Trends in venture deals in the gaming industry – legal assessment of REVERA

Representatives of the REVERA law firm, Anna Solovey and Victoria Semenitskaya, spoke about the trends of 2023 in gaming industry transactions.

Anna Solovey, Advisor, Head of the M&A and Corporate Structuring Practice of technology companies, and Victoria Semenitskaya, Lawyer of the M&A and Corporate Structuring Practice of technology companies

First, a little bit about our experience and the general situation. In 2023, we ourselves mainly accompanied investment deals in game studios. There were noticeably fewer exits than in previous years. The largest transactions occurred in the console and PC segment (which corresponds to the general investment trend in the gaming industry), while there were several transactions in the mobile segment.

Now to the trends.

Strengthening investor control over investment spending

Previously, the goals of using investments were often defined by general formulations "for business/product development" in sections with assurances and obligations of the founders and the target company*. Now, in almost every transaction, the goals are narrowly fixed, while specifying:

acceptable expenses (e.g. development, marketing) and prohibited expenses (e.g. dividend distribution);
a specific product for the purpose;
reservations about changing goals with the consent of the investor (including for situations where one product "did not take off", but there are other ideas);
the company's obligations to provide a breakdown of investment expenses.

*Target company (from the English "target" – "target") – the company with which the transaction is planned.

Moreover, it is often the responsibility of the founders and the target company for the misuse of investments. For example, punitive call options*, which give the investor the right to buy shares from the founders and receive a larger percentage in the company.

*Call option – an agreement under which one of the parties (the option holder) has the right to purchase its shares from the other party (to force the other party to sell its shares) upon the occurrence of certain circumstances at a predetermined price.

Increasing investor's attention to sanctions and AML compliance*

*Sanctions compliance – verification of the company in order to identify the risks associated with the introduction of sanctions restrictions. AML compliance (from the English anti-money laundering – "countering money laundering") is an audit of a company in order to identify cases of financial crime (money laundering, terrorist financing).

The control of counterparties (participants in the transaction) within the framework of sanctions and AML compliance occurs at different stages of the transaction. With the tightening of regulatory requirements, the investor's desire to insure himself and his investments is increasing, therefore, risk hedging tools have become standard:

anti-sanctions and anti-corruption assurances and guarantees (moreover, target companies and founders give them both in relation to themselves and in relation to their employees, directors, agents);
obligations to use investments in compliance with sanctions and anti-corruption legislation and responsibility for their violation;
AML statements (statements on behalf of the target company to the investor that it did not commit violations of anti-money laundering legislation).

*Hedging (from English "to hedge" – "to fence", "to limit") a mechanism for reducing risks and limiting losses from negative scenarios through protective tools.

Tightening of KYC compliance* from the providers' side

*KYC (from the English "Know Your Customer" – "know your customer") – verification of the party to the transaction in order to identify the person, verify the sources of funds, connections (whether the party was involved in criminal activity) and financial capabilities.

Against the background of increased banking compliance, we observed a deepening of KYC checks by service providers (agents assigned to the target company and providing services to a nominal address, director, secretary). In different jurisdictions, transactions were accompanied by detailed KYC checks of investors (with a multi-level structure of owners, verification at each level up to UBO*), more extensive KYC requests compared to previous years, large packages of documents and long review periods.

*UBO (Ultimate Beneficial Owner) – the ultimate beneficial owner or an individual who actually owns the company.

Loan provision after signing the Term Sheet*

*Term Sheet is a non–binding document in which the parties fix the basic terms of a future transaction.

A common practice in recent transactions is when, after signing the Term Sheet, the investor gives the target company a short–term loan (the so-called bridge loan to cover current expenses while awaiting basic financing). There are both interest-bearing and interest-free loans, as well as standard ones, which target returns immediately after receiving investments, and convertible ones, including with a discount (with a discount on the share price in the main round). In fact, such a loan is a part of the investment that is paid in advance.

Post-closing expansion

Post-closing, i.e. obligations after closing the transaction. Previously, such closing was limited to registration procedures (reflecting the investor's entry in the company's corporate documents). Now other obligations are increasingly being fixed, usually related to the elimination of risks identified on legal due diligence* (for example, in terms of IP purity). The goal is to document and define deadlines for resolving issues that were not closed before the transaction or intentionally left for post–closing so as not to delay the closing time.

*Legal due diligence – verification of legal documentation and transactions of a company within the framework of its purchase, sale or merger with another company in order to identify risks and problems related to the legal aspects of the business.

Creating option plans for employees

ESOP* has become a frequent element of transactions. This applies to both conventional ESOP and phantom options** (including in unusual forms, for example, options for phantom shares in foreign analogues of limited liability companies). If the ESOP is at the stage of inception or initial implementation before the transaction (for example, shares are reserved for ESOP), then already in the round investors insist on further steps. First, the ESOP agreements are fixed in the Term Sheet. Secondly, obligations are imposed on post-closing to create an option program within a certain period of time.

*ESOP or Employee Stock Ownership Plan (option program, option plan) is a system for motivating employees by granting them the rights to receive shares of the company. In the future, an employee can receive part of the company's profits from these shares through dividends or the sale of shares.

**Phantom options are an employee motivation tool that assumes that the employee owns virtual shares in the company (there is no actual ownership of shares, the employee does not become a member of the company). If the company's valuation increases, the value of the virtual shares also increases, and the employee can receive an amount equal to the increase in the value of their virtual shares.

Using the Disclosure Letter*

*Disclosure Letter – a document in which the target company and the founders list what does not coincide with the assurances and guarantees from the contract with the investor, and explain to the investor the reasons for such discrepancies.

False assurances from the transaction documents are usually disclosed in the text of the assurances itself through reservations, exceptions and wording adjustments or through the preparation of a Disclosure Letter, when the assurances do not change, and inconsistencies are disclosed separately. In recent transactions, we see a trend towards using the second option (usually due to the requirements of the investor). Moreover, this tool is used both in transactions using standardized documents, where filling out the Disclosure Schedule form is provided (for example, in BVCA templates – documents of the British Venture Capital Association), but also in general, in any transactions with "their" customized drafts of documents.

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The listed trends in different variations were found in almost all gaming deals in 2023. In our opinion, they will remain in 2024. We assume that the features of transactions in 2023, which appeared a little less frequently, may also be relevant and become trends as early as 2024: for example, the consolidation of tools for controlling the involvement of founders in business (reverse vesting*, call options to buy out shares from the founder with insufficient involvement).

*Vesting (from the English "vesting") – the gradual receipt of shares, depending on compliance with certain conditions. In normal vesting, shares do not initially belong to the founder, but are accrued in stages if certain conditions are met. With reverse vesting, the shares initially belong to the founder in full, but if he does not fulfill certain conditions (for example, involvement in business development or achievement of indicators), part of the shares will cease to belong to him.

We recommend paying attention to trends when preparing for investment rounds and wish you successful deals in 2024.