CREATING AN EFFECTIVE OPERATING AGREEMENT

Jerry Merola, Chief Financial Officer
Amusement Entertainment Management, LLC

Whether you're an operator or a location owner, the importance of establishing an effective Operating Agreement for amusement games cannot be overemphasized. In the course of performing performance audits for operators and entertainment centers, our firm continues to be quite surprised at the intermittent use and limited scope of such Operating Agreements. Many operators comment that a fully-detailed agreement "scares away" potential business, while location owners indicate that they "want to keep their options open" in the event that an operator's performance proves to be substandard. Granted, many of these entities have continued to operate comfortably without a contract, and in some cases almost wish to ignore it, in fear that the establishment of a contract now will be met with rejection from the other party.

Do you absolutely need a contract? To adequately answer this question, consider some of the fundamentals of an effectively-designed amusement game agreement:

1. Confirmation of the Correct Legal Name and Entity of Each Contracted Party.

In the event that a dispute cannot be settled amicably between the parties, it may become essential to seek legal representation to uphold the terms of the agreement. In many cases, a default under an Operating Agreement has damaged one of the party's businesses, for which a monetary settlement becomes necessary. To insure the enforceability of the Agreement, however, the correct legal entity must be identified as having been a party to the Agreement. Additionally, confirm that the entity is not simply a "shell" corporation, otherwise any future legal action will probably yield little, if any, value in the recovery effort.

2. Detailed Schedule of the Type, Number, and Condition of Equipment Units to Be Supplied, Including Units For Future Rotation

From day one, disputes can easily arise between the parties over verbal promises and assumptions. A location owner may be shocked to find that some of the game units that have arrived are not "new" but "reconditioned". Others may be older, less popular units that pale in comparison to offerings at nearby competitors' facilities. As time goes by, fewer and fewer new games are rotated into the facility, resulting in a stagnant game lineup and a host of unhappy patrons.

Each of these issues can be avoided by identifying - in advance - each game and support component that is to be placed within the facility. It's important that a mutually acceptable game schedule be defined between the parties, listing all video, pinball, redemption, novelty, kiddie ride, and bill changer equipment to be provided. In this way, any deviations or substitutions will require the mutual consent of the parties prior to delivery. Take time to understand the differences between various versions of the same game, the revenue impact of utilizing larger or smaller cabinets, and the names of games that require frequent service or have a history of frequent breakdowns.

3. Define the Precise Location, Position, and Hours of Operation of the Amusement Operation within the Facility.

Things aren't always as they appear. What looks like the ideal site one day can quickly become quite unappealing as the contract wears on. Without a firm, written understanding of the location and placement of amusement equipment, the operator may find his or her equipment relocated to an alternate, less appealing area of the facility. In some cases, new attractions may take precedent over the games, and command the prime space once controlled by the game operation. Other concerns include a unilateral decision by the location to cut or restrict the hours or days of operation for the game areas, effectively limiting the games' ability to generate maximum revenues.

4. Frequency of Collections, Service, and Distribution of Proceeds

To prevent misunderstandings between the parties, always establish a standardized collection timetable within the Agreement, including the methods by which collections will be performed. If the collection will be performed under dual control, the Agreement must stipulate that each party provide an authorized representative at a time and day convenient to both parties. The amount of service provided should be dependent upon a predefined formula (i.e. - one hour per $500 of gross revenue) in an attempt to match the operator's labor expenses to the income potential of the location. The percentage split and distribution of proceeds should also be defined, along with penalties for late or partial payments. Should a non-payment condition result, the injured party will be have a greater likelihood of recovering lost proceeds via legal channels and minimize the chances of incorrect interpretation by the court system. Finally, any state or local gross receipt taxes and licensing expenses should be identified, and the responsibility for each allocated among the parties.

5. Identification of Each Party's Requisite Share of Operating Costs and Consumables

Many location owners are new to the concept of redemption and merchandise dispensing equipment. As such, they may not be aware of the ancillary costs of operating such equipment, including ticket purchases, merchandise and plush expenses, and added labor requirements. These costs should be identified within the body of the agreement, along with an established "mark up" formula for redemption counter merchandise. Our firm establishes a "mark up" formula that is specific to each location, thereby accounting for specific game payout percents, competition, and entertainment value. These guidelines must be followed to avoid "overcharging" an operator for tickets redeemed at a redemption counter.

6. Establishment of Performance Guidelines and Evaluation Criteria

Probably one of the greatest areas of dispute results from a misunderstanding over the acceptable levels of performance. A location owner may not understand why her location lacks several of the newly introduced games, and begins to apply pressure on the operator to comply. Conversely, the operator may be hesitant or unwilling to provide new or additional equipment based upon the location's flat or lackluster earnings performance. This deadlock does little to improve game performance, and in most cases results in a breakdown of the operator - location owner relationship. To avoid this, consider establishing a predefined criteria to measure equipment performance. This can be accomplished by establishing a minimum average return per game (if analyzing by group) or by calculating a per game return as a percentage of the game's market value. Regardless of the method chosen, the operator and location owner can now realistically analyze game performance and routinely make adjustments to comply with the standards. In the case of a strong earning location, this analysis will build the argument for increased investment in new equipment; in the case of a weak or deteriorating location, the parties will be able to identify the trouble spots and "right size" the game investment. In practice, this simple process has provided each party with the tools by which to work together, and most importantly, maximize the game operation's performance.

