The End Game: How Top Developers Sold Their Studios - Part One
March 3, 2004
In November 2002 Angel Studios was purchased by Take Two for $28 million in cash and 235,000 shares of stock. A month earlier Activision purchased Luxoflux for $9 million and 110,000 shares of stock. That same year Infogrames (now Atari) purchased Shiny for a surprising $47 million, and who can forget Microsoft's purchase of Rare for a whopping $375 million? And the list goes on: Massive Entertainement, Rainbow Studios, Barking Dog, Black Box, Shaba Games, Gray Matter, Treyarch, Outrage, Volition, Digital Anvil, Westwood Studios, and more. All have been purchased by a major publisher and experienced the thrill of the end game.
For many developers, selling their studio is the final prize for a race well run. But what do you really know about how a deal goes down and whether or not you are a good prospect? What is it that will make your studio attractive? How will your company be valued? And perhaps most importantly, what can you do to prepare?
In this two-part series we will discuss the acquisition process as it relates specifically to the game industry. It is based on interviews with key executives from both sides of an acquisition transaction: independent game studios who have been purchased and the publishers who purchased them. Interviews were also conducted with attorneys and investment firms that deal in mergers and acquisitions within the game and software industries. And finally, research was conducted to quantify specific transactions and acquisition details.
In this first segment we will explore the relationship between developers and publishers and the motivations of each to enter into an acquisition. Beginning with a condensed history of game developer acquisitions, which you will find surprisingly informative, we will then look at why developers sell their companies and why publishers are interested in buying them.
In the final part segment, we will then look at how a developer's monetary value is determined, how the deal is put together, and what can go wrong during the acquisition process. We will end the series by considering the future and what the prospects might be like for you to one day play The End Game.
You should understand that mergers and acquisitions are complex business relationships that require the help of legal and accounting professionals. The information contained in this article is intended to give you a basic overview of this process as it relates specifically to the interactive game business. Neither Dan Lee Rogers nor BizDev, Inc. makes any representation or warranty of any kind, whether expressed or implied, with respect to the accuracy or completeness of the information. All information is provided on an "as is" basis, including, but not limited to, warranties of merchantability, non-infringement, or fitness for any particular use.
Acquisition History in the Game Industry
Much of the information included in the table below was collected from financial data released by publishers as required by the Security and Exchange Commission (SEC). Notwithstanding this, I am thankful for the input provided by numerous individuals as well. Please note that information from non-public sources is speculative and presented only in an atmosphere of more fully understanding the dynamics of the industry.
By overlaying the acquisitions in this table with major industry events (such as the introduction of the PlayStation 2) you can imagine how environmental factors could have affected each transaction. Microsoft's purchase of Rare in September 2002 could be an example of this.
$375 million dollars in cash (the purchase price of Rare) is the most paid for any developer to date. Although Rare was a proven developer of hit games, it appears to be an unusually large sum for a development studio. However, when you consider environmental factors, such as Microsoft's goal to establish itself as a premium console manufacturer (Xbox), it is more easily understood. Rare not only added positive net income to Microsoft Game Studios, but it helps secure their position in the console market. And if indeed this goal is met, then not only will the acquisition have a positive effect on Microsoft/Rare's future product sales, but on the sales of all Microsoft Xbox products.
* Information speculative
Why Developers Sell Their Studios
Without surprise, financial security is the most common reason for independent developers to sell their companies. But this should not be confused with a take-the-money-and-run scheme where one sells his company and retires to a beach in the Bahamas. Occasionally a developer will leave shortly after an acquisition, but in general this is not in line with a publisher's expectation. Publishers expect to see a significant return on their investment, and acquisitions are structured to ensure this through the continued participation of key employees.
