Six legal mistakes app developers make – Part 2

[Dan Rogers has worked with leading video game companies for 20 years. As an attorney, he has advised and negotiated with interactive game publishers, independent developers, and technology companies around the world on matters of intellectual property, licensing, and contractual law.]

A recent Game Developer’s Conference study found, unsurprisingly, that 53 per cent of the attendees they polled identified themselves as indie developers, with nearly the same percentage saying that they work in companies with ten or fewer people.

With the explosion of mobile and casual gaming, this has created exciting times for entrepreneurs, but the reality is that most independent game developers lack the legal expertise necessary to navigate this new publishing world.

Many will make it through unscathed. Others, unfortunately, won’t be as lucky.

In the first half of this series, we discussed three legal mistakes that indies make more often than they often realise: unintentionally infringing another’s IP rights, failing to secure copyrights and trademarks before an infringement is discovered, and failing to use properly drafted contracts with contractors.

We continue now with three more common indie legal mistakes.

Mistake #4 – Failing to Properly Incorporate and Operate

C Corp. S Corp. LLC. No Corp. Most indies understand that a corporation is a legal entity that provides them a certain level of liability protection, but few realise that ignoring corporate formalities can render this shield vulnerable to attack.

The legal term for breaking through a corporation’s structure and reaching the principals and officers inside is called ‘Piercing the Veil’, and it’s fairly descriptive of what happens: a legal death ray essentially cuts through the corporate force field, leaving the individuals inside liable for the torts and infringements of the company they thought was protecting them.

How the corporate veil is pierced is generally determined on a state-by-state basis, but here are some common ways it can happen:

– Ignoring corporate formalities. Generally, corporations exist in the eyes of the court so long as they operate as such. Corporations, for example, are required to hold regular meetings, have adequate funding, and faithfully keep maintain their business records and transactions.

C Corporations that fail to do so risk being deemed an alter ego of the principals and stockholders running the organisation. When this happens, these same people can be liable for the corporation’s acts and debts.

– Co-mingling personal and corporate money. Similar to the above, when a party can show that the corporation is nothing more than façade, proven by a lack of distinct and separate corporate funding and monies, the corporation’s protective armor can be penetrated.

– Fraud. Where the court finds a corporation is a sham to hide illegal activities, the parties inside can be liable for acts of the organisation.

Another issue raised is in the corporate form itself. When and how you chose to incorporate – whether as an LLC, C Corp, or otherwise – will mandate what procedures you are required to follow. Failing to pay attention to these details can be fatal. And one thing you can count on: those who bring suit against your corporation will look at this very closely.

Finally, consider that while LLCs and S Corps may, in some ways, be easier to manage, venture and angel funds generally prefer to invest in entities where stock and options of various flavors can be issued and tax issues minimised

Mistake #5 – Failing to Create Bulletproof Partnership Agreements

Mike Kerns (fictitious name) was raised in a middle-class neighborhood in Southern California. Self-reliant, street-smart, with a loyalty tenet cast from Band of Brothers clay, he was never shy about expressing his opinion. That’s what Peter Morris (name also fictitious) liked about him. Peter believed that Mike would make a great addition to his small but profitable video game consulting firm.

So Peter brought Mike on board with the idea that Mike would eventually become a full partner. Two years later they were bitter enemies, and Peter acknowledges that if not for the partnership agreement he insisted Mike sign, things would have ended much worse.

Surprisingly, few take the time to create clearly thought-through partnership agreements, despite the fact that, according to Harvard Business School, 90 per cent-to-95 per cent of all start-ups fail.

Think of a partnership agreement like a marital prenuptial, and then consider what it clarifies:

– Ownership of technologies created prior to the partnership and use thereafter.

– Who’s in charge and how decisions are made.

– Whether a spouse can become involved in the business at the death or disability of a partner.

– How profits are divided and when.

– What expenses the company will pay.

– Whether and what type of health plan the partners can participate in.

– What happens when a partner leaves voluntarily.

– How partners can be removed.

– What happens when the corporation dissolves.

– How new partners will be brought into the company.

Each of these issues can turn into a powder keg where partners have failed to agree in advance. On the other hand, for those who take the time to create solid partnership agreements, a break-up may be painful, but at least the rules of the road are defined.

Mistake #6 – Failing to Understand the Implications of Third-Party Investments

Cash is king, especially when a business is in start-up mode. But where you get your investments and how you treat them afterward can have significant legal implications, especially with regard to Security and Exchange Commission regulations.

The laws in this area are complex, and it takes an experienced lawyer to help you through them. For simplicity sake, however, alarms should ring when you are thinking about:

– Selling, offering to sell, or exchanging your company stock, since these activities require compliance with complex SEC regulations. While there are exemptions – including private placements, sales to accredited investors, seed capital, and crowd-funding (discussed briefly below) – you’ll need competent legal advice to know if you qualify and what obligations and filings are necessary.

– Advertising or making general solicitations to market securities. What’s a security? Any sort of investment or interest in a company, which can mean anything from stock to a percentage of a corporation’s assets or profits.

– Selling securities or promising future profits to investors who make less than $200,000 annually or with a net worth of less than $1 million.

– Issuing early stage equity, since this can greatly impact mergers or acquisitions later.

Crowdfunding has also become a popular way for game developers to finance their projects. Be aware that while this activity is recognised in the United States, things have been moving forward rather quickly and loosely.

As a game developer, two concerns should be on your mind before you launch your next crowdfunded project:

– Lawsuits initiated by disappointed backers are becoming more common. Recognise that your donation-based campaign creates a contractual obligation, and over promising or under delivering can be grounds for a breach of contract claim. So before launching your next campaign, make sure you’re properly incorporated.

– Equity based crowdfunding, meaning you offer an interest in your company or profits, is complex and the rules are still being finalized. While everyone is anxiously awaiting for SEC rules in this area, for now it’s probably best to hold off.

Who would have thought five years ago – when EA, Activision, and Ubisoft were dominating all the distribution channels – that a handful of young programmers and artists working from their garage could develop, market, and launch a game that not only competed with them, but could beat them soundly.

At the same time, the legal risks involved in app development are growing. The six issues we’ve discussed are common but by no means comprehensive. These days a prudent indie needs to make sure their legal ducks are as orderly as the code that’s driving their next hit game.

This information is not legal advice. This article is provided for commentary purposes only, and is not legal advice nor does it create an attorney-client relationship between the author and any reader.