Secrets of the Game Business (Game Development Series)

Most companies write business plans to obtain financing. Others do it to secure contracts and partnerships. In both cases, a sound money management plan is of the utmost importance.

Types of Financing Deals

If your studio needs funding, you must determine which type of financial arrangement between you and your backers will be most appropriate. There are three general categories of funding you might solicit:

• Debt. This category includes credit margins, "bridge loans" allowing you to cover cash flow shortages until a milestone payment arrives, bonds, and mortgages. Lenders avoid risk, and they want to get their money back (with interest) on a precise schedule. Therefore, debt funding is easier to obtain if you already hold a letter of intent or work-for-hire contract from a publisher, or if you are willing to offer significant collateral (e.g., a house) to secure the loan.

• Equity. Family, friends, financial angels, and some investment funds might be interested in providing a studio with long-term capital in exchange for a percentage of ownership—and thus a share of future profits. Equity investors might be willing to accept a higher risk factor than lenders, but mavericks beware: while any business failure is painful, one that destroys your relationship with loved ones will be much worse. As a rule, investors will expect to earn back their seed money within two to three years and receive a 25 to 40% return thereafter.

• Venture capital. Some investors specialize in high-risk, high-payoff companies. A typical VC contract involves the studio selling a percentage of its stock to the investor at a certain price and buying it back later at a higher price so that the venture capitalist will be out of the picture within 3 to 10 years. Usually, VC is only available to companies with extremely high potential—for example, those that hold the rights to a breakthrough technology or show immediate stock market perspectives. At the height of the dot-com bubble, VC firms expected 100 to 500% rates of return on their investments within one year.

Depending on your company's business model, some of these types of financing will be easier to obtain than others: venture capitalists have little interest in stable, low-growth companies, while banks will not risk large sums unless the loans are secured by contracts with well-defined milestone payments.

Pro Forma Financial Statements

To convince potential investors and partners of your company's potential, you must demonstrate financial viability. To do so, you must provide the following statements:

• Cash flow statement. This document lists cash receipts and expenditures, demonstrates your company's liquidity, and shows how much external funding you will need at any given time. Table 2.2.1 shows a simple cash flow statement. Don't forget to take trade show expenses and representation into consideration!

  Table 2.2.1: Simple Cash Flow Statement (Simple Studios Inc.)

  Receipts	Q1 2003	Q2 2003	Q3 2003	Q4 2003	Q1 2004	Q2 2004	Q3 2004	Q4 2004
  Equity funding	$250,000.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00	$0.00
  Milestone payments	$0.00	$100,000.00	$100,000.00	$200,000.00	$100,000.00	$100,000.00	$200,000.00	$0.00
  Royalties	$0.00	$0.00	$0.00	$0.00	$0.00	$150,000.00	$150,000.00	$150,000.00
  Tax credits	$0.00	$20,000.00	$20,000.00	$20,000.00	$20,000.00	$40,000.00	$40,000.00	$40,000.00
  Govt subsidies	$100,000.00	$0.00	$0.00	$0.00	$150,000.00	$0.00	$0.00	$0.00
  Total	$350,000.00	$120,000.00	$120,000.00	$220,000.00	$270,000.00	$290,000.00	$390,000.00	$190,000.00

  Expenses
  Rent and suppliers	$8,000.00	$8,000.00	$8,000.00	$8,000.00	$10,000.00	$10,000.00	$10,000.00	$10,000.00
  Capital expenses	$100,000.00	$0.00	$0.00	$0.00	$100,000.00	$0.00	$0.00	$0.00
  Salaries (burn rate)	$120,000.00	$120,000.00	$120,000.00	$120,000.00	$240,000.00	$240,000.00	$240,000.00	$240,000.00
  Income tax	$0.00	$0.00	$0.00	$100,000.00	$0.00	$0.00	$0.00	$0.00
  Total	$228,000.00	$128,000.00	$128,000.00	$228,000.00	$350,000.00	$250,000.00	$250,000.00	$250,000.00
  Quarterly variation	$122,000.00	-$ 8,000.00	-$ 8,000.00	-$ 8,000.00	-$ 80,000.00	$40,000.00	$140,000.00	-$ 60,000.00
  Cumulative	$122,000.00	$114,000.00	$106,000.00	$98,000.00	$18,000.00	$58,000.00	$198,000.00	$138,000.00

• Earnings statement. This document summarizes sales, costs, and profitability. It differs from the cash flow statement in several important ways; for example, sales are "earned" as soon as they are closed, but accounted for in the cash flow statement only when the invoice is paid. Table 2.2.2 shows a simple earnings statement.

