Where Is The Independent Money: The Venture Capitalist Edition

Even though game budgets are going up and the time to contract with publishers is getting longer, console developers still rely, almost exclusively, on publishers as their sole source of revenue. The same market forces which drove film studios to seek alternative sources of finance are at play in the game business. But the money is not here yet. I started writing this as the first installment of the search for independent money for game developers. VCs are my starting point, because they have been circling the industry the longest, and even made some successful investments over the years. In the middle of writing it I heard Bing Gordon left EA to become a partner at Kliener Perkins, one of the top venture capital firms in the world. If you read N'Gai Croal's faq with Bing, you will see, as a partner in the vc which backed EA, one of the fathers of the game business as we know it is not going to invest in the games we play on the console.

When I worked for Cooley Godward, the firm did a lot of work for venture capital firms and the companies they invested in. I just started working with game developers and the VC's started to read about Myst and Doom. Other attorneys in the firm who were doing real work and did not have time to play with my game clients would refer calls to me. The calls were always the same.

"I want to invest in some of that multimedia stuff. Who should I invest in?"

"Well I wouldn't give any money to anyone who would take it." was my standard reply.

"That's funny, now where I can put some money?"

"Well, if you want to fund Presto's next game it would be about a few hundred thousand dollars."

"That's not enough. Do you know it takes the same amount of time to track a multi million dollar investment as one of a few hundred k?"

"I know."

"Who will take more? "

"No one you want to give it to."

Some of them did find investment opportunities. Rocket Science, Crystal Dynamics, Digital Pictures, Anyriver Entertainment and a few others took their money. Contrary to reports at the time, Rocket Science founders said they really didn't buy a moon rock. Each of these closed their doors or sold at lesser valuations a few years later. The losses stung for a while and were attributed to the industry, when it was really the choices, not the industry, which was flawed. There has not been a significant investment in a US developer since.

VCs had invested in game companies prior to the developer investments, but these companies were truly disruptive and more portfolio than content oriented. Investments were made into EA and Spectrum Holobyte when games were distributed in plastic bags to computer stores. Ten years after EA, the same VCs invested in 3DO's effort to launch a new hardware platform. In the eyes of the VC's each of these was a success. Until Netscape, 3DO's 1993 IPO was one of the hottest to hit the Silicon Valley. The first open market trades were double the initial offering price. It was also one of the first non-biotech companies to provide VC's with public market exit before the company generated any revenue. This should tell you, they do not always define success the same way you do.

Some developers think they are perfect for venture capital. They create and own proprietary technology and upon success there is a disproportionate return. The risk can be further mitigated by track record. Developers who make great, best selling games, tend to make more best selling games. When was the last dog from Blizzard? Unfortunately, the VC's don't agree. The pat answer given to developers is "VC's don't invest in content. Game development is a hit driven business and we need leverageable technology." This works to get the developers to leave you alone, but it is only part of the answer.

From an investment standpoint, games are in fact the worst kind of content. If I make a film, I have the opportunity to recoup through theatrical distribution, television, cable, dvd's and even on line. If I have a bad game, I have an opportunity at retail, and that is it. If it does not sell, there is no library value and no secondary market. The technology side is not an awful lot better. When the VC's say leverageable, they want to know there is an opportunity for the thing they paid for, even if the thing they invested in does not pan out. Google search technology used to drive bright yellow servers? Viagra as an angina medication? These tech company missteps laid the groundwork for future opportunities. The search technology did not make sense with yellow boxes, but it turned out to be very ad serving friendly, and Viagra . . . . The investors did not get what they paid for, but the investment was not lost when the original goal was not achieved. If I make a great new animation technology or physics library, I may be able to leverage it into other games, possibly the animation business, but it is not likely to create a new billion dollar business. In short, in games, failure is FAILURE and the upside is not enough to interest a VC.