Many of the developers we spoke with sold their companies out of growing concern for growth and the complexities of working with multiple publishing partners. Generally, their collective motives fell into these categories:
- Concern over growth
- Concern over technology changes
- Leverage marketing and distribution
- Benefits for employees
- Personal growth
Concern Over Growth
Many developers who have sold their studios concluded that a single publisher partner was necessary in order to simplify business relationships and provide long-term financial stability. Also, an underlying concern was that their selling-price was at an all-time high.
As one developer explained, "As your size grows dramatically, projects can get behind and publishers may refuse to pay, some may cancel projects, and others may go out of business. When you're smaller it may be possible to weather these events with personal cash, loans, etc., but as a larger developer a "Perfect Storm" of these events can deliver a really serious blow".
For a developer, sustained growth becomes increasingly complex and risky as the studio grows, since most publishers require non-compete agreements that prevent them from working freely within the industry. To keep teams busy, they often worked with publishers that were less stable financially then themselves. So as their burn rate increased, mistakes and wrong turns were more costly and deadly.
The transition from one console generation to the next is a powerful catalyst to secure business relationships.
For some, during the transition from PS1 to PS2, their motivation for selling was based on concerns about the implications of technology changes. One developer put it this way: "The amount of time it took to develop a game was doubling. The amount of people it took was doubling. Hence the cost was going up about five times. And yet the cost of the software was unchanged if not descending. So the risk on each product was going up and the potential profit per person per year was going down. We sold the company partially to mitigate that risk."
As we move into the next generation of console systems (PS3 and Xbox 2), many developers believe it will be harder and more costly to develop and maintain leading-edge technology. This is especially true when you consider that publishers such as EA and others are investing millions of dollars in technology that can be used throughout their company. In the future, the ability for an independent developer to compete primarily on technology may be more difficult, and this could encourage some to look for secure publishing partners.
Leverage Marketing and Distribution
For other developers, especially in the formative years of the industry, distribution and marketing needs played a significant role in their decision to sell. Papyrus, as example, had built strong development and marketing teams, and initially sold their products through Virgin Interactive (via a 3rd party distribution deal). After Sierra acquired them in 1995, sales and profits increased due to Sierra's strong distribution channel and in-house manufacturing.
All of the developers we spoke with were concerned about the long-term welfare of their employees. As a small company, it was challenging to provide the level of health insurance, job security, and retirement benefits offered by publishers. Additionally, since many had distributed stock or options to employees, the liquidity of this benefit was ultimately dependent on an acquisition.
Personal Growth and Achievement
A less tangible but equally compelling reason for selling was the realization of a life-long dream. Most of the individuals we talked with had been in business for several years prior to their acquisition. Selling their company was a benchmark both in self-actualization and industry recognition of their achievements.
Why Publishers Purchase Game Developers
Publicly owned publishing companies have an insatiable appetite
for growth and net profits. Each is on a full-time mission to increase
their revenue, trim their operational costs, and take the advantage
from their competitors. Like a global sports game, they are engaged
in a winner take all competition for the hearts and wallets of game
consumers. If your company can assist them in this endeavor then
you could be an acquisition candidate.
But until a publisher sees material value, there is little chance that you'll find an interested partner. Publishers generally purchase developers for these reasons:
- Development expertise
- Financial growth
- Competitive advantage
- Proprietary technology
- Intellectual property
Most publishers are interested in working with teams with proven capabilities, and they tend to acquire developers with whom they have worked with in the past. For most, they purchase studios in order to increase or upgrade their development ability, and all the publishers we spoke with agreed that the talent, the culture, and the experience of the team were among the most valuable assets a studio could offer.
A driving reason for purchasing an independent developer is to increase the publisher's net income. Since a public company's performance is measured by growth and profitability, if, by acquiring your company, they can increase net profits they are rewarded by their stockholders and the Stock Market. The higher the perceived value, the higher their stock price. The higher the stock price, the more money the stockholders will receive.
