Does The Venture Model Make Sense For Gaming Anymore?

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Just about eight weeks ago or so, I was on a call with Zynga’s COO David Ko following the company’s first quarter earnings report. Zynga was trying to manage expectations for the coming two quarters by saying it had paused its game slate to re-evaluate every upcoming title on the table.

I can’t remember the exact question I asked, but it was something like, “Finland’s Supercell made $104 million in profit on a headcount of 100 last quarter while you made $4 million in net income with roughly 3,000 people. Does your headcount and structure make sense?”

Ko, who has a reputation as a savvy operator and is very media-trained, dodged the question saying, “We’re the biggest believers in social gaming across all platforms. This year, we will measure our progress by our ability to bring existing franchises to mobile while maintaining profitability.”

However, even if some Zynga employees were caught off guard by this month’s layoffs, the writing was very clearly on the wall. A company that had grown up built for one platform (Facebook), wasn’t well-adapted for the realities and economics of building titles on Android and iOS.

They aren’t the only publicly-traded Western gaming company grappling with major platform shifts affecting the entire industry. In the first half of this year, both Zynga and EA have shed roughly 1,500 jobs. While their situations are unique, both rounds of layoffs have to do with the stagnation of gaming platforms like consoles and Facebook against the rise of iOS and Android.

While there are plenty of emerging mobile gaming companies like Supercell and King, the situation raises a question I’ve been thinking about for the last several months.

Is the venture model of funding gaming companies, which prizes a large exit through a sale or IPO and rapid growth, well-suited for a new world where companies can rise and fall as quickly as their hits climb and tumble off the charts? Are we in a period where new incumbents will rise up and eventually hold on to their dominance, or are we in a new era which is just inherently more chaotic and unpredictable?

Zynga, which took around $850 million in venture funding, put huge pressure on itself to grow quickly. In Zynga’s fastest-growing days, the company was adding several people a day. That has ultimately made it difficult to maintain a cohesive company culture and adapt to rapid industry shifts.

Toward A Dividend-Based Model?

While gaming startups may need some initial capital to market their titles, they can throw off lots of cash if they’re successful. Meanwhile, the IPO door is closed in the short-term because of Zynga’s lackluster debut, and the market for large nine- or 10-figures exits is quiet as giants like EA and Zynga re-strategize. At the same time, while barriers to entry are rising, the network effects that the biggest companies have aren’t as strong as they used to be in the console era where relationships with retailers and distributors mattered.

I’m not the only one who is thinking this way. Perhaps with fewer exit opportunities and lots of potential cash flow, dividend-based returns just make more sense.

On a call last week with longtime EA executive Neil Young, who sold early mobile gaming company Ngmoco to DeNA for up to $400 million and is now on a new non-gaming startup N3twork, said that gaming financing needs to be rethought.

“The restaurant financing model might work for games. You could get a payback through a new split of dividends,” he said.

Then there are smaller investment firms like iVentureCapital out of Hamburg, Germany, a traditional hub for browser-based gaming companies, that has backed gaming companies like Kamcord and is open to earning dividend-based returns.

Still others are experimenting with contracts for revenue share instead of outright ownership. Rizwan Virk, who co-founded and sold Gameview Studios to DeNA, then invested in Tapjoy, Pocket Gems and Funzio, which was eventually acquired by GREE for $210 million, said he’s been asked by developers in the last few months for advice on how to structure these kinds of deals. He added that each case is really unique and that he doesn’t have a blanket recommendation for going one way or another.

“What’s happened in the last six to 12 months is that VCs and even a lot of super angels aren’t investing in as many game startups anymore. So the companies with funding — the ‘haves’ like the VC-backed startups and big mobile guys — are turning into publishers or funders of games in exchange for a revenue share with the developers, or the ‘have nots’,” Virk said. “This becomes a way for developers to not give up a big chunk of the company for a relatively small amount of money.”

There are also several very successful mobile gaming companies like Minecraft-maker Mojang and Temple Run-maker Imangi Studios that have gone for years without taking outside venture funding.

Why might a dividend- or revenue share-centric model make more sense? Here are a couple factors to consider:

Haves And Have Nots

One dynamic that’s been interesting to watch as the mobile gaming industry has matured over the last couple years is a mutual disdain that certain gaming founders and venture investors have for each other.

Studios that are successful can throw off in excess of $1 million per day. (Supercell last said it was earning $2.4 million per day. That’s like printing a Series B round every week.) So the “haves” definitely don’t need funding. If anything, many of the rounds that have happened over the last few years like with Rovio and Supercell, have been secondary — meaning founders, early investors and employees took cash off the table. The capital didn’t go into the companies.

