Kim-Mai Cutler wrote an interesting piece in Techcrunch this week about venture financing and the games business. Greatly simplified, her main thesis is that venture capital may not be the best vehicle for financing video game companies. In general, I agree with her – for the vast majority of game companies. Most game development should be financed through other means. I frequently tell entrepreneurs who pitch me a promising game idea that they will make more money by bootstrapping, or seeking publisher financing, rather than venture financing.
All Games Companies Are Not Alike
In order to understand why, it’s important to understand that there are really two types of startup companies in the video game business with two very different value propositions: pure content companies where the value and defensibility comes primarily from intellectual properties and the associated cash that flows from hits; and companies where the principle value is not based on IP but on something else, be it platform, or distribution, or audience aggregation.
Most companies in the first category – pure content companies, public or private – trade at relatively low revenue multiples, while companies in the second category can trade at multiples that look more like software-as-a-service enterprise companies or traditional venture-backed growth companies. Many venture capitalists have failed to understand the distinction, and have frequently ascribed growth multiples to pure content companies, with predictable results.
It is easy to see why this happens. A good free-to-play game developer can generate revenues and profits early in its company life-cycle that would make a SaaS investor drool. If you can convince yourself that the company with a big hit has attributes which nudge it into that prized second category, it can be hard to resist. Clearly Accel was thinking this way when they invested in Angry Birds developer Rovio, and clearly IVP, Atomico and Index felt this way about Clash of Clans developer Supercell. Time will tell if that judgment is correct.
Adding further complexity, companies in the second category, companies where the value proposition is not entirely based on cash flow from hits, often develop and publish game content, too, and frequently rely on cash flow from hit games. Further, all game companies are susceptible to Marchetti’s Second Business Law: “All growth companies eventually become cash flow companies; you just want to be really huge when that occurs because your multiple will compress.” This happened to EA. In the packaged goods heyday, they were a really valuable distribution and publishing platform, and were valued like a growth company at more than 5X revenues. In the last decade, their competitive advantage in retail has become far less relevant, and they now trade more like a cash flow business, at just over 1.5X revenues.
The Importance of Sustainability
So how does a venture capitalist sort out this complexity? For me it always turns on the sustainability of the company’s competitive advantage. This seems obvious but it is remarkable how often it is ignored.
In the pure content business, sustainable hit creation is really, really hard. It happens, but in the hyper-competitive, multi-platform modern games business, it doesn’t happen very often or for very long. Usually when you see examples of longer-term competitive advantage through content, there is something else going on – for example, id Software’s 10-year run with Wolfenstein, Doom and Quake was predicated on a sustainable lead in 3D graphics technology combined with leading-edge first person shooter design. You could see similar patterns in Pixar’s meteoric rise to dominance in feature film animation. Remember, they were originally a hardware company with proprietary 3D rendering technology.
In the second category, competitive advantages in distribution, plaform or technology can be used to leverage and reinforce a content business in ways that create sustainability over time. This was true for EA in the 90’s, when their astonishing retail distribution muscle allowed them to invest in the EA Sports brand, and that brand further solidified their retail power. More recently, Valve’s Steam platform has benefitted from players who signed up to Half Life, Portal, and Team Fortress; having a powerful platform with lots of users attracted great third-party content for distribution, which allowed Valve to diversify content risk for their overall business. They make higher margins on their own content, but they don’t have to rely entirely on that content to drive revenues quarter after quarter. In my own case, we built JAMDAT into a powerful distribution platform in a high-friction mobile environment, then pumped great content like Tetris and Bejeweled through the platform to create outsized growth and profits – content we were uniquely able to afford because of our distribution power.
The Zynga Problem
A large portion of Cutler’s essay is devoted to Zynga. Everybody who has a vested interest in the next-generation games business is suffering from the current problems of Zynga as a public company. In the West, Zynga’s performance has negatively affected the whole next-generation video game business (this is not the case in Asia, where appetite for games companies among public investors is still strong – vis Gungho, which added $12 billion in market cap in the last 6 months). According to Yahoo Finance, Zynga’s trailing twelve months Enterprise Value to Revenues ratio is less than 1X. The Street doesn’t even see them as a very good cash flow business, let alone growth business.
The real tragedy is that Zynga had a chance to be in that second category of companies if they could have harnessed their incredible distribution and audience aggregation advantages from early in their life-cycle and created long-term sustainability. The big risk for Zynga early on was whether Facebook would press their platform advantage and squeeze Zynga’s margins directly (through revenue splits, ad costs and limits on virality), and indirectly, by encouraging competition. When it became clear that Facebook didn’t care about their games platform, and was prepared to let Zynga roam free, Zynga had one of the greatest growth runs I have ever seen.
But two things happened. First, Facebook lost a ton of altitude as a games platform, through lack of innovation, the fact that playing games on Facebook lost its original novelty, and from outright indifference. Zynga was, by that point, inextricably bound at the hip to Facebook, and got dragged down with the overall Facebook games market. This is not unusual – it happens all the time when companies become overly reliant on a single distribution platform. It’s happening to GREE and DeNA in Japan today as the smartphone revolution eliminates the need for feature phone portals.
Second, Zynga never successfully leveraged their unprecedented audience power outside Facebook. Zynga always made better games than people gave them credit for, but they were never true content innovators. Their success was very much the product of their enormous audience. But that audience did not translate to competitive advantage on mobile, where competition was much more fierce and distribution much more tightly managed by Apple’s App Store, or in core, where design was at a premium. The failure of HTML5 as a bridge technology from the web to mobile didn’t help. Mobile required native development, which was an altogether different skill set held by altogether different talent.
These are problems with Zynga’s strategy, execution, and leadership, not problems inherent in the games business. All businesses experience platform changes and customer acceptance risks. How you navigate those changes and risks is the measure of the forward multiple you deserve. Wall Street is not currently convinced that Zynga has navigated them well, or will in the future. That doesn’t mean that games companies can’t create venture returns – in fact, if Kleiner Perkins had let their Series B investment in Zynga ride, they would have a very respectable 5X return even today. And I really don’t think Zynga’s unique predicament means that the public markets will be closed to games companies forever.
The Venture Opportunity in Games
At Benchmark, we invest when we see the outlines of sustainable competitive advantage, as we did with JAMDAT‘s feature phone distribution business (acquired by EA for $680MM after a successful IPO; still a leading market share player on iOS and Android as EA Mobile), Riot Games’ invention of a new genre with League of Legends (acquired by Tencent for $420MM and still growing like crazy), Gaikai’s cloud distribution platform (acquired by Sony for $380MM and integrated into the Playstation 4 platform next year), Natural Motion’s unparalleled 3D character engines and 3D design (which produced industry-leading revenues in 2012–3 on CSR Racing and My Horse, and which you’ll see in it’s best expression in Clumsy Ninja), Jenova Chen’s John Lassiter-like storytelling and multiplayer innovation, or Meteor’s Storm Cloud platform (currently hosting Hawken, the free-to-play shooter). We’ve tried to support games companies which we believe can create venture returns, regardless of current fashion.
These are outliers. For most games companies I see, venture funding is, as Cutler correctly argues, not the right fit. Alternative methods, like publisher financing, or dividend-based rather than equity-based payouts, could work great for pure content companies. These models would help investors capture value without reliance on a big-dollar exit, and would distribute hit-risk more equitably.
But for the other kinds of game companies, companies that can put capital to work beyond content development, venture is an ideal vehicle, and, at least in Benchmark’s case, an available one.