for a greater proportion of the taxes on the earned profits. This also means that shareholders who are employees will pay FICA taxes on their salaries as well as income taxes on their portion of the company's profits. This isn't necessarily a double tax--the salary is subtracted from the profits prior to application of the federal income tax. Non-employees are only required to pay the income tax commensurate with their ownership in the company.
Because shareholders are taxed whether or not there is a cash disbursement of profits, it is advisable for S-Corps to provide cash disbursements of profits to shareholders that are at a minimum enough to cover the taxes themselves. This is usually set out in the shareholder agreements.
The decision to be treated as an S-Corp. should be between you and your accountant. You get the same legal treatment as other limited liability entities, such as LLCs, LLPs, and C-Corps. Deciding to elect S-Corp status is usually something you can determine when you are filling out your annual or quarterly tax information.
Conclusion
The foundations of your company will be based on these early decisions. Before you can build you business, you have to take steps to determine what is best for your business and the individuals who work with you. These general concepts will play a constant role in the success or failure of your business.
The second and final part of this series will be posted on 5/12 - Ed.