VC's need an exit in 3 to 5 years. Console game developers don't go from zero to Google in five years. Biodemic did sell for USD 860 million plus, and Rare sold for USD 375 million in cash, but these are really aberrations (any publishers interested in acquiring one of my developer clients should substitute the last portion of the foregoing sentence with "and these represent some of the only justifiable and rational valuations for developers in the history of our industry"). When a VC looks at a developer of console games, they see the opportunity to invest 10s of millions of dollars into a game, or game specific technology. If it doesn't work, the only value is the undepreciated value of the equipment in the shop. If it works, they can double, or if they are lucky, triple their money on a sale of the company.

You may notice I was only talking about console games. I was not talking about MMO's. VCs love MMOs. Red 5, Real Time Worlds, Perpetual, Turbine, Mythic and a bunch more are able to secure venture money because they are creating new game paradigms which are disruptive to the very lucrative, existing game business. There are comps. VC's love comps. Comps with exits while the market window is still open, be still my heart. Warcraft stands as a shining example of what can happen in success. If you think Warcraft can't be beat, you are not thinking like a VC. Remember when Yahoo was the king of search when Google launched? They see each MMO investment as the one which will topple Warcraft as number one. VC's are preconditioned to invest in MMOs from their experience in industries like biotech.

VC's have been investing in biotech for years. It is an industry where they will put hundreds of millions of dollars into researching a drug. If the drug shows efficacy in animals, research moves to humans. If it makes it shows efficacy through two phases of human testing, it moves into a blind study. When the blind is removed, if the drug is more effective than the placebo, it is worth billions. If not, you hear a large sucking sound coming from where the company used to be. One of my friends worked at biotech company with a product which made it all the way through the final round of testing. When the blind was removed they found the placebo was 50% more effective than the drug. I jokingly told him they should market the placebo. He did not think it was funny.

MMOs are more like Viagra than like console games. Developers of MMOs are raising tens of millions of dollars in capital to build a game. Unlike console developers, in addition to the game, they must buy or build technology and resources for q/a, customers support, billing, security, serving, distribution, marketing and a myriad of other tasks traditionally handled by a publisher. This narrows the field and makes success less likely - a barrier to entry. High barriers to entry into large markets make the reward great. The size of the reward is indicated by comparable companies. Any startup is going to to model success from the value placed on Blizzard in connection with the Actard deal. At every given opportunity, Activision executives identify Blizzard as the value in the relationship. Simple, superficial, press release math would ascribe a 9 plus billion dollar value to Blizzard's operation. Even assuming the accuracy of the rumored USD 100 million production cost of Warcraft, this is a nice return. The valuation does not stand alone. Asian MMO companies raised boat loads of money on the Chinese exchange. A lot of them remain cash rich, even after the collapse of the Chinese markets. While the equity value may have decreased, the games continue to operate on their very large margins. We can shorten this one by saying, an MMO is a lottery ticket and there is often room for one in the portfolio.

When you sit and scratch your head about why a widget maker like Slide can command a USD 50 million investment at a USD 550 million valuation, when Irrational Games sold for much less during the development of Bioshock, think about who is spending the money. Before you start to complain about VCs lack of vision, look in the mirror, many really are smart and really do understand exactly what you are doing. They are simply not interested. Your business is about as vibrant as a steel mill. VCs are looking for high risk, high return. A console game developer is usually either a startup offering high risk, low return, or a going concern offering low risk low return. It doesn't mean it is a bad business, just not for them.

If you really want to get their money, think about these things, because the VCs will:

1) Does your management team have proven execution experience in the roles they are taking in your company?

2) Is the idea already being done?

3) Are you disruptive to the current market?

4) Do you have a strong barrier to entry?

5) Do you have an effect way to attract people to your business?

6) Will you be building proprietary technology?

7) Will your customers pay money for your service?

8) How big is the market?

9) Is there a visible exit?

10) Is there an opportunity for to make barrels of money (10x return) a 3 to 5 year window?

If you make it through these questions with good answers, you are probably not building the next GTA and you may have a shot at VC money.


emufoot said…
Keith, Haven't spoken in ages, just wanted to say I stumbled across your blog, and it's a great read. Cheers, Stephen (RGM)

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