The Finer Points of starting your Development Company [Part I]

I previously went over some of the general characteristics, advantages, and disadvantages of small business types. I’d like to discuss one more small business type before discussing entity formation.

S-Corporation

For tax purposes, an S-Corporation is a federal tax classification that permits the entity to not be subject to an income tax (similar to a LLC). Instead, all profits and losses pass through to the shareholders and are taxed on their personal tax returns. The election to be treated as an S-Corp is based almost entirely on tax treatment. The fees associated with being treated as an LLC in some states (such as CA) may turn out as greater than they would be if you elected S-Corp treatment. 

In an S-Corp, instead of members (as you’d have in an LLC), you have shareholders. Those shareholders are subject to a pro rata tax, to be claimed on their personal tax statements, based on profits earned by the business. This means that shareholders are taxed based on the number of shares they own in the business. A majority shareholder will be responsible for a greater proportion of the taxes on the earned profits. This also means that shareholders who are employees will pay FICA taxes on their salaries as well as income taxes on their portion of the company’s profits. This isn’t necessarily a double tax—the salary is subtracted from the profits prior to application of the federal income tax. Non-employees are only required to pay the income tax commensurate with their ownership in the company.

Because shareholders are taxed whether or not there is a cash disbursement of profits, it is advisable for S-Corps to provide cash disbursements of profits to shareholders that are at a minimum enough to cover the taxes themselves. This is usually set out in the shareholder agreements.

The decision to be treated as an S-Corp. should be between you and your accountant. You get the same legal treatment as other limited liability entities, such as LLCs, LLPs, and C-Corps. Deciding to elect S-Corp status is usually something you can determine when you are filling out your annual or quarterly tax information.

Forming a Business Team

Developers take great care in deciding who will code, design, and manage projects. At least equal care should be taken when deciding who you want to help you run the business portion of your business.

Your Lawyer: Developers want entertainment attorneys. Why, you ask? It is much harder to break attorneys in non-entertainment industries out of the habit of negotiating unfair clauses. Entertainment lawyers are experienced in working within the confines of a bad deal, because they understand how leverage has worked to manipulate every facet of the entertainment industry. Publisher/developer deals are inherently unfair, and the people who understand this best are those who have also worked with record deals and studio deals. Good entertainment attorneys will be able to squeeze the best deal possible for a client out of what will ALWAYS be a bad deal. Entertainment attorneys also work with many of the contracts and issues we’ve discussed previously, including intellectual property licenses, work for hire licenses, and NDA’s. This doesn’t mean that you have to hire an entertainment attorney—especially considering the number of sleazy entertainment attorneys out there.

A bad attorney is worse than no attorney at all, so the practice area is less important than your lawyer’s commitment, ethics, and willingness to learn. What do you need a lawyer? You need someone with a very strong understanding of all of the Intellectual Property issues that arise in gaming. You want an attorney with transactional experience, one who can take apart a contract and explain it in plain English. You also want an attorney who can write the kind of contract that specifically applies to your transaction. It should be noted that law schools don’t spend a lot of time teaching students how to deal with contracts. Law students are practically force fed litigation in most ABA accredited schools, and they only learn about contracts when they get into practice.

Most importantly, you want an attorney who cares about what they are doing. A good attorney will always take the time to find the best answer if she does not know it off hand. Similarly, a good attorney will learn about the industry her clients specialize in by taking the time to read about the industry, the issues, and the kinds of transactions involved. Good attorneys don’t rely on their gut, and they don’t give simple one word answers. It is not the attorney’s job to make decisions for you. Instead, it is the attorney’s job to lay out the array of possibilities ranging from worst case scenario to best, and provide counsel on what actions will lead to the best case scenario. A good attorney leaves the final determination to the client and consults the client when doing anything on behalf of a client.

Look for someone who cares about your work as much as you do and someone who returns your phone calls. Any time you’re deciding on an attorney, make sure you get references. Ask for a list of their past clients, if available. If not, as for the names of other attorneys who are able to vouch for the one you are interested in hiring.

Be careful about hiring your friends. Get everything in writing and make sure you get a copy of the fee arrangement, regardless of how well you know the person. It is also important to make absolutely sure that your attorney has a reputation for discretion and confidentiality, ESPECIALLY if you are hiring an entertainment attorney. A lot of very prominent and successful entertainment attorneys have a very bad habit of disclosing proprietary and/or confidential information about cases and transactions they are working on to increase their own personal leverage and clout. It’s important that developers in particular stay away from this kind of lawyer. Also, check out a recent article by Tom B. for how to train your attorney— this should be required reading once you’ve found an attorney you want to work with.   

Your Accountant: The responsibilities of your accountant are no less rigorous than the responsibilities of your lawyer. Your accountant is your financial guru and unless you have a background in accounting yourself, someone you must trust implicitly. As with your lawyer, your accountant should have a good grasp of your industry and the kinds of transactions you will be engaging in. Your accountant should also be aware of some of the tax issues that may come up for digital distributions and brick and mortar distributions (sales tax, VAT tax, etc.). As with a good lawyer, it’s important that your accountant cares about your business and has a reputation for honest business practices. Once again, you will probably want to get references.

Your Business Manager: For many small developers, the business manager is also the lead developer or the project manager or the CEO of the company. That being said, your business manager is responsible for the day to day business of your company. This includes payroll, hiring and firing, enforcing business practices that protect proprietary information and trade secrets, managing documentation and data, marketing and advertising for your company, and negotiating deals with third parties for SDKs, manufacturing and distribution, game engine licensing, and licensing your own products to others. If your development team is the pumping heart of your organization, your business manager is the brain that keeps the rest of the body of your business moving. Ideally the business manager is the person most invested in the success of your business, as she is the person most responsible for the business’s success or failure.

Your business manager should be a voracious reader. She should read all of the primary trades both online and off (PC Games, Game Developer, GDNet, IGDA white papers and articles, the Byron Report, news sites and blogs). She should also read books about business management. Because she’s the business manager of a development company, she should read books and articles specifically designed for the governance of those kinds of companies. She should understand the development process. She MUST be able to make tough decisions, such as firing or disciplining individuals for bad conduct. In short, your business manager should be an intelligent hard ass who lives and breathes your company’s business. She can be less of an obsessive hard ass if your company is in a position to delegate some of her duties to others, but typically it’s good to have someone who is just that committed.