As the games industry develops and changes, there are a range of models being used by studios to get their games published. When budgets are tight, studios and individuals are working together in different ways, but it means game developers need to be careful when considering their options. Game Republic asked Chris Taylor from Game Republic Affiliate Eaton Smith LLP to share his insights in this feature.
Been offered Sweat Equity or Revenue Share? Pros and cons for use in game dev contracts
Necessity is the mother of invention, as they say. Whilst there is less funding in game development at the moment, thankfully that does not equate to a reduction in developer creativity. In this context, however, we’re not talking about creativity on screen; we’re talking about inventive business solutions that are coming to the fore to keep games being developed.
The traditional model of engaging a freelancer and paying the fees is alive and quite well. However, where a project may not be funded, there is still a game to be made and a vision to be shared. The question then is how to engage the necessary talent on a tight or non-existent budget. There are a couple of routes that are becoming more popular in these straitened times.
Sweat equity involves receiving shares in the company engaging the freelancer in return for the services, rather than direct payment. As an alternative, revenue share means receiving a percentage of the income generated from the game; again, that would be instead of direct payment.
So, what might a freelancer need to consider if offered one of these options?
Well, it often boils down to attitude to risk as well as considering any immediate needs. If cash is needed imminently for whatever reason, delaying payment to an unknown point in the future isn’t really an option and so a freelancer may need to pass up on these routes. It also must be said that payment is not guaranteed – with each route, you are dependent on the game being somewhat successful.
So, assuming that delaying payment to a future point is possible, let’s look at some issues associated with each of the routes. We look at them from the perspective of a sole trader freelancer.
Sweat Equity
Whilst there are upsides to agreeing to a sweat equity offering, there are also risks. We look at some of both below:
The pros:
- Your shareholding relates to the company, not just the immediate game in development. It is the company that you are becoming invested in, not just the immediate game.
- If the company performs well and has a good slate of games over time, the value of your shares could increase many times and pay out good dividends, that being the way shareholders receive money out of the company. This could enable returns way beyond what you might have received as a straight payment for your services.
- If the company is acquired, your shareholding would be part of the sale. As you would receive a portion of the sale proceeds, this could be many multiples of the amount you would have received for your services.
The cons:
- Receiving shares in return for your services will not unlock any immediate value or cash. Dividends are paid to shareholders once there are “distributable profits” to share. So, as those are calculated after other costs of the business, dividends are often only distributed after those costs are ascertained. How long can you go without receiving any money from the arrangement? It is also possible that the game does not perform well and the company closes without any payments being distributed.
- The company will have to take care as to its offerings of percentages to those involved. The founder(s) will want to see a reasonable return for their efforts and if they have given away more equity than they thought, they could receive less than their fair share.
- There could be tax-related issues regarding the allotment of shares, creating a tax liability on the freelancer, especially if current market value is not being paid for the shares. In the services contract, it may be sensible to set out the value of the services involved, and record that this is to be settled by allotting shares of X% in the company. If taking this route, we would always advise both freelancer and company taking legal/accountancy/tax advice so that such implications can be explored and catered for as much as possible.
Further issues to consider but which are neither pros nor cons include:
- As lawyers, we would always recommend a shareholder agreement where there may be multiple shareholders. This helps to regulate dealings between shareholders and can enable the founders to remain in control of the direction of the company. So, anticipate entry into a shareholder agreement to be part of the arrangement and, amongst other things, that could include some controls on the sale of your shares, should you wish to exit. The development company will need to consider changes to its Articles of Association as well.
- Ensure that you are allotted shares that permit participation in dividends. Whilst you may receive a small percentage of the same “class” of shares as the founders, it is also possible that you might receive shares of a different class; for example, shares that permit the payment of dividends, but which don’t permit voting at shareholder meetings. In that case, you might not be able to influence the direction of the company.
