An oral history of the video games business

My first job was writing about computer games in the late 1990s. Therefore the podcast Gamecraft by Mitch Lasky and Blake Robbins is enjoyable listening. It is a deep-dive into the games industry starting in the early 1990s with shareware and iD Software. I’m only a bit into the first episode, but am already looking forward to all eight episodes.

Games been culturally important for a long time, but how three different business models (free-to-play and “pay $60 upfront” and “pay $12 per month”) can all exist and be successful is worth learning from (especially if you’re in a different business). Also how the different models have allowed the industry to grow significantly and use the sheer size of the smartphone platforms to go beyond the PC and the console market (the PS5 has “only” sold 30 million units since its release in November 2020, while Apple sells more than 200 million iPhones per year).

10 % cut is managing expenses, 20-30 % is going for profitability

The number of announced personell reductions at larger US tech firms continue, just in the last day or so with Coinbase cutting 20 % (after cutting 18 % in June 2022), Flexport also cutting 20 % and Carta cutting 10 %.

It is new proof points of the reset many companies are doing, and probably a combination of cutting personell to get better financial results (duh!) and not getting bad press (“as everyone is cutting”).

For high growth tech businesses that have had the focus on revenue growth, there is quite significant difference between a 10 % cut and a 20-30 % cut.

A 10 % cut is in reality mostly a slightly more conservative way of managing overall expenses, and not enough to drive significant improvement to profitability. Profit improvements need to come from relatively significant revenue and gross profit growth.

A 20-30 % cut of all personell has more significant profit impact and combined with other savings measures can take a company closer to profitability alone. Even if some gross profit growth is often needed to.

Game on!

Adam Schaub and Marcus Jacobs have started Seider, a Stockhom-based games studio, and raised capital from A16Z Games. Video and mobile games is one of the sectors where Stockholm and the wider Nordic ecosystem have real depth from multiple large successes (King, Supercell, Unity and many others). “Standing of the shoulder of giants” is a strength of any ecosystem, and with the giants in the games space I expect many interesting gaming companies to be built in Stockholm going forward.

Games in an area where generative AI can be helpful, e.g. for things like outdoor world generation and creation of graphical assets. It might not be quite as good as AAA-work by specialists, but it can be quite close and probably take costs down 90 % over time for AA/AAA or improve the graphical quality of smaller productions. Which both are very interesting.

Storytel 742 MSEK in Q4 revenue

Storytel, the audiobook subscription company, has had a bumpy ride on the stock market the last 2 years, especially in 2022 after founder Jonas Tellander left his role as CEO in February 2022.

Founder leaving, somewhat of a reset in the growth/profitability trade-off and crashing tech valuations is an unpleasant combination. Still, the company managed to stay above two million subscribers in Q4 of 2022, of which a little more than half in the Nordic countries.

Two things worth noting:

  1. Despite losing subscribers during 2022, Storytel has grown revenue as the average revenue per user has increased
  2. Gross profit for non-Nordic countries was 47.3 % in Q3, compared to 41 % in the Nordic countries and the 25 % gross margin Spotify had in that period (across both Premium and ad-supported).

Going public, and then private

After a startup has grown larger (hopefully $100 million in revenue), a good way for founders and early investors to exit is via a listing on a stock exchange of the company. The overall leaders in this aspect is the Nasdaq and New York Stock Exchange, who really are the only western stock exchanges for very large companies ($10 billion+ in market capitalization) to list.

But for smaller companies there are many local/national stock exchanges to list at, and the Stockholm Stock Exchange and the affiliated First North are two good places for this.

One interesting aspect is when a company is not doing great and gets an acquisition offer to sell all shares and leave the stock exchange. One such example in Stockholm is Readly, a digital magazine service. The company listed in 2021 and have had a tough time growing (ca 30 % growth and significant losses planned for another 1-2 years). Local major publisher Bonnier offered to buy out Readly (as they would likely get economies of scope and a better licensing situation as they are a major magazine publisher), and now we’re seeing at last one major mutual fund (Robur) being against selling.

The main challenge with Readly for me is that founders have left and early investors seem to be willing to sell. That is not unlike TradeDoubler many years ago when they had an offer from AOL, and Swedish mutual funds declined to sell. It will be interesting to see if the result will be the same.

Complexity is a killer

Fred Wilson (partner at USV and long-time blogger) had some good observations in his What will happen in 2023 blog post.

On the new fundraising environment (lower valuations and higher demands on startups to be funded) he writes:

“This new normal will lead to many flat rounds, down rounds, inside rounds, and rounds with a lot of structure on them. None of that is good, but the worst of those options is rounds with a lot of structure. I believe founders and CEOS and Boards should take the pain of a new valuation (flat, down, whatever) over structure.”

Structure (I interpret this as things like tougher terms in Shareholders agreement, additional approval rights, preferential options deals, additional board seats, aggressive preference rights etc) might feel better than a lower valuation initially for a founder, but I agree with Fred. If at all possible (enough money to execute the plan without excessive share dilution) it is better to go with a clean structure and a lower valuation than a complex structure and a slightly higher valuation.

Getting willing sellers and buyers to meet

Some very good comments on tech M&A by Rick Sherlund (vice chairman investment banking Bank of America, formerly top tech analyst at Goldman Sachs for 17 years).

The very high valuations in 2020 and 2021 make it hard to find willing sellers, as they see the current valuation (-80%) as too low. Rich points out that fast growing unicorns can get back to the same valuation in dollars as in 2020/2021 in an acquisition offer through high annual revenue growth (50%+), higher margins (after cost cutting), possibly lower US interest rates and bid premium (40%). All in all it sounds like end of 2023 or 2024 to see all that play out, and that if $100 million+ software companies can continue growing fast this year with a likely recession and cost cuts in their sales & marketing organizations.

Layoffs to increase profit, in order to retain key staff?

In 2022 the focus of public market stock valuations went from revenue growth to profitability. This has impacted small and large technology companies, and layoffs started already last year (in Stockholm both Klara and Kry made cuts to their respective organizations). Now a second phase of layoffs are coming with Salesforce, Amazon and Vimeo announcing new layoffs in the last day.

An often used reason for layoffs have been something along the line of “we hired too many people due to the pandemic”. To some extent that is true (especially as the headcount growth from 2020 to 2022 has been 20 %+ at many companies), but the default mode for major tech companies for the last 10 years have been to hire additional staff if that can increase revenue growth.

As the trade off revenue growth/profit has changed, another part of the reason for the headcount cuts is that, for the time being, it is more important to increase profit margins than revenue growth to drive stock valuations. And stock valuations are important not only to shareholders, but to the companies themselves as they are paying staff in restricted stock units and/or options, and if that part of compensation gets cut 50-90 % it will likely impact retention of key employees.

What is the final valuation?

If the founders of a startup manage to build an extraordinary software company that becomes very large (billions of dollars in revenue), at some point the company will be valued in-line with other mature, successful technology companies. Based on observation my rule of thumb that is a price/earnings ratio of circa 20.

The P/E ratio should be adjusted for growth rate, level of profitability, long-term prospects etc. This is not a small thing, especially considering that one of the most noteworthy things of the last 10-15 years is just how fast FAANG companies grew when they already had tens of billion of dollars in revenue.

And for smaller companies that haven’t reached ‘steady-state’ growth and profit margins, the P/E can reasonably be significantly higher both from lower than steady state profit margin and much higher growth.

In the earliest stages of a company’s lifetime, I don’t look at P/E or price/revenue but rather the likelihood (both operationally and funding-wise) of the startup becoming a large company and what characteristics it is likely to have at that point.