The Lawyer's Daily: The importance of due diligence in the e-gaming sector

This article was originally published by The Lawyer’s Daily, part of LexisNexis Canada Inc.

Due to the dynamic nature of the electronic gaming industry, there are many serious specific concerns that an acquirer should be aware of when considering an acquisition. The following are specific potential issues that must be considered during the due diligence review.

Corporate structure and shareholder rights

Many e-gaming companies begin as small independent studios that struggle to obtain financing. These startups must look to all possible avenues for funding including friends, family, angel investors and the founders themselves. Through a combination of debt and equity financing, this process can create complex corporate and share structures that may carry a variety of security holder rights that could undermine the profitability of the acquisition or thwart the transaction in its entirety. Some of these possible rights include veto rights, redemption rights, pre-emptive rights and the forced conversion of convertible securities. It’s important to understand what rights are available to which security holders in order to ensure a successful business acquisition in the e-gaming industry.

Material contracts

Due to the dynamic and competitive nature of the industry, e-gaming companies tend to have multiple streams of revenue that are consistently evolving. A 2019 Ernst and Young survey found that 68 per cent of video gaming executives thought that “slower growth of new gamers will cause the industry to seek new ways of earning revenues.” For example, revenue streams can include agreements with publishers, consumer subscription agreements, in-game micro-transactions and in-game advertising as well as traditional brick and mortar retailers. Proper due diligence needs to be carried out to not only understand the target’s business model but to ensure that key revenue securing contracts are legally protected in the case of a change of control transaction.

E-gaming companies are dependent on an infrastructure of information technology (IT) support structures. This IT consists of hardware, software and cybersecurity services that are essential to the business’s operations. The licensing and service agreements that secure this IT must be reviewed to ensure that the suppliers will not have rights in the case of a change of control that are detrimental to the acquirer, such as terminating the agreement altogether.

A thorough due diligence review is also integral to ensuring that the acquirer obtains all intended intellectual property rights. In the gaming industry these rights can include: trademarks for valuable brands; copyrights for computer code and visuals; and patents to protect inventions.

There is a currently a shortage of talent in the gaming industry. The Ernst and Young survey cited above found that not only did the surveyed e-gaming executives rank talent recruitment as the biggest driver of M&A activity in the industry, but 52 per cent believed that the talent shortage was expected to increase over the next five years. This means acquirers must be diligent in ensuring key employees cannot simply leave or set up a competing company after the acquisition. This requires an understanding of whether the talent is legally considered employees or contractors, which can be a blurry line due to the culture of e-gaming studios, and a review of the relevant employment or service agreements.

Liability concerns

There is an array of specific liability concerns that an acquirer needs to be aware of when buying an e-gaming company. During an equity-based acquisition (a share transaction), acquirers can become liable for the prior actions of the target.

For e-gaming companies, one possible source of liability is employer liabilities that can arise due to the culture of “crunch” in the industry. Crunch is the practice of having employees work long and uncompensated hours just before a launch. A target that participates in crunch may be liable for unpaid overtime and be in violation of employment laws.

E-gaming companies need to be diligent in regards to possible anti-money laundering, gambling and tax liabilities. The presence of in-game transactions, secondary markets for video game items and fiat currencies creates an opportunity for money laundering. Acquirers must be diligent in reviewing the target’s compliance with relevant anti-money laundering laws. Furthermore, gambling restrictions are common and varied across different legal jurisdictions. The presence of in-game loot boxes (paying with in-game currency or real money for in-game items) and the rise of e-sports gambling can cause an e-gaming company to inadvertently violate local gambling laws. Each of these possible sources of liability can result in large monetary losses. Consequently, a thorough due diligence review of the target for any regulatory non-compliance or pending lawsuits is imperative for any hopeful acquirer.

Conclusion

The e-gaming industry is an extremely dynamic and innovative market. This level of persistent transformation may result in many business opportunities but also comes with increased financial and legal risk. Therefore, it is crucial to perform a thorough due diligence review of the target and be aware of the possible sources of risk when conducting an acquisition.