Unlocking hidden value - easy trick for managing creative startups post-acquisition
By S.L.
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Executive Summary
The average EV/Revenue multiple in the global gaming industry is 2.2x according to industry reports. Thus even a 14% increase in revenue can boost the company valuation by 30% for small video gaming startups.
Research published in the Strategic Management Journal suggests that every addition of a single hierarchical level in video game startups is correlated to an increase in global unit sales by 14% at the cost of minimal reduction in creativity rating scores of products.
All else being equal, firms acquiring gaming startups should look for acquisition targets with flatter hierarchy to which they can easily introduce more levels to unlock higher sales and enterprise value.
Unlocking hidden value: a minor sales bump can have a major impact
Video gaming usage hit a dramatic peak during the pandemic, and while the growth in M&A deals has started to cool down post-pandemic, it is still increasing (7% year-on-year growth 2022 vs. 199% year-on-year growth 2021). The increasing cost of capital has likewise also cut the valuation of game developing startups with a dramatic decrease in the median EV/Revenue multiple from 5.9x in Q4 2020 to 2.2x in Q4 2022 (“Video Games & E-Sports: 2023 Valuation Multiples”, Finerva, May 2023). So even at Q4 2022 multiples, a 14,000 increase in global unit sales for example (which is a 14% increase in revenue for the startups with 100,000 unit sales) would be an over 30% increase in valuation at 2.2x EV/Revenue.
M&A deals for the video games industry in that year reached $41 billion (US) in 222 deals with an average of $184.6 million (US) per deal – so with an estimated 560,000 in unit sales on average say. This surpassed the size of private investments ($10.1 billion (US)) or public offerings ($4.6 billion (US)) in the industry in the same period. Out of the total video game industry, game developers and publishers accounted for the largest share of the M&A transactions (87.8% in 2021 and 66.6% in 2022). $27.3 billion (US) acquisition deals in 2022 were collectively closed by the top five buyers in the industry: Microsoft, Sony, Take-Two Interactive, Electronic Arts, and Tencent (Investgame 2023 2020-2022 the Most Exciting Time in the Gaming Industry; Drake Star 2023 Global Gaming Report Q2 2023).
Management hierarchy: not always a creativity vs efficacy trade-off
The supposed benefits of “flat startups” have been widespread amongst academics, popular media outlets, and entrepreneurs themselves for the past few decades. To find a real-life and empirical answer to how organizational hierarchy affects novelty of core product and basic business outcomes, a recent study published in the Strategic Management Journal studied 6,234 startups in the video game industry. The study showed that startups with more hierarchical levels suffered a very small decrease in creativity as shown from the reviewers’ ratings. However, this was compensated by a large increase in the commercial success because a single additional hierarchical level was also correlated to an increase of 14,000 units of global sales. This increase accounted for, on average, 14% of the sales of the startups in the study, and could be a significant factor for their commercial success given the size of the startups.
The study suggests that the current landscape of the gaming industry is experiencing a dramatic increase in task complexity. Therefore, adding more hierarchical layers for the video gaming startups benefits commercial success by improving the task decomposition and specialization of the employees and their managers.
The companies analyzed in the study had an average of 26.11 employees, and were ranging from having one hierarchical level with only two employees to having more than thousand employees in seven hierarchical levels. The list of the names and job titles of their employees were collected and analyzed to assess the management hierarchical levels, which was the independent variable of the analysis. On the other hand, the novelty (based on the analysis of certain words describing novelty or creativity from 240,000 review ratings) and the sales (based on the number of units sold globally) were collected for each startup’s video game portfolio as the dependent variables. It was noted that all startups in this dataset were private, therefore the information on metrics such as profit, revenue, or return-on-investment were unavailable.
The average startup size of approximately 100,000 in global unit sales is far smaller than the typical video game acquisition in 2022. Given the disparity, it is unclear if the hierarchy to sales correlation would hold for the whole number (ie 14,000 more unit sales) or the percent (ie 14% more sales) for the size of companies in actual deals from 2022. However, even taking the most nominal impact of 14,000 more unit sales on a larger video gaming company, the impact could be 2.5% more sales on average and thus 5.5% higher valuation at 2.2x EV/Revenue – or a $10 million (US) value increase on an average for M&A deal in 2022 simply after an addition of a single hierarchical management level post-acquisition. Over 222 deals, that could be billions more in value created for acquirers.
A new criteria for vetting pre-acquisition targets
This information delivers some critical lessons for the senior management of the firms in the video gaming industry that make M&A a major part of their growth strategy:
Day One: The original study does not provide parameters on the maximum or minimum number of hierarchical levels for a gaming company nor which types of management positions are optimally added. Therefore, gaming companies in the M&A space are strongly recommended to replicate the paper’s findings with their own acquisition records and data which would also include far larger company sizes.
After: For startups already acquired, the parent company should be unafraid to add hierarchical levels to the acquired subsidiary, at least experimentally at first, to track performance changes. Having fewer hierarchical layers does not wildly improve the creativity ratings and the company hierarchy shows a much stronger correlation with the revenues than creativity ratings – i.e. the risk of reduction in the creativity ratings of the acquired startup should be miniscule.
Finally: All else being equal, these firms should look for acquisition targets with more flat hierarchical structure. It will give the acquiring firms room to safely introduce more hierarchical layers to their subsidiaries. This means more potential to increase the revenue, and thus enterprise value, of the acquired startups.
Even after that, managers dealing with post-acquisition should increase the hierarchical layers of the acquired subsidiaries in incremental stages to assess the marginal improvements in revenue (or any losses in creativity) corresponding to the increase in hierarchical levels as suggested from the original study.
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S.L. is a PhD candidate at the University of Toronto and a member of the Graduate Management Consulting Association (GMCA Canada). The research applications proposed in this article are solely the views of the author and do not necessarily reflect the views of the original academic journal article authors nor any individual member of our Editorial Board.