Investing in Content

The other day, a friend sent me an introduction to a game company with a note saying, in effect, "I thought you might be interested in this since you invest in content."

Certainly, looking at some recent investments Benchmark has made, you might get that impression. Riot Games, Meteor/Adhesive, Red Robot Labs, and two as-yet unannounced new investments [subsequently announced: Jenova Chen's thatgamescompany and next-gen mobile publisher NaturalMotion] are all companies with core competencies in game design and development.  Yet, in none of these instances would our investment properly be characterized as an investment in content.

Why the misunderstanding? A lot of it has to do with the changing nature of publishing in the video game business in recent years.

In the past, publishers played four key roles in the video game value chain:

1. Product development capital. Until recently, publishers were the sole source of development dollars for the creation of new products (unless a studio had the resources to self-fund development). Large, expensive development teams, often working for years before seeing any revenue, required lots of deficit spending.
2. Marketing reach.  Publishers not only spent millions of dollars on conventional media buys (magazines, television) but also managed a ton of channel marketing, spending on merchandising (end caps, marketing circulars), co-marketing with platform providers, and point of sale promotion.
3. Physical goods distribution. Publishers provided the capital and logistical support necessary to build the retail inventories of packaged products. They pre-paid platform licenses (which often required letters of credit to the tune of millions of dollars before a single disk was sold at retail). They organized the shipment of packaged goods to stores, and managed returns of unsold or defective inventory.
4. Intellectual property management. Often publishers managed "franchises" -- video game brands deployed across a number of platforms, requiring a number of localized versions. Generally, the core development team would concentrate on one or two key platforms and the publisher would manage development of ports and localizations, and control sequels. In addition, publishers could pay for and manage the substantial costs associated with major brand licenses (like sports or movies). 

All of these publishing services benefitted from economies of scale, and publishers had incentives to aggregate products in order to spread cost and risk across a portfolio. Publishers with lots of good product flow got better treatment from platform providers and from retailers, too, further reinforcing the benefits of aggregation. The supply-chain nature of the packaged goods business created an environment in which these services could demand a substantial premium, both in revenue share and, ultimately, in equity value.

Think about what has happened to this model in the last seven or eight years. Capital is now more readily available for game development than ever before, and, further, modern games (and not just mobile or social games) require much smaller teams and much shorter development cycles, and therefore far less pre-revenue capital expenditure. The internet profoundly alters the nature of marketing reach, frequently to the disadvantage of incumbent publishers, and certainly changes the nature of channel marketing. Games are increasingly delivered as services rather than goods, and even when they are delivered as goods they are delivered electronically with a distribution infrastructure that can be rented from cloud providers like Amazon.

So, what is a modern video games publisher? What is the new set of skills and assets that a modern publisher must possess? The new paradigm of online, free-to-play gaming based on virtual goods sales has completely invalidated most of the old value-creation mechanisms (this should be obvious to anyone who has looked at market cap as a multiple of sales for EA or Activision vs. Zynga or TenCent).

In my opinion, the four traditional publishing values have collapsed down to two completely new ones:

1. Customer acquisition leverage. Selling games-as-a-service, generally free-to-play and actualized by the internet, has more to do with traditional e-commerce than with traditional packaged goods distribution. A key component of e-commerce is funnel management. You need to find or create demand, aggregate that demand through downloads and activity, and direct a portion of that engagement and activity to sales. The key skill in this new environment is leveraged customer acquisition -- i.e., a competitively advantageous ability to get customers into the top of the funnel in hopes of selling them something along the way. And, by the way, I don't consider the ability to buy traffic slightly more efficiently than your competitors as a sustainable competitive advantage. CPI marketing is like SEM -- good for a short-term arbitrage and cash-flow generation, but bad for long-term value creation. To foster true organic customer demand, content must be at the core. It is both the honey-pot attracting new users and the motor for on-going engagement.
2. Integrated merchandising and game design. In the old packaged goods days, development teams made games, and sales and marketing teams figured out how to get people to buy them. If customers played them a lot, that probably generated some good reviews and good word-of-mouth for marketing, but ultimately publishers only really cared about generating enough buzz to get a customer into an EB or Target to plunk down $50, whether that customer played the game or not. Now, not only do the games have to be engaging enough to get customers to want to buy virtual goods to enhance the play experience, the games themselves need to be created with the merchandising of virtual goods as a core design value (as well as all the e-commerce instrumentation and analytics). Again, content is central; the store and the game are, in the best sense, one.

The companies that figure out next-gen publishing will create the greatest venture capital returns. Whatever you think about its current stock price, Zynga has clearly validated this concept, and scores highly against my two core next-gen publishing values. Conversely, companies that develop next-gen content alone can produce cash flow (look at just about every successful company selling one-off games on iOS, for example), but rarely high-multiple equity value. By way of example, look at the recent large acquisitions in the mobile games space, where companies sold for between 2-3 times annualized revenue run rate; versus over six times run rate for a company like Riot, that had deeper control over commerce and audience.

So, in a round-about way, this is why I back games companies that develop content. I am really backing platform-based publishers, and my goal is to see them scale to multi-product powerhouses.  But I don't believe you can create publishing leverage by starting with the platform. I think it fundamentally starts with great content.

As much as I admire and appreciate pure game development platforms, I think they will struggle to cross over from tools companies to publishers or distributors without creating partner friction. Meanwhile, companies like Valve are using must-have content (Half Life, Portal, Counterstrike, DotA) to aggregate large audiences (on the Steam platform); those aggregated audiences then create customer acquisition leverage for future Valve titles and also for titles from third parties who pay a toll for access to that highly-qualified audience.

That, for me, is the essence of value creation in the games business, and that's what's guiding my investments in these great and diverse companies in the Benchmark portfolio.