This point can be illustrated using our previous example of Rare and Microsoft. Prior to its acquisition, Rare had sales averaging 1.4 million units per title, with more than 90 million units sold since the company was founded.i If we assume that Rare is capable of continuing to deliver 8.4 million dollars annually to Microsoft's bottom line in the future, then this would reflect positively on Microsoft's annual net earnings:
1.2 Million Units Annually (slightly lower than their sales average)
× $35 Wholesale Price per Unit
× 20% (An estimate of profitability per unit)
= $8.4 Million Dollars Annually in Net Income
For Microsoft, $8.4 million dollars in additional annual net income is fairly insignificant, but if you consider that their investors value every incremental net income dollar at a multiple of 21.77 times that numberii, it is more meaningful. Loosely defined, this revenue stream is valued by Microsoft shareholders at $182,868,000 (21.77 × $8.4M). While this is still far below the $375 million that Microsoft paid for Rare, it does help explain how positive net income is valued.
Publishers also grow by opening new markets and genres. For example, although Electronic Arts dominates the sports genre they have little penetration in the 3rd person action genre (Crash Bandicoot, Spyro, Ratchet and Clank). If EA believed that they could earn significantly more revenue by competing in this market, it could be motivation to purchase an independent developer that specializes in this genre. The more profitable the developer, the more attractive they would be.
Finally, financial growth can also be obtained by acquiring a team to which a publisher has major financial commitments, most often in the form of on-going royalty payments. Electronic Arts' acquisition of Black Box may fall partially into this category. Black Box was the independent developer responsible for EA's hit series Need For Speed, and no doubt, EA was paying Black Box significant royalties as a result.iii By purchasing Black Box, EA recaptured these royalty payments and acquired a proven development team.
It is often advantageous to purchase a developer that has been
successfully operating in a space where a publisher is having difficulty.
It is even more attractive if by doing so they can take market share
from their competitors or make it more difficult for them to compete.
Activision's acquisition of Infinity Ward in January 2003 accomplished
just this. A significant number of Infinity Ward's staff came from
Electronic Arts where they were key developers on the hit product
Medal of Honor. By acquiring Infinity Ward, Activision not
only secured a proven team of specialized developers for their own
World War II series, Call of Duty, but they also struck a
blow to EA.
Developers who own technology that publishers perceive as superior are often candidates for acquisition. Such was the case with Luxoflux. Activision was attracted to Luxoflux based appreciably on their cross-platform technology and their ability to bolster Activision's internal development capability.iv
Proprietary technology is attractive to publishers, but it is often weighed against a make-or-buy decision. Electronic Arts, more than any other publisher, is capable of developing highly advanced technology in-house. But if a developer can help them enter a market more quickly, then it can be a catalyst for purchase. Jerry Bowerman, chief operating officer of EA Vancouver, felt strongly that even in light of EA's capabilities, technology was still the key, "If they don't have a non-compete, and they own the technology, and they shipped a hit, then they are going to get acquired."
Sierra's purchase of Headgate Studios is an example of this. In 1996, when Headgate was purchased, Sierra was expanding its Front Page Sports line of products. Although Headgate had not yet shipped a game, Sierra believed that Headgate's golf technology would allow them to enter this segment of the sports market more quickly and with less risk. For them, the purchase was justified based on future sales in a genre where they had no prior presence.
When Electronic Arts purchased assets from Virgin Interactive in 1998 for $122.6 million dollars, they were interested in the properties created by Westwood Studios, and in particular, the Command and Conquer franchise. Command and Conquer has been one of the best selling real-time-strategy games of all time, and by adding it to their portfolio, Electronic Arts immediately became a leader in this category.v While $122.6 million dollars was sizable, EA could justify it based on forecasted sales of it and other Westwood properties. Ownership of Westwood's IP was a key to the acquisition.