  Table 2.2.2: Simple Earnings Statement (Simple Studios Inc.)

  	Q1 2005	Q2 2005	Q3 2005	Q4 2005	Total 2005
  Milestones and royalties	$400,000	$250,000	$200,000	$1,200,000	$2,050,000
  Development costs	$350,000	$350,000	$350,000	$350,000	$1,400,000
  Gross margin	$50,000	($100,000)	($150,000)	$850,000	$650,000
  Overhead	$100,000	$100,000	$100,000	$100,000	$400,000
  Gross profit	($50,000)	($200,000)	($250,000)	$750,000	$250,000
  Income tax	($7,500)	($30,000)	($37,500)	$112,500	$37,500
  Net profit	($42,500)	($170,000)	($212,500)	$637,500	$212,500

• Balance sheet. This document summarizes a company's assets, liabilities, and book value. Since game studios rarely own many assets except quickly depreciated computers and software, this statement is less important for you than for a traditional business such as a manufacturing plant, but lenders in particular will still want to see it, because they can seize assets if you default on your payments. A 1:1 ratio of cash and accounts receivable to short-term (one-year) liabilities is considered comfortable.

The business plan should include monthly statements for the first year, and quarterly statements for the next two years.

Your Financing Proposition

Having prepared your cash flow statement, you know how much external funding you will require to support your operations. It is now time to propose a deal to your prospective financial partners. Do you ask for a single equity investment in the entire amount, or are you willing to bring in multiple partners? What percentage of your stock are you willing to offer in exchange? If you prefer a loan, venture capital, or a combination of both, what interest rate are you willing to pay?

As a general rule (with many exceptions), angels and funds don't like to provide a disproportionate share of a company's money: they are more comfortable if the principals and/or a number of other institutions participate as well. On the other hand, venture capitalists often demand a high percentage of the stock, or provisions that let them increase their ownership (and ultimately wrest control from the promoters) if the company fails to meet the expected buyout schedule.

Capital Structure

List current owners and debtors, their stakes in the company, and their roles in its management, if any. A second table showing the situation after the proposed funding must also be provided.

In addition to the principals' investments in the company, you might also want to declare the salaries they will be receiving until the company releases a title or signs a publishing contract. Investors tend to frown upon promoters who pay themselves generously at this stage, so you might have to prove your commitment to the company by taking much less than you could be making as an employee elsewhere; your payoff is supposed to come later.

Case Study 2.2.3: Minimizing the Cost of Money

An overly aggressive venture capital buyout can cripple a company. So can deteriorating relationships between dissatisfied shareholders. Common sense dictates that game studios should cap the potential negative impacts of outside capital influxes, by minimizing the amount of money they have to bring in and/or by cutting on the premiums they have to pay for it. Here are a few ways to do so:

• Select venture capital partners who are accredited by fiscal authorities. In some jurisdictions, VC firms receive tax credits on risky investments; if this is the case in your state or country, you will not have to guarantee as high a rate of return to secure an investment.

• Find alternative suppliers. If you can bear the risks associated with a non-standard 3D animation package or programming environment, their suppliers might be willing to sell them at a substantial discount to gain a foothold in the game industry.

• Lease instead of buying. In some jurisdictions, lease payments are 100% tax deductible, while purchased equipment must be depreciated over several years even if they are paid in advance. Computers, office furniture, and some software packages can be acquired this way.

• Consider a second mortgage. If you are going to have to put your home up as collateral on a business loan anyway, why not get a mortgage and invest the money in the company? Mortgage rates are often lower than those granted on business loans.

• Cross-subsidize. Accept work-for-hire deals, subcontract your workforce to other companies during downtime, and use the income to pay for your own original development projects.

• Sweat equity. Some employees might be willing to work for less money at startup in exchange for a share of the company's stock. Unfortunately, this mechanism is often abused; several projects advertised on industry Web sites in 2002 asked for several months of unpaid work (in one case, as much as three and a half years) in exchange for vague promises of regular employment—no stock—in the future. Remember that you always get what you pay for.