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Anna Solovei, Counsel, Head of M&A and Corporate Structuring of Technology Companies Practice, and Viktoryia Semianitskaya, Associate in M&A and Corporate Structuring of Technology Companies Practice
In 2023, we mainly advised on investment deals in game studios, with fewer exits than in previous years. The largest transactions occurred in the console and PC segment (which aligns with the global gaming industry investment trend), while several deals were in the mobile segment.
Now let’s delve into the key trends.
Strengthening control over the use of investment
Formerly, the use of investment purposes appeared in founders’ and targets’* representations and warranties and were often generically described as “for business/product development.” Now, in almost every transaction, the purposes are defined and specified narrowly, including:
- Permitted expenditure (e.g. development and marketing expenses) and prohibited expenditure (e.g. dividend payments);
- Particular product to be developed within the purposes;
- Investor’s consent requirement for any changes in the purposes (including for cases when one product has failed, but there are other ideas);
- Requirement for the company to provide breakdown investment allocation reports.
*Target company is a company that is the subject of an attempted deal.
Furthermore, we often see liability imposed on the founders and the target company for the misuse of the investment. This may take the form of call options* that entitle the investor to buy back shares from the founders and secure a higher stake in the company.
*Call option is an agreement giving one party (option holder) the right to purchase shares from the other party (to force the other party to sell its shares) at a predetermined price upon the occurrence of certain circumstances.
The second option is instruments that force the target company to redeem the shares from the investor, allowing the investor to recover their funds. Redeemable shares are calculated from the total number of the investor’s shares in proportion to the number of misused investments.
Growing focus on sanctions and AML compliance*
*Sanctions compliance involves screening the company to identify the risks associated with introducing sanctions restrictions. AML (anti-money laundering) compliance deals with screening the company to identify financial crime (money laundering, terrorist financing).
Checks of the parties to the deal for sanctions and AML compliance occur at several transaction stages. As regulatory requirements have become more stringent, investors have become more willing to protect their investment, and risk-hedging* methods have become standard:
- Anti-sanctions and anti-corruption representations and warranties (with target companies and founders providing these both for themselves and their employees, directors, and agents);
- Commitments to use investment in compliance with sanctions and anti-corruption laws and liability clauses for breaches thereof;
- AML statements (representations made by the target company to the investor about non-violation of anti-money laundering laws).
*Hedging is a risk management strategy employed to offset losses in negative scenarios using protection tools.
Enhancing provider KYC compliance*
*KYC (Know Your Customer) is a process of identifying and verifying the party’s identity, sources of funds, connections (whether the party was involved in criminal activity), and financial capabilities.
Against the strengthening banking compliance, we observed deepening KYC checks by service providers (agents offering corporate services to the target company, including the nominee, directorial, and secretarial services). Across jurisdictions, transactions involved extensive KYC checks of investors (with multiple ownership layers – checks on each level up to the UBO*), more comprehensive KYC requests compared to previous years, large document packages, and time-consuming reviews.
*UBO (Ultimate Beneficial Owner) is an individual who has the ultimate effective control over a company.
Loan grant upon signing a Term Sheet*
*Term Sheet is a non–binding document outlining the basic terms of a future transaction.
Upon signing the Term Sheet, it is common for investors to provide the target company with a short-term loan (a so-called bridge loan to cover current expenses before the main financing is received). There are interest-bearing and interest-free loans, standard loans repaid by the target company immediately upon receiving the investment, and convertible loans, including those with a discount (with a discount on the share price in the qualified financing round). Such a loan constitutes a part of the investment paid in advance.
Post-closing extension
Post-closing obligations used to be limited to registration procedures (reflection of the investor’s entry in the company’s corporate documents). Increasingly, other obligations, usually related to addressing risks identified in legal due diligence* (e.g. IP issues), are now commonly included in post-closing sections. The purpose is to formalize and define deadlines for resolving issues not resolved before the transaction or deliberately left for post-closing to avoid delaying the closing date.
*Legal due diligence is the verification of legal documentation and transactions of a company within the framework of its purchase, sale, or merger with another company for identification and assessment of the risks related to the legal aspects of the business.
Development of stock option plans for employees
ESOP* has become a frequent element of transactions: both standard and phantom option* plans, including in unfamiliar forms, such as options on phantom shares in limited liability companies where ownership is expressed by percentage and membership units. If the ESOP is in its initial implementation stage before the transaction (e.g. shares are reserved for the ESOP), investors usually insist on further steps in the financing round. First, the Term Sheet sets out the ESOP arrangements. Secondly, post-closing commitments include establishing an option program within a specific timeframe.
*ESOP or Employee Stock Ownership Plan (option program, option plan) is a system for motivating employees by granting them the right to receive the company’s shares. In the future, employees may receive a part of the company’s profits from these shares through dividends or the sale of shares.
*Phantom options are an employee motivation tool assuming that the employee owns virtual shares in the company (with no actual ownership of real shares, the employee does not become a company’s shareholder). If the company’s valuation increases, the value of the virtual shares also increases, and the employee can receive a cash consideration equal to the increase in the value of their virtual shares.
Use of Disclosure Letter*
*Disclosure Letter is a document in which the target company and the founders list everything that does not match the representations and warranties in the investment agreement and explain why those “non-matching” things are the way they are and the reasons.
Inaccurate representations and warranties from the transaction documents are usually either disclosed in the text of the representations via disclaimers, exceptions, and wording adjustments or by preparing a Disclosure Letter, whereby the representations are not modified, but inconsistencies are disclosed separately. In recent transactions, we see a trend towards using the second option (usually at the investor’s request). Moreover, this tool is common both for transactions contemplated by standardized documents, which provide for the completion of the Disclosure Schedule form (for example, the BVCA templates — documents of the British Venture Capital Association), and in general, in any transactions with “own” customized draft documents.
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The above trends appeared in variations in almost all gamedev transactions in 2023. In our view, they will remain valid in 2024. We assume that the features of the 2023 transactions, which were slightly less frequent, may also be relevant and become trends in 2024: for instance, tools to control the involvement of founders in the business (reverse vesting*, call options to buy out shares from founders in case of their insufficient involvement).
*Vesting – gradual receipt of shares, depending on compliance with certain conditions. In traditional vesting, shares do not initially belong to the founders but are accrued in stages if certain conditions are met. In reverse vesting, the shares initially belong to the founders, but if they do not fulfill certain conditions (for example, sufficient involvement in business development or KPI (key performance indicators) achievement), part of the shares will cease to belong to them.
We recommend keeping an eye on trends while preparing for investment rounds and wish you successful deals in 2024.
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