7. Creation of Permissible Discounting Guidelines

Discounting, by design, has become a standard within the family fun center market. Left unchecked, however, too little or too much discounting can permanently limit the potential of a facility and result in game earnings that fall well below realizable levels. Consider the facility owner that sells game tokens for $0.16 each (a 33% discount). Doing so can effectively build player participation, but if too large a percentage of tokens are sold at this level, the operator's share of game revenues may be insufficient to cover the debt service on the games and the cost of labor and repairs. Restricting the discount program too heavily will tie the hands of the location owner, and limit her ability to compete within the marketplace, further reducing game revenues.

To prevent such conditions, an Operating Agreement should identify how discounts may be offered (i.e. - through promotions, group packages, bill changers, etc.), the rate at which they are offered, and the maximum number of discounts offered (typically as a percentage of total token sales). Tokens sold at a discount in excess of these limits will be treated as full-paid sales, with the operator receiving his share based upon a token's full value.

8. Responsibilities of Each Party's Staff With Respect to Maintenance, Customer Service, and Security

As we all know, the success of any game operation is dependent upon the commitment of the operator and the location owner. With that in mind, each party must focus on offering patrons a quality experience that is both trouble-free and exciting. Inoperative or dirty equipment, unhelpful staff, and unruly patrons will negatively impact a guest's experience within the game areas and further erode revenues. Customer service is not optional, but expected from each party's employees. An operator's technician, while busy fixing an out-of-order game, must always attempt to assist a guest in need. Ditto for employees of the location owner. Simple issues such as to coin or ticket jams, frozen video screens, or spilled milk shakes should be handled quickly and efficiently by EITHER party. The Operating Agreement must, again, spell these issues out, otherwise a coin jam in the location's top game may render it out-of-order for days until a technician is scheduled to visit. The same holds true for security of the equipment: an operator's investment lies within the hands of the location owner, and as such, relies upon the location owner to insure that the equipment is not damaged or vandalized during business and non-business hours.

9. Provisions for Insurance In the Event of Loss, Damage, or Injury

As an operator or location owner, eventually something WILL happen. Fire, tornado, or mishap resulting in injury can occur at any time. To guard against catastrophic loss, each party must be adequately insured and be willing to represent same in the Operating Agreement. An injured party may likely file suit against the location, operator, distributor, and manufacturer. Is your client prepared for such an event? Are you? Short of negligence or willful misconduct on the part of an employee, have you indemnified or been indemnified against any and all claims, demands, judgements, damages, cost, or expenses resulting from or arising out of the use by any person(s) of the amusement games? If not, you will likely be named as a defendant in a legal proceeding. Given the costs of a defense these days, it actually pays to establish such an understanding now.

10. Agreement Length, Notification Requirements, and Exclusivity

An adequate agreement term is essential for both the location owner and operator. All too often, location owners comment that they would prefer "month-to-month" agreements, thereby leaving their options open in future periods. Operators on the other hand, routinely seek agreement lengths of 36 to 60 months, with automatically renewable provisions and option periods. While opinions will vary on this subject, I believe that at the very least, a 36-month term is necessary to encourage an operator to make a substantial investment in the location owner's facility. Naturally, the operator is gambling on the hopes that a three year minimum operating period will provide sufficient cash flows to service equipment debt and generate a reasonable profit. As an agreement reaches maturity, an adequate renewal/non-renewal notification period ranging, perhaps, from 30 to 60 days will provide each party with reasonable notice by which to adjust operations in a controlled, methodical fashion.

Most importantly, an operator who completely details his investment in specific equipment (as mentioned under "Detailed Schedule of Equipment") deserves the right to exclusivity. An operating agreement must protect against violations of exclusivity and establish the conditions of default - as well as the penalties resulting therefrom.

11. Events of Default or Breach, Remedies to Cure, and Damages Resulting From Failure to Cure

What happens when one party fails to hold up their end of the bargain? What are the responsibilities of the other party? As an example, what if the operator fails to provide service for two weeks straight? What if the location owner withholds payment? What if the equipment is constantly vandalized and the proceeds stolen? These are all breaches and/or defaults under a well-developed operating agreement, for which specific remedies must be enacted to effectively cure such events. If a cure is not forthcoming and the damaged party seeks legal intervention, the damaged party's rate of success is improved if the operating agreement has already laid out the guidelines for protection.

12. Establishment of Assignability Requirements For Change of Ownership or Venue

Recently, we received a call from a concerned operator who indicated that his top location had just been sold to an unrelated party. The new owners had brought in some of their own equipment and entered into an agreement with another vendor. As the operator lacked an Operating Agreement, he had little recourse to the seller or the buyer. A simple assignment provision incorporated into an Operating Agreement can mean the difference between losing a great account and maintaining it. An assignment provision should require that if the location is sold, moved, or transferred to new owners, that operator's agreement remain in force until its maturity. A buyout option can also be offered, allowing the seller or new buyer the right to "buy out" the agreement early based on a predetermined settlement amount (i.e. - 15% of the original game asset investment).

13. Determination of Governing Law, Exclusive Jurisdiction, and Venue

Sometimes the parties are unable to settle their differences without legal intervention. When enforceability of the agreement becomes necessary, it's critical that the laws of the appropriate state be utilized, along with exclusive jurisdiction and venue in a specific county. Otherwise, you might find yourself bringing suit (or defending yourself) in another state in which your current legal counsel is unable to represent you. For instance, the location may be based in Georgia, but its corporate owners may be based in Texas. A non-specific agreement coupled with effective lawyering can result in the matter being moved to Texas jurisdiction, resulting in substantial expenses (and headaches) for you.

When you're ready to develop a custom agreement, always consult a qualified attorney skilled in the area of contract law. By jointly developing an Operating Agreement, your counsel can more adequately represent you in the event of legal action. Consider an Operating Agreement to be a virtual road map through the term of your business relationship, and remember that a little work now can protect your investments - and your business - in years to come.