United States: eSports Investments: Virtual Games Require Real Due Diligence

It takes a lot to pack New York's 18,000-seat Madison Square Garden, which has hosted some of the greatest sports and entertainment events of all time. Last fall, the arena was sold out on two consecutive nights, but the fans weren't cheering for the Knicks' Carmelo Anthony, or Rangers' captain Ryan McDonagh. Instead, they passionately followed the moves of "jungles," "supports" and "top laners" from around the world, playing a video game called League of Legends.

To say that eSports is having a moment in the sun is an understatement. Last year saw a plethora of investors – everyone from team owners and celebrities to private fund executives – turn their focus to eSports. And the slew of investment activity is expected to continue as the industry matures. The Philadelphia 76ers acquired not one, but two teams – Team Dignitas and Team Apex; while the investment group aXiomatic, which includes Steve Case, Tony Robbins and Magic Johnson, bought the Dutch-based Team Liquid. The co-owners of the Sacramento Kings also bought Team Coast, and then proceeded to rebrand the team as NRG with help from investors Shaquille O'Neal, Alex Rodriguez and Jimmy Rollins. Even celebrity DJ Steve Aoki got into the game by buying a majority stake in Rogue, a team that plays five popular games.

All of the relevant metrics seem to point to eSports rivaling, or even exceeding, the size of other major international sports. But investors coming to the deal table are not guaranteed a slam dunk. Many leagues that have formed around top games remain in their early stages. Team valuations and revenue opportunities can also vary to the extremes, making it hard to get a handle on what's market. Finally, many teams grew out of an underground gaming culture, so it's common for player contracts, financial statements, vendor contracts and other documentation to raise questions during the due diligence process. An M&A attorney advising on an eSports investment should expect the unexpected, and be prepared to call in a range of specialists in areas such as employment, intellectual property, real estate and immigration.

Types of Teams

Teams vary in their size, focus, stability and notoriety, and consequently in their valuation. Some teams focus their efforts on a single game, such as Dota 2, CS:GO or League of Legends. These teams typically consist of 3 to 7 players, coaches and an administrative support staff. On the other hand, teams such as Fnatic, Evil Geniuses and Team SoloMid field multiple squads that compete in different games. Such diversification enhances the ability to generate revenue; however that comes at a cost, in terms of added infrastructure, employees and overhead.

Another key consideration is whether a team has a guaranteed slot in a major gaming competition, or whether it needs to buy one, or even compete for one through a promotion and relegation system. These slots are valuable for a number of reasons, including the fact that they provide significant branding and revenue generating possibilities. When teams with guaranteed slots become available, they usually attract intense interest and bidding. Recent sales have been reported in the seven-figure range, including the sale of Team Coast for a reported $1.4 million, and Gravity to former NBA star Rick Fox for $1 million.

Another option that exists is purchasing a franchise. Several eSports leagues are starting to emulate the business models of the NFL, NBA and other major leagues. For example, Riot Games, the publisher of League of Legends, recently announced that it would adopt a more traditional franchise and revenue sharing model. Under the new system, ten teams will become permanent franchises, at a reported cost of $10 million per franchise. Blizzard Entertainment has also indicated its desire to move its Overwatch League to a franchise system with city-based teams, at a reported franchise fee of $20 million.

Franchises typically provide owners with stability, a greater say in the league's growth and operation, as well as a slice of the league's revenue streams, including the lucrative media rights. Investors seeking to enter a franchise-based league will have to closely scrutinize the league regulations, the process for resolving disputes, the revenue sharing terms and the parties' other key rights and responsibilities.

Sponsorship Revenue

Traditional sports teams have diverse revenue streams, including ticket and merchandise sales, media rights, arena naming rights, concessions and even parking. In eSports, corporate sponsorships make up a significant slice of most team's current revenue.

In many cases teams directly strike marketing partnerships with companies that find the eSports demographic appealing. For example, GEICO sponsors Team SoloMid, while Comcast Xfinity sponsors Evil Genuises, a team that's active in two of Comcast's major markets. At the same time, corporations also strike league-level sponsorships. Examples of that include Coca-Cola's sponsorship of League of Legends, and Buffalo Wild Wings' sponsorship of ELEAGUE, a popular league backed by Turner Sports and WME\/IMG.