The acquisition of DMA gave Take Two ownership of Grand Theft Auto franchise, which proved later to be an incredibly profitable purchase. Sierra's acquisition of Papyrus was based substantially on the license that Papyrus had negotiated with NASCAR. And perhaps the most recent example of an acquisition motivated by a license is that of Shiny by Atari for $47 million dollars. Atari was keenly interested in acquiring the rights to The Matrix, so much so that they took out a loan in order to finance the purchase.vi
Dating and Marriage
Developers often refer to their publisher relationships using the analogy of dating and marriage. One developer told us that when a publisher and developer sign a development agreement for a single product, it is very much like a first date. At this point neither party knows too much about the other. Their attraction is based on what they perceive the other can do for them, and the date can either go well or terribly wrong. If it goes well, then there is likely to be a second date, a third, and perhaps, if the two continue to find each other attractive, marriage (or acquisition). Our developers cautioned young developers to consider every project and relationship a potential marriage. They advised others to "end well" on every project, since one never knows if the relationships forged on one of these "dates" might turn out to be something more permanent.
One of the most significant aspects of an acquisition is the permanence of the relationship. Once an acquisition is competed, it is nearly impossible to unwind the relationship. Borrowing from a well known expression affords us the ability to pass on a bit of wisdom: What two companies join together is nearly impossible to pull apart.
Because of this permanence, certain aspects of the relationship should be carefully considered:
- Employees and redundancies
- Deal structure and performance incentives
For both publishers and developers, culture is an important component of the purchase decision. EA's Jerry Bowerman explained it this way, "…we look at culture very carefully. What would happen if we purchased a company that had been in business for years and during that time they never worked on the weekends? Here at EA we do whatever it takes to get a product out on time. So that would cause a lot of problems for both of us."
Not only is the work schedule an important aspect of culture, but issues can include whether employees have private offices or cubicles, whether snacks are free or paid for by the company, whether the Christmas party is small or elaborate, and literally hundreds of other subtle procedures and policies. No matter how insignificant these may be, all contribute to the heart and soul of the developer's culture.
Both parties want to make the transition as easy and painless as possible, since distractions are costly, translating into poorer product and late deliveries. The two must carefully consider the operational procedures of the other and whether their marriage will work. If in the process of an acquisition a publisher destroys a developer's culture, then they end up killing the very thing that they worked so hard to get.
Stuart Moulder, Microsoft's GM agreed. "Assume that most publishers are purchasing a developer to gain the benefits of the developer's creative talent (rather than just for IP or some other reason). Then a publisher needs to understand the developer's culture, respect it (it's that culture that is at the heart of the developer's success) and its people."
Independent developers are used to calling their own shots, making decisions quickly, and taking risks in order to grow their companies. For many, the idea of having to report to a "manager" is foreign and troublesome. But, once a developer is acquired they are likely to lose a significant amount of the freedom that they enjoyed as an independent.
For Rainbow Studios, one of the prime attractions to THQ was that Rainbow would be allowed to work autonomously. At the same time, Mark DeSimone (Rainbow President) also knew that Rainbow would be giving up ultimate control, especially in terms of the products they would be allowed to build. But they were reminded that in the process of working as an independent studio, they were dependent on their ability to convince someone other than themselves that their ideas were sound. So things didn't change that much.
Naughty Dog's Jason Rubin has been pleased with the level autonomy that Sony has allowed them continue to enjoy. He believes that this has a lot to do with the healthy relationship that Sony and Naughty Dog had established prior the acquisition. This is what he had to say about life post-acquisition: "I don't look at my job at Naughty Dog as being any less important. I still try to make the best games possible and I still work just as long and hard at it."
Once a developer is acquired there are significant changes to policy and procedures that restrict a founder's ability to react to market conditions. And this can be an issue that is surprisingly tough to swallow. One of the worse things an independent developer can do is to give up control of their company on paper but not emotionally.
Employees and Redundancies
An independent developer's employees are its most valuable assets. How they are treated, how their stock options are dealt with, how their health and retirement benefits are considered are sensitive issues to be discussed during the negotiation.
