Timing Is Right for Digital Content –

Venture capitalists have traditionally shied away from investing in pure media and content plays, given the hits-driven nature of the business, as well as the perceived lack of differentiation. Yet, unlike many more traditional venture-backed industries, spending on entertainment and media in the United States continues to grow at a healthy 6% rate, which begs the question: Could the timing finally be right?

According to PricewaterhouseCoopers’ Global Entertainment and Media Outlook, last year’s domestic entertainment and media market was valued at $458 billion. This includes niche sectors such as filmed entertainment, television networks, recorded music, magazine publishing, theme parks and newspaper publishing. For the purpose of this discussion, we will focus on two specific markets: The filmed entertainment and the video game markets.

The filmed entertainment market experienced $31 billion in spending during 2002, according to Salomon Smith Barney, while the video game market saw 20% growth up to total spending of about $13 billion. And, as Figure 1 shows, this growth pattern has been continuing for several years now. So again we ask: Why haven’t traditional venture capitalists been actively investing in certain sub-segments of media and entertainment?

Though overly simplistic, one can usually answer this question in a single word: Hollywood. Indeed, the thought of making an investment that lives under “Hollywood rules” is understandably scary for any venture capitalist. Not only are exit multiples unknown, but actual exit strategies are untested. These worries are exacerbated when, as Forbes magazine recently pointed out, Paul Allen still hasn’t received a dividend check from DreamWorks despite box office hits like “Gladiator” and “Shrek.”

Investors are usually unable to obtain returns, as building a valuable company in Hollywood often equates to winning an award, rather than building a profitable, sustainable business. This is the project-focused nature of the beast. If you have ever talked with anyone in Hollywood, they are always raising money for a specific project, rather than raising money for a company designed with a long-term vision and a viable business model.

Having said all of this, one must acknowledge that technology is beginning to change the face of Hollywood.

Whether it is in the film industry, the music industry or the gaming industry, technologic proliferation is enabling improvements that were once considered impossible. For example, visual effects used to be few and far between and only in high-budget movies, but now computer generated-based visual effects have become a standard in making any movie. In fact, recent Hollywood hits like “Spiderman,” “Lord of the Rings” and “Matrix Reloaded” experienced amazing box office success thanks largely to the phenomenal special effects that computer-generated imagery (CGI) allowed them to create.

Music used to be purchased in stores, but now consumers can legally (and illegally) download it off the Internet. Apple experienced more than two million song downloads 16 days after the launch of iTunes. And, from a consumer’s perspective, technological acceptance is growing in spades. For example, video games used to be primarily played by young techie males, but recent studies have shown both a more equal distribution of gender, and an increase in the age of players. In fact, the technology revolution is now enabling the convergence of film, gaming and music in Hollywood.

For certain markets, the convergence of media and technology is offering new possibilities to potential investors, as well as to consumers. A unique opportunity exists for certain VCs to combine their know-how of building successful technology companies with compelling content in a non-Hollywood fashion.

Battery Ventures is a strong believer that there is a profitable wave to be found thanks to the convergence of media content and technology, and we believe that by applying certain venture capital disciplines to this growing market opportunity interesting possibilities will emerge.

Though this article could not possibly cover all the options that Battery Ventures is considering in this space, below are a few sub-sectors that could see substantial growth from the convergence of media content and technology:

Animation

The traditional animation market, known as 2D cel animation, used to revolve around highly sophisticated artists painting characters and landscapes on acetate sheets that were subsequently photographed one frame at a time. Artists not only struggled with the complexity of the process itself, but also with the nature of 2D vs. 3D. In 1995, “Toy Story” became the first full-length CGI feature film. Though a great success for Pixar and a break-through for the industry, the technology and process required for such a feat was extremely expensive and not easily replicable for other companies. Ten years later, off-the-shelf software makes building a CGI animation studio more of a reality.

Given the extreme popularity of this market (no CGI movie has to date grossed less than $70 million in worldwide box office sales and the average is around $360 million) and the dearth of family content, one could imagine building quite a successful, profitable company to compete with $2.8 billion market-cap Pixar. Additionally, as briefly described above, more and more box office hits are relying on the magic created by computer generated imagery, and Hollywood is clearly demanding easier to use tools and software to satisfy the public’s insatiable demand for “cool,” yet realistic-looking effects.

Online Gaming

The concept of people able to play against several friends has been around for as long as arcades. Now imagine being able to play against more than several friends who aren’t in the same physical location. Further, imagine a sports game with up-to-date statistics on players and current events. These are the key elements of online gaming: the possibility to play anytime, against anyone with up-to-the-minute content updates. High-speed bandwidth now reaches more than 25% of all U.S. Internet homes and more than 40% in certain parts of Europe and South Korea.

In addition, both Microsoft and Sony have Internet-enabled their consoles to further enable this to be a reality, assuming you would prefer playing through a console. Though the verdict is still out on what the exact business model will look like, on thing is for sure: The emergence of this space-which some analysts estimate will hit more than $2.7 billion in 2006-will require investments both on the infrastructure and content side.

Next-Gen Video Gaming

Video game consumers are getting more sophisticated and demanding. They continue to expect a richer gaming experience and one that should be pervasive on all platforms they enjoy playing on, whether it’s a PC, a console or a phone. Efforts to keep them satisfied are adding increasing costs to developers and publishers: Average development budgets have gone from the $2 million to $3 million range into the $5 million to $8 million range. Given the pressure that publishers are experiencing to obtain shelf space and command mind share, one can easily imagine possibilities around leveraging technology to reduce development costs, and increasing retention through a better gaming experience.

The obvious question will be just how big a market these solutions will create. But it is hard not to see the parallels between the increasing complexity in this market and that experienced in the chip design industry, which, with the luxury of hindsight, led to the creation of some fairly large, successful software and design companies.

The list could go on: new forms of content distribution, new ways to interact with your viewers and new platforms for children’s animation for the television, to name a few. As previously mentioned, we are already seeing an obvious convergence between the video games and the movie industry (and vice versa), and one could easily imagine seeing technology play a significant role in facilitating migration of one from another.

Though many would argue that technology alone cannot change the inherent Hollywood-esque issues I mentioned earlier, we at Battery believe the time has finally come where tech savvy investors can make sizable returns capitalizing on the convergence of media content and technology. The past decade has been focused on investing and building the highway of communication, and now the time has indeed come to invest in content and technology that will ride on the highway. We fully recognized that, similar to other sectors, not all companies are guaranteed winners, but with the right mix of people, technology, process and strategy, the convergence of media and technology is creating a pocket of opportunity for traditional investors.

Geraldine Alias is an associate in the Wellesley, Mass., office of Battery Ventures, where she focuses on the communications industry. Prior to joining Battery in 2002, Alias worked in Silicon Valley for McKinsey & Co., where she provided strategic and operational advice to telecom and enterprise software companies.