It is important to clearly understand the sponsorship rights of leagues, teams and players, and understand if league-generated sponsorship revenue flows to teams. In doing so, pain points could emerge. For instance, traditional sports leagues often give category exclusivity protection to their top sponsors. One example is the PGA Tour's agreement with FedEx, which keeps golfers who are sponsored by a FedEx competitor from participating in the FedEx Cup race. Similar protections in emerging eSports leagues could similarly enhance, or stifle the ability of teams and players to monetize their brands.

Other leagues, such as Major League Baseball and the National Hockey League, also have the right to digitally replace a team's stadium signage during a nationally televised game. Should this become prevalent in eSports, teams without a league revenue sharing agreement could lose out on lucrative advertising revenue.

Media Rights

Major eSports events attract audiences that rival some of the world's great sporting events. For instance, last year's World Series attracted 23 million U.S. viewers, and the NBA Finals attracted 20 million. By comparison, the 2016 League of Legends World Championship had 43 million global viewers. Because of this immense exposure, media rights agreements should be closely scrutinized.

Media rights agreements can take different forms. One example is a distribution deal that a league will strike with a streaming video provider. For example, Major League Baseball's streaming business, BAMTech, recently forged a six-year deal with Riot Games to stream League of Legends content; while YouTube signed a multi-year deal to exclusively stream ECS's CS:GO league. Many other cable and streaming broadcasters are actively competing for eSports viewers, including ESPN, Turner Sports, Facebook, Amazon's Twitch and Activision-Blizzard's MLG.tv.

Teams also frequently have their own media rights agreement with a streaming video provider. These deals typically call for the team to produce exclusive content, such as game tutorials, practice matches and player interviews. In exchange, the team could receive a flat fee, a variable payment based on hitting certain milestones in viewable hours or another metric, or another type of arrangement based on the team's marketability. Investors should ensure that contracts between players, leagues and broadcasters clearly delineate the rights and responsibilities of all parties. Even with clear language, subtle nuances may exist. For instance, a team could derive significant revenue from Twitch content created by, or starring the team's best player. Should that player fail to produce the required content, the revenue will be put in jeopardy. Are there adequate provisions in the player's employment agreement to protect against such a scenario? 

Another forward-thinking consideration for investors is the existence of streaming video micropayments. A pioneer in this area is Twitch, which lets viewers "cheer" for content using "Bits," animated emoticons which are purchased by fans and then donated to the content creator. In 2016, Bits accounted for $5.9 million in revenue for Twitch content creators, however that could increase, and potentially the concept could expand to other streaming video providers. If it does, investors will have to pay close attention to how the content is created, and who shares in the revenue.

Finally, the need to obtain and insure copyright ownership of all media content should not be overlooked. Any original content created by employees within the scope of their duties is considered a work-made-for-hire, which automatically makes the team the copyright owner. But if an independent contractor is hired to create the content, the copyright remains with the contractor, and the team only gets a limited license to use the material – unless a written work-made-for-hire or copyright assignment agreement is signed.

Tournament Prizes

According to an industry source[I], total tournament prize money in 2016 grew by 39 percent, from just under $66 million to more than $92 million. One major contributor to that was the Dota 2 championship tournament, where a Chinese team took home $9.1 million, part of a $20 million prize pool that was the largest in eSports history. While these prizes make headlines, many players and team owners say the prize pool structure contributes to a boom or bust ecosystem. Teams are thriving one day, and defunct the next. In the near term major prizes will be a staple of the tournament scene, but that could change as franchise business models take hold. 

Player Salaries and Expenses

Player salaries and related expenses can vary considerably, but they usually make up a large part of a team's overhead. One example is the League of Legends team Ember, which disclosed that it pays its players between $60,000 and $70,000, with up to $27,000 in performance bonuses. Others peg the market for advanced players at anywhere from $40,000 a year, to upwards of $200,000 a year for elite players. On the high end, one potential anomaly is the South Korean League of Legends prodigy Faker, who is rumored to have a $2.5 million salary with the SK Telecom T1 team. Teams also typically have coaches and analysts, whose salaries will vary based on their reputation and expertise. In addition, top teams often provide perks to their players, such as psychologists, gym memberships and personal chefs. 