Because retention is an important issue for both the buyer and seller, key employees are often offered performance and retention incentives as part of the purchase. Who pays for these programs is decided in the negotiation, but clearly both parties know that retaining know-how is critically important.
While retention is critical to the success of a merger, it makes little sense for a publisher to retain a developer's employees in areas where the publisher has established leadership. A developer's sales, marketing, accounting and finance, and IT employees are often made redundant soon after an acquisition.
Publishers know that creativity is closely tied to the developer's work environment. As a result, many developers continue operating from their same office after the acquisition, their lease or property being transferred to the publisher. However, it is important to understand that once an acquisition is complete a publisher has the authority to move or shut down any facility they own (unless there is a contractual obligation in place to prevent it).
EA's move of Westwood Studios in early 2003 is an example of this.
Prior to the acquisition, Westwood (Virgin) had invested in a new,
50,000 square foot building in Las Vegas. The building included
motion capture facilities, comfortable offices, and was a showcase
not only for the game industry but for Las Vegas as well.
After the acquisition Westwood continued to operate from this facility, but in 2003, EA closed it and relocated key employees to Los Angeles, where they were consolidating operations with other west-coast studios. While this has surely been an adjustment for Westwood's employees, they along with other LA-based EA teams will enjoy a new 250,000 foot campus in Playa Vista.
Employees at Bungie may have faced a similar experience. After their acquisition by Microsoft in 1999, Microsoft opened Bungie West in Seattle, relocating many long-time Chicago natives there.
Surprisingly, price is one of the easier issues for the parties to agree on. It is made easier primarily because both parties employ attorneys and accounting professionals who have standardized methods for assigning value to a developer's assets.
David Lee, a partner at the law firm White & Lee in Silicon Valley explained. "One of the things we do is to help sellers determine a valuation that is justifiable. Obviously we want them to get the highest price possible. We also want to make sure that they have a clear understanding and expectation of what life will be like in the new company."
In order to define a fair price it is important to understand the basic concepts of valuation, which are detailed in the next section.
Deal Structure and Performance Incentives
The implications of mergers and acquisitions are highly complex. Seasoned tax attorneys and accountants expend significant amounts of energy and expertise to understand the financial impact that an acquisition will have on the parties. The information included below is a generalization intended only to help you understand the basic concepts and structures.
How a deal is structured, and in particular, the tax implications for both the buyer and seller, are key issues. As with all acquisitions, the parties must decide whether to structure their deal as an asset sale, stock sale, whether it will be a tax-free or taxable transaction. Whenever possible, the parties try to maximize the overall benefits and minimize the tax implications. Generally, buyers prefer to purchase assets and to leave the developer's liabilities behind. But what developers need to keep in mind is that as a seller of assets, they are taxed on the gain. As a result, sellers (developers) prefer to sell their stock (rather than assets) and rid themselves of their liabilities.
Cash Only. Regardless of how the deal is structured, a buyer may want to fund the acquisition with cash, their own stock, or a combination of both. In the case of Rare, public records show that the acquisition was a cash sale whereupon Rare received $275 million from Microsoft (Nintendo was paid another $100 million).
Stock Only. In other deals, a developer may not get any cash up front. Such was the case with Headgate Studios, which was purchased by Sierra in 1996. In this deal, Headgate was given an undisclosed amount of restricted stock, which prevented Headgate from selling for a certain period of time. Obviously, there was less liquidity with restricted stock, but Headgate evaluated the risk and determined that market conditions were favorable for this type of a transaction. And it paid off. Shortly after the acquisition, Sierra was sold to CUC and Headgate's restrictions were lifted.
For George Metos of Sculptured Software, in a similarly structured acquisition by Acclaim, things seemed to go in the opposite direction. Sculptured was purchased by Acclaim in October 1995, and shortly after the acquisition Acclaim restated their income. Naturally, the stock price dropped significantly. Sculptured was able to re-negotiate and came out okay in the end-but there were scary moments in between.
