VC investment in the games industry

By November 23, 2010Games

I attended a lunch event today kindly hosted by law firm Osborne Clarke and Nicholas Lovell (co author of our “50 questions you should ask before raising venture capital” series of blog posts – next instalment tomorrow on Nicholas’s Gamesbrief blog).  There were about twenty of us at the lunch, with a roughly equal split between games entrepreneurs and VCs, and the aim of the event was to stimulate dialogue between the two sides and start to eliminate some misunderstandings between the two groups.

As an aside, when I played back the conversation in my head it seemed to me that the communication gap between VCs and games entrepreneurs is a variant of the gap between VCs and all entrepreneurs.  From the entrepreneur side that gap is usually described as a lack of risk appetite from potential investors, or sometimes a misunderstanding of the level or risk involved, and from the VC side we often feel that the entrepreneur sees less risk in her business than we do.

On the back of the lunch I thought it might be helpful to set out some of the characteristics that make a games company attractive for venture investment.  A couple of caveats are in order first:

  1. This is only a guide and it is more than possible that DFJ Esprit, or any other fund, would make an investment in a games company with none of these characteristics
  2. Many companies won’t need investment by the time they develop the characteristics I describe, and earlier stage funds than ours might work with a shorter list, and in particular they may by happy with less evidence of success
  3. The characteristics I describe below are supplementary to the standard venture requirements for big market, good product and great team – in fact they are probably best viewed as indicators that the market is structurally attractive (as opposed to merely ‘big’)

For me the quintessential VC games investment is in a games developer/publisher that is one of the first to exploit a new platform.  Patrick O’Luanaigh of nDreams gave a brief talk at the lunch and he identified being early to a new platform as one of four viable strategies for games businesses.  I would agree with that, and even go a little further and say it is the best strategy, provided the platform is an attractive one.

Startups that have recently been successful with this strategy include:

  • ngmoco, early to the iPhone, recently acquired by DeNA for $303m (plus $100m earnout) on 2009 revenues of $3.2m
  • Zynga, early to Facebook, still private, but slated for IPO with shares trading at a $5.5bn valuation (this may well be artificially inflated due to the limited number of shares available)
  • Playfish, early to Facebook, acquired by EA last year for a rumoured $300m (plus $100m earnout)
  • Jamdat, early to mobile, IPO in 2004 which took it up to c$800m in value.  Jamdat was alter acquired by EA

By now you might be wondering what makes a platform attractive – I would posit the following:

  • first, the obvious one – size – to get the big exit you have to believe that tens or hundreds of millions of people will play games on the new platform
  • a reason to believe a startup can prevail versus larger and better funded competition – that often takes the form of some insight or knowledge about the new platform which larger games companies will take a while to figure out – with Facebook that was a combination of the idea that new and exciting game mechanics were made possible by social, an understanding that Facebook offered a viral distribution model, a view that social networks would be huge for games, and an idea that games could be monetised by virtual goods
  • the ability to launch a handful of games within the lifetime of the investment – one of the attractive things about new platforms is that game development costs start low and only rise once the success of the platform has been proven
  • some early success, both for the company and the platform – in practice this usually means one or two games launched
  • a view that the platform will be stable and that the platform owner won’t be able to appropriate all the value for themselves – with new platforms that usually means there are alternatives to choose from, be they multiple social networks or multiple mobile platforms

There are a couple of categories of games company that we have been looking which don’t have these characteristics and that I want to call out as also being attractive – firstly companies selling software to the growing ranks of independent games developers, and secondly games developers/publishers with a new angle on mature platforms (e.g. I was talking to a guy today who is building a social games company which sounded interesting despite the fact that the Facebook platform is mature – his angle is localisation of games for non US markets enabled by incredibly detailed analytics).

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  • Jof

    2009 revenues for ngmoco $3.2m?? Surely not that low?

  • I was a little surprised, and the number may not be accurate. That said, they only got started that year.

  • I’ve been thinking about this over the long weekend here and I’m still bothered by your position in this post.

    I can’t argue with the opinion that being early to a platform is a good strategy for a quick exit and high returns. I’m not sure it’s the best strategy for building a long-term business with high margins, strong culture, sustainable revenue growth, etc. None of the examples you list have yet demonstrated such a long-term business, and only Zynga still has the chance. Jamdat came closest, but if you read their filing statements you’ll know that their margins were eroding and they were entirely at the mercy of the carriers and IP owners (like everyone in the mobile games ‘1.0’ business).

    It seems to me that having a thesis of ‘you must be first to a high growth low-barrier platform and get big there quickly’ is a sure way to shut down investment in games during periods where there is no such platform or ‘new wave’. Facebook and to some extent iOS have been extraordinary opportunities to profit from large installed bases and distribution platforms that are very generous with user acquisition and revenue share. Such opportunities do not come along often; does that mean that games remain poor investments during such times? Maybe it does, but that’s rather sad.

  • Maybe I made my post too black and white. As platforms mature it definitely gets harder to build a large VC backed business – largely due to rising competition and game development costs – but certainly not impossible.

    Investment at a larger scale than works for VCs becomes possible, as do new ideas/approaches (I think I mentioned an analytics based approach that is interesting now).