Employment Agreements

Athletes in traditional sports leagues have clearly defined contracts; however eSports contracts are still evolving. Many of these contracts were handshake deals put to paper, while others were drafted without input from legal counsel. As such, gray areas often exist.

For instance, a provision may state that a team will provide a player with "top-notch" housing, computers and benefits. But "top-notch" is a nebulous term at best. Contracts also might not conform to federal and state regulations regarding wages, overtime and health insurance. Employment agreements should also be scrutinized for what they don't state. For example, contracts with minors should include a provision that the player reviewed the contract with legal counsel, to avoid disputes regarding an imbalance in bargaining power. In addition, investors will want to insert key man provisions in a purchase agreement, to help ensure that valuable players and support staff don't bail once a deal has closed. 

It is also important to view employment agreements through the eyes of a general manager. Are the highest performing players sufficiently incentivized to perform their best? Does a top player have an unenforceable non-compete clause, or a poorly worded exit clause which would allow them to easily jump ship to a competitor? Are you saddled with a contract for a toxic player who's ruining the team's ability to win and attract sponsors? Investors should have an outsized focus on this area, because success depends highly on player skill, marketability and team synergy.

Trademark Filings

Branding an eSports team is just as critical as it is for a traditional sports team. If an acquirer intends to rebrand a team, an important first step is researching a name and logo that will serve as the primary trademark and service mark brand(s). In the U.S., trademark rights can only be obtained after commercial use begins. Therefore it's critical at the outset to perform searches to clear a proposed mark for use and registration. If an investor intends to keep a team's existing branding, then due diligence must be done regarding the team's existing name, logos, website branding and domain. This includes a review of pending applications or issued registrations, and any upcoming registration or other government trademark office filing requirements.

Since eSports is a global phenomenon, marks must also be researched and registered in key markets, including the European Union, China, South Korea and Japan. The U.S. and many other countries are parties to a treaty that provides priority filing dates tied to the dates of U.S. applications, however trademark rights are territorial. Just because a mark is available or registered in the U.S., that doesn't mean it is available elsewhere. In addition, most foreign countries grant trademark protection based on registration, which does not require use in commerce. For these and other reasons, foreign trademark searches should be conducted early on, ideally through local counsel who can opine on the results, and foreign trademark applications should be filed promptly after filing in the U.S.<</p>

Bad faith trademark filings in foreign countries, particularly China, also require a proactive global trademark protection plan, working with foreign trademark counsel and agents. Numerous countries, including the U.S., are parties to an international classification system, which requires trademark applications to fall into one of 45 classes of goods and services. Using this system, eSports investors can protect their marks in multiple areas beyond gaming, such as apparel, posters and streaming match videos.

Publicity Rights

Another important step is to make sure that you have rights to use each player's name, image, likeness and other elements for marketing purposes, because such uses can run afoul of state rights of publicity laws. These laws vary from state-to-state, and some do not require state residency as a condition of asserting rights, an important fact when dealing with travelling players and events in multiple cities. In New York, for example, publicity rights only apply during a person's lifetime, but they also extend to a person's actual voice. In contrast, California has a broad statute which also covers a person's signature and lasts for 70 years after death. As there are no major eSports players unions yet, player contracts must include publicity rights sections, especially if you have a star player who can help monetize the team's brand. Like any other professional sports league, it's much easier to get these rights now, but should unions be formed, the rights will be harder and more expensive to acquire.

Getting to the Finish Line

Many other questions abound. Some will seem granular in nature, but they can affect the team's viability. For instance, immigration specialists should be called in to review the temporary visa status of international players and administrative staff, and their ability to maintain that status going forward. Real estate concerns will also be prevalent, since many deals will involve the acquisition of a training facility, player living facility or a combined facility; or the assumption of a lease for the facilities. If the property is a combined facility, is it zoned for commercial use? And does it comply with local department of buildings requirements?

Whether or not eSports meets the vaulted growth predictions remains to be seen. But by thinking creatively, a savvy investor can position themselves for healthy returns.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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