Making games is fun!
That’s probably what you thought when you started your journey as a first-time indie game developer. The unfortunate reality is that developing games to sell to the public is a business, first and foremost. That’s not to say that it can’t be fun – however, it’s important to keep in mind that business issues are often key to sustaining your new company.
As a game lawyer, I work with a lot of first-time developers on a number of legal and business issues that they commonly face. This series of five posts will outline the major areas where your new business (better get used to calling it that) needs legal coverage.
I should point out before we begin, that while I am a lawyer, I’m not your lawyer. Consult a professional before implementing any information in this series of articles. These concepts are generally applicable in the United States, but may vary state-by-state and may be wholly different outside of the US.
In this first post, we will discuss forming a separate business entity.
Why should you form a business entity?
Forming a legal entity separate from yourself is one of the most important things you can do as a new indie studio. There are a number of reasons for this, including:
- Limiting your personal liability and shielding your personal assets from the company’s debts
- Creating a transferable business that you can potentially sell for a profit in the future
- Allowing investors to easily invest capital in exchange for equity in the business
- Giving a professional appearance to customers, investors and potential partners
- Having a legal entity is necessary in order to get your game on some publishing platforms (Xbox One, for example)
These are all great things for your new game development business. In some cases, like getting your game on certain platforms, they are required.
Let’s dig down into some of the details.
What kind of entity should you form?
There are four main types of legal entities:
- Sole proprietorships
- Limited Liability Companies (LLCs)
The first two are the default entity types that kick in as soon as you go into business for profit. If you’re by yourself, you’re a sole proprietor. If you’re with others, you’re a partnership. These entities don’t offer any limited liability for your personal assets. That means that you are personally liable (or liable for your ownership percentage, in the case of a partnership) for any business debts. If you own anything of value in your name, this can turn out to be a real problem.
The better way to go about it is to use a limited-liability entity. This is usually either a corporation or an LLC. These provide a shield against creditors who will try to reach through to your personal assets. These entities also create a structure that allows others to invest money in exchange for equity and other rights. This separate existence allows the company to continue on, even after you have left the company or sold it to others.
Choosing between a Corporation and an LLC
The choice between Corporation and LLC usually has to do with what your plans for the company’s future. If you and your partners wish to just keep making games and earning money from them, then an LLC is often the best choice. It is much simpler to run and you have a lot of flexibility in how it is structured.
On the other hand, if your goal is to have your game dev startup receive angel, venture capital and “friends and family” investment, a corporation is your best bet. A Delaware corporation, in particular, is what most investors will be looking for. This is for a few reasons:
- Delaware’s corporate law is generally familiar to most serious investors and their corporate lawyers, so there aren’t many questions about how an issue will be settled
- Most forms involved in creating and investing in a Delaware corporation are pretty standardized by this point, so investors don’t have to figure out what you’re doing differently
- Delaware is a very corporate and investor-friendly state in which to incorporate
If your goals involve investment or some kind of exit from running the company at some point, the corporation is generally the best way to go. It is possible, however, to start life as an LLC for simplicity’s sake and later “convert” to a corporation. This conversion generally involves three major steps:
- Forming the new corporation
- Transferring all of the LLC’s assets to the corporation, and
- Dissolving the LLC.
For those who don’t know where they may be headed, this can be the best way to go.
There are other entity types, like Limited Liability Partnerships and Professional Corporations, but most game developers don’t need to be concerned with those.
What is the difference between a C-Corp and an S-Corp?
If you’ve decided to form a corporation, you have the option to either stay a default “C-Corporation” or elect to be taxed as an “S-Corporation.” At first this may seem a bit complicated. However, it really only affects how your corporation is taxed.
Basically, with a plain old C-Corp, there are two levels of taxation: the corporation itself pays income taxes, then the shareholders pay taxes on any money that is distributed to them. This double-taxation is one of the few disadvantages of the corporation as a business entity.
The federal government allows corporations that meet certain requirements to file something called an “S-Corp election.” This changes the double taxation of the C-Corporation to a single, “pass-through” level of taxation. This means that shareholders report their portion of the corporation’s income, losses, credits and deductions directly on their personal income tax returns. For the record, this is also how taxation of LLCs works by default.
Only certain corporations can file for S-Corp election, however. The corporation must meet the following criteria:
- It must be a domestic corporation (organized in a US state)
- The owners/shareholders must be individuals and estates, but not partnerships, corporations or foreign non-resident individuals
- There can’t be more than 100 shareholders
- The corporation can only have one class of stock
- The corporation can’t be one of certain types of ineligible corporations
If those are met, filing for S-Corp status is possible. However, institutional investors like venture capitalists will generally be less likely to want to invest in an S-Corp. As I stated above, if investment is not being sought, it is usually easier to just form an LLC rather than going through the extra steps involved in creating an S-Corp.
How do you actually form the entity?
Many first-time businesspersons try to take the cheap and easy way out by using LegalZoom or another self-help business entity site. Technically, you can file the forms yourself on the state Secretary of State’s website. I would never recommend either of those, though.
Personally, I recommend working with both an attorney and a tax advisor through the whole process. The attorney can do a number of things that a self-help site like LegalZoom can’t:
- Discuss your particular situation and goals for the company
- Decide on the appropriate type of company and equity structure
- File the correct forms that are both correctly filled out and tailored to your company
- Create the various documents for the company, from corporate bylaws to intellectual property assignment agreements (we’ll get to those in the next article)
Your tax advisor can help you understand the tax implications of forming a company and assist in important decisions, like whether to form a C-Corp or an S-Corp. Getting a team of professionals working with you from the beginning can help you to avoid huge problems down the line.
I’ve worked with more than a few clients to fix mistakes that were made in trying to do this kind of thing by themselves. Either they formed the wrong type of business entity for their particular goals, or they simply made mistakes during the process. If you’re going to be spending time and money on starting your business, it pays to do it right.
In the next article in this series, I will discuss the importance of owning the intellectual property in your game and how to do it.
While you’re waiting, why not sign up to get info on my full course on starting your indie game company? I expect the course to be released in the next few months, covering everything from the legal aspects of game development to marketing and sustaining your business. Sign up here for more information.