At the same time, other studios like Temple Run-maker Imangi Studios, Minecraft-maker Mojang, Backflip Studios and Subway Surfers-backer Kiloo, haven’t taken funding because they haven’t wanted it or the terms weren’t right.

And the “have nots,” whether they’re companies that have yet to see a major hit or need cash to keep going in a lull, obviously find it hard to raise on decent terms. Booyah, an early, hyped mobile gaming company founded by Blizzard alums and backed by Kleiner Perkins and Accel, is on its third CEO in two years.

Certain top-tier venture investors, likewise, can be wary of the hits-driven nature of the business. Greylock doesn’t have a mobile gaming bet, although their China fund does with Hoolai. Sequoia hasn’t publicly made a bet on a mobile game development company since Pocket Gems in 2010, although they’ve backed educational app makers and players that help the broader ecosystem monetize like Chartboost.

The concern is that with a hits-driven business, an investor might come in with too large a valuation if they price a company at its peak. The company could later fall off if they don’t have other follow-up hits.

Because of the hits-driven nature of the business, you could even say that Supercell took a knock on its valuation. At a $770 million valuation, the company was priced at only about 1X its annualized revenue based on the $179 million it made in the first quarter of this year. Then at a $2.27 billion market cap, Zynga is valued at only $600 million more than the cash, short-term and long-term investments it had on its balance sheet at the end of March.

Equity Structure

Secondly, the normal equity breakdown — which is a perennially touchy issue for any company — makes even less sense for a gaming company.

In a business with really strong network effects, like a marketplace like Airbnb or a social network like Facebook, the first 20 employees almost certainly have more impact on the trajectory of a company than the 1000th or 1500th employees, who arrive once a company has momentum.

But in a gaming company, which by nature has lumpy and unpredictable revenues, a 500th employee is arguably equally capable of producing the next great multi-million or billion-dollar franchise as the 50th. So the reward structure has to reflect that. It probably has to differ from the large equity drop-offs that you would normally see between earlier and later employees in a typical venture-backed company. At this point, Zynga is going to have a hard time recruiting the best talent in the world given the layoffs, the present size of the company and the earlier PR nightmare it had with equity clawbacks.

Companies like Supercell are trying to fight this dynamic by building a strong culture that prizes talent and creative risk-taking. In their secondary round earlier this year, they gave all employees the opportunity to take roughly 16 percent of their stake in the company off the table.

The Exit Market

Lastly, it’s hard to read the tea leaves right now and understand whether the IPO market is just in a temporary lull for gaming companies, or whether there is something more long-lasting and structural at play.

Right now, it’s difficult to make the case for any freemium gaming company to go public unless they can prove they have a model that defensibly and reliably produces revenues and hits. With the decline of their player base on the Facebook platform, Zynga’s debut has damaged short-term IPO prospects for other gaming companies. Competitors like Kabam have released basic earnings figures to send a message to public market investors that the whole category isn’t bad.

But the two or three companies that might have a shot at an IPO have too short a track record. Supercell has two games, Candy Crush Saga-maker King only came to mobile platforms last fall and Kabam has been on iOS for a year and a half. The exit market for large acquisitions in the West is also quiet now as EA and Zynga go back to the drawing board, and Japanese companies like GREE and DeNA work through their last round of U.S. deals.

Public market scrutiny has also been tough for Zynga as it works through this transition. The amount by which their shares have sold off has to be intimidating for any gaming CEO considering listing in public markets. For a lot of companies that want to preserve their unique cultures like San Francisco-based midcore game maker Kixeye or Supercell, it just makes sense to stay independent and private for the foreseeable future.

So we’re looking at a host of companies that have stayed private, generate huge amounts of cash and may stay that way for awhile. What this means for investors and employees is that they’ll have to sit tight and wait for the M&A and IPO market to heat up again. Or financing will have to change, so that stakeholders can be rewarded in a different way.

There Are Still Believers, Though

To be fair, nine out of the top 10 grossing games in the U.S. iOS market today are from venture-backed or publicly-traded companies. Funding from top-tier firms does tend to go toward really good teams. Plus, with marketing and production costs rising, many gaming companies do need capital to start off.

Yet no money comes without strings attached. While Supercell is conscientiously trying to hold off the pressure to grow too fast, the investors who went in on the last round — IVP, Atomico and Index — are effectively betting that the company will be worth at least $2 or 3 billion some day. And Kabam, which has taken at least $125 million in funding, may be too large to be acquired at this point and may have to wait for the IPO market to clear.

But for gaming startups being founded today or for investors looking at the space, the market seems ripe to find new ways to fund creative talent.