- Remember that if all shareholders are holding the same class of shares (usually, “ordinary shares”), each person coming in under “sweat equity” arrangements will dilute the percentages of other shareholders’ shareholdings. So, that 10% that you took a while ago might drop to a lesser percentage as time goes on.
The upsides are there but you need to be sure that it fits with your current or short-term financial requirements and understand that it is not entirely free of risk.
Revenue Share
As with Sweat Equity, there are benefits and risks to receiving revenue share in return for services. We look at some of both below:
The pros:
- As dividends are paid by a company to its shareholders out of its end profits, payment of revenue share would be ahead of a payment to shareholders. Therefore, under this route, you are more likely to receive regular payment as it is out of revenue received from the game, not company end profits.
- The expectation would be that in return for agreeing to work for initially no return and taking a risk in that sense, you will participate in the revenues raised from the game beyond the amount you might ordinarily have received for your services. The amount will depend on the terms of the contract.
- It is a contractual relationship and there may be scope for negotiating your “entitlement”. Arrangements could vary between, for example, “X% of net revenues for Y years from launch” or “until you have received [2x or 3x] the original value of your contribution” and that value would have to be assigned a figure in the contract.
The cons:
- This could affect your tax status. Income tax will apply on the amounts later received and if the delayed payments take you beyond the threshold at which you have to charge (and pay) VAT, you will need to take that into account. You may already have taken tax advice in the past, but we would always recommend taking accountancy/tax advice where there is a change to your business activities.
- There is the danger that the promises of revenue share to several participants may in fact seriously erode the amount that shareholders might receive in the future. A solution could include setting aside a contractually defined, ring-fenced net revenue percentage out of which revenue share contributors are paid. It could get complicated and spreadsheets may be involved!
- The game may not do well – this could result in little or no payment and perhaps less than if you had been paid for your services as normal. However, remember that the arrangement arose because there wasn’t the money there to pay you in the beginning. This is why crediting in the game is important, enabling people to point to experience and involvement even if it does not result in good income. Crediting has its own value!
- You may need to spend time earning other income to tide you over for other costs. If so, ensure that you can deliver on your contractual/milestone obligations to remain qualifying for revenue share.
Again, there are other issues to consider, such as:
- The arrangement is contract-based so take care to read the contract for obligations on service delivery (so that you aren’t going to have the arrangement terminated for failure to deliver) but also be clear on revenue share entitlement once the game is launched.
- It is likely that the revenue share will be based on “net revenue”, being what remains after various game-related costs have been discharged. Understand what costs make up the net revenue calculation. Bear in mind that if you are a later participant, the developer will be reluctant to alter the description of the costs that make up the net revenue calculation.
- You are participating in the fortunes of the game, not the company; so, if the game does okay but the company has a later hit, you won’t get to share in that bigger pot.
High Risk High Reward or Immediate Income but less Lucrative Reward – Your Choice
Both sweat equity and revenue share have advantages and disadvantages. Sweat equity offers a potentially high reward but it comes with a higher risk and delayed receipt of money for your efforts. Revenue share provides a comparatively (slightly) more immediate route to income but will likely be less lucrative in the long run. Neither provide income in the short term nor a guarantee of payment.
Whilst payment on usual terms for your services might be the sensible and least risky route, the above may help you to consider the risks and benefits of each route should you be offered a choice of sweat equity or revenue share where funding on a project might be tight.
If you need a revenue share contract reviewing or if you are a developer and perhaps need one preparing for your next project, do get in touch as Eaton Smith LLP can assist. We can also assist developers in the allotment of shares as sweat equity so do contact us for assistance if this is the route you may be considering. We can be contacted by email via christaylor@eatonsmith.co.uk or samcrich@eatonsmith.co.uk.
Disclaimer: Nothing in this piece is legal advice and the issues covered are non-exhaustive. It is intended to provide information of general interest about current legal issues. As all circumstances are different, you should take specific legal and accountancy advice before acting in reliance on any of the information provided.