Milestone-Based Financing

Gaming VC: Content Investing with Milestones

Venture Capital (VC) is a relatively nascent asset class, with the first true VC firms emerging in the 1960s and 1970s (Venture Forward). While dedicated gaming VC firms are part of a more recent sector-focused trend in venture capital, venture investment into the gaming ecosystem has a much deeper history. For example, Sequoia’s first $3m fund backed Atari in 1975 (Sequoia).

Given venture’s focus on disruptive and emerging technology, alternative funding structures have continually adapted over time. A “one-size-fits-all” approach to financing early-stage companies has never been the status quo, as evidenced by the emergence of equity-preferred, liquidation preferences, debt instruments, and even milestone-based financing. In some cases, the most ambitious projects often require significant upfront capital to get products to market. For example, building a video game designed to compete with $100m+ AAA budgets will require significant development (and ultimately marketing) resources before the game can go live.

With those factors in mind, investing in “content” (i.e., funding studios that develop games or other forms of interactive entertainment) is known to have a higher risk profile due to the sheer volume of content that is released each calendar year. Compared to other companies in B2B SaaS and Consumer Tech who certainly have dozens of competitors, video game content has thousands of new-entrants to compete with each year. Additionally, the go-to-market timelines for content are often much longer (2-5 years) than B2B or B2C SaaS companies.

While newer funding structures for startups such as venture debt have emerged in recent years, the proportion of funding compared to traditional venture capital is miniscule.

Given how different financing within gaming is compared to other entertainment mediums such as film and music (which focus more on revenue share models), the investment structures around gaming content may warrant the emergence of a new funding approach. This week, we want to theorize a new structure for VC investments into gaming content: milestone-based financing.‍

The Publishing-Only Model Will be Replaced‍

Milestone-based financing is not an entirely novel concept with gaming. That being said, it is most often associated with the publishing business model rather than venture capital. When an independent developer and publisher negotiate development and distribution timelines, funding can be segmented to different areas such as building out their multiplayer functionality or marketing and user acquisition. However, this structure usually focuses on solving for budgeting by business unit rather than gating access to funding based on expected performance.

The gaming content VC model we are discussing today guarantees (either by contractual agreement or perhaps even cash held in escrow) access to multi-stage funding as long as certain performance targets are met. In combination with the commoditization of access to self-publishing tools, the rise of developer-publishers, and the bear market that will likely be here for the next 1-3 years, we anticipate that milestone-based financing will become more common amongst gaming VC investments. To this end, we think that this financing structure will eventually result in standalone AAA publishers becoming obsolete.‍

More Capital Unlocks Tangible Targets for Startups‍

With the emergence of milestone-based financing, this inherently de-risks certain investments while simultaneously encouraging capital allocation to big and ambitious products. These larger content studios would then have the advantage of a clear line-of-sight to the unlock of additional capital (i.e., hit their KPI’s). Instead of a startup needing to fundraise every 18-24 months (very time consuming), teams would be able to focus on building their product while having clarity on what their targets are to unlock a new pool of funding (without having to run a full new process). This could also help insulate a startup from the macroeconomic environment (our current climate) and cyclical gaming trends.

However, in order for founding teams to take this type of deal, they will need to forecast out for 2-5 years in order to set the appropriate KPI targets. Today, Seed-stage companies typically forecast their finances and expected KPIs 18-24 months into the future. In a multi-stage, milestone-based model, we anticipate that this will need to be at least 3-4 years into the future. Outside of projecting performance and finances, this model could also limit a startup’s ability to pivot (assuming they still want the locked-up financing).

Given the amount of unknowns that are inherent to early-stage investing, a milestone-based approach would likely result in VCs over-scrutinizing or over-analyzing founding teams and their visions. A potential ripple effect of this dynamic could be locking out younger, less experienced founders from receiving this type of funding as the goal posts are no longer getting the product to the next phase and round of funding, but bringing the product to market as a commercial success (5+ years).

Complex funding structures would likely mean more time spent fundraising at the beginning of the company’s life cycle. Startups would spend a considerable amount of time seeking out capital partners that not only understand their vision but agree on the projected milestones. While the upfront rounds have the opportunity to be much larger, unless a company finds a single, well-funded capital partner, multiple partners equals more complexity in negotiating the right targets.‍

Increasing Style of “All or Nothing”‍

On the Venture Capital side, the milestone-based financing model theoretically enables faster feedback loops. Having explicit targets for funding means that there are clearly defined moments where the company receives additional funding or that committed VC capital is freed up for new investments. Setting aside capital for reserves (i.e., follow-on financings) is no longer necessary as it is built in at the beginning.

The de-risking (for the VC) of this type of milestone-based investment comes from the results-based tranche structure, not from the traditional avenues of de-risking. Traditionally, VC’s de-risk investments by 3 primary avenues: 1) deal terms (valuation, liquidation preference, etc); 2) co-invest with other firms who have complementary skill sets (geo focuses, user acquisition, economy balancing, etc); and/or 3) write follow-on checks at the VC’s full discretion at a future date. The emergence of milestone-based investments partially removes the 3rd one, as “full discretion” is replaced by “milestone unlocks”.

Thus, this structure is even more “all-or-nothing” than traditional VC. If a company does not hit their next target, it frees the investor from the on-paper requirement to invest further and the company must instead go out and fundraise again (reinstating the VC’s full discretion for follow-on checks). While this seems like a simple reversal back to the classic VC model, the inability to hit targets can damage the asset’s reputation to a later stage investor and may further prevent a company from being able to raise another round. In short, a company committing to milestone-based financing needs to be highly confident that they can hit their targets. For many founders, this is a great fit.‍

Takeaway: Milestone-based financing has the potential to be a component of the next evolution of video game content investing. The guaranteed unlock of milestone-based capital, as long as targets are hit, gives startups partial insulation from macroeconomic factors and sets clear goals for their internal teams. This well-funded pipeline of studios is likely to promote additional competition to the well-established AAA incumbents. While the milestone-based investment structure is certainly not commonplace today in gaming VC, we anticipate that this model will soon emerge for larger content deals ($30-75m) that are raising mega rounds early on (pre-product).