Cash and Stock. Many deals are a combination of cash and unrestricted or restricted stock. The acquisition of Angel Studios by Take Two in November 2002 is a good example. In this deal, Take Two gave Angel Studios $28 million in cash and 235,679 shares of restricted stock. The total value of the deal was $38 million.
The acquisition of Barking Dog by Take Two in August 2002 was similar. In this deal, Take Two paid Barking Dog $3 million in cash and 242,450 shares of restricted stock.
Debt Assumption. A publisher may also assume the debts of a developer, as was the case with Volition when they were purchased by THQ in August 2000. In this deal, Volition was given 890,100 shares common stock, 109,900 shares common stock (in the form of options), and THQ assumed $500,000 in debt incurred by the company.vii
Publishers often build incentives into deals that translate into additional income based on future performance by the studio. This mechanism is especially useful when the price difference between what a publisher is willing to pay is a significantly less than what the developer is asking.
As an example, if our fictitious developer, PlayWare, Inc. has an asking price of $20 million and a significant amount of this is based on anticipated net sales, then a publisher may respond with a counter-offer, saying, "We'll give you ten million dollars now, and if you hit that sales number, we'll give you the other $10 million that you are asking for."
Performance incentives were used in Activision's acquisition of Luxoflux in October 2002. In this deal, Luxoflux was purchased for $9.0 million in cash, but the terms also specified that an additional 165,000 shares of Activision stock could be issued to Luxoflux equity holders and employees over several years, depending on the "satisfaction of certain product performance requirements and other criteria." viii
Conclusion To Part 1
Acquisitions move silently beneath the waves of our industry. While finalizing this article Electronic Arts announced the acquisition of NBA Street Series creator NuFX. The announcement comes as no surprise to industry insiders because NuFX is a proven hit maker and its relationship with EA has been forged over time. Yet it is likely that both parties evaluated the opportunity based on criteria described in this article. And in the end they concluded that an acquisition was in their best interest.
But the process of determining a price for NuFX was an additional effort similar to what will be described in detail in our concluding segment. In this final article we will discuss many of the technical aspects of a developer acquisition, including valuation and the specifics activities that both parties undergo during the process.
ii 21.77 was Microsoft's forward P/E ratio in early February 2004. It is used here as an example only.
iii On January 27, 2004 Reuters reported that Need for Speed Underground had already sold 5.5 million units, and was the top selling EA product during the holiday 2003 season. While NFS Underground was developed by Black Box as a wholly owned EA company, one can assume that had the acquisition not occurred, EA would have paid Black Box sizable royalties for this product.
iv Activision's Quarterly Report, November, 2003: "… we have also continued our focus on establishing and maintaining relationships with talented and experienced software development teams. During fiscal 2003, we bolstered our internal development capabilities with the acquisitions of two privately-held interactive software development companies, Z-Axis and Luxoflux."
v February, 11 2003 Electronic Arts Press Release: "The Command & Conquer line of games is one of the most popular franchises in gaming history. To date, the franchise has sold more than 21 million units worldwide on multiple platforms, and the series has landed in several editions of the Guinness Book of World Records as the best-selling computer strategy game series of all time."
vi Atari's 2003 annual report notes in connection with the Shiny Acquisition, the Company obtained a $50.0 million medium-term loan from Infogrames SA.
vii 05.09.2000 THQ Inc. (NASDAQ NMS: THQI) announced that it had acquired revolutionary game developer Volition, Inc. As consideration for the transaction THQ issued approximately 890,100 shares of common stock, assumed existing Volition stock options providing for the future issuance of approximately 109,900 shares of THQ common stock, and assumed approximately $500,000 in net liabilities. The acquisition was consummated on August 31, 2000 and will be accounted for as a pooling of interests.
viii Activision 2003 Annual Report.