Secrets of the acquisition process from EA and Zynga (straight from the horse’s mouth!)

The corporate development folks over at Electronic Arts and Zynga shared some insider advice last night on how the acquisitions process works at both companies.

I’ve excerpted some advice from the panel, which was held last night at Pillsbury, a law firm in downtown San Francisco.

Michael Chang, a director of corporate development at Electronic Arts, Grant Olsen of Zynga’s corporate development team, Jeremy Liew, managing director at Lightspeed Venture Partners and Mark Otero, who was CEO of KlickNation, a core gamer-focused company that Electronic Arts bought for the Bioware label spoke about how these deals are done.

Some key takeaways:

1) Be extremely careful about your early agreements, especially with game publishers: Sometimes publishing arrangements that contain options on future games can kill deals because acquirers want teams to work on their games right away.

“With some companies, there have been publishing arrangements that made it unpalatable for us to go forward,” Chang said. He gave an example of an unnamed company that had signed a deal for three games. “We needed to use them immediately, but that deal locked them up on three more titles. That left them with very limited options.”

2) It’s worth it to spend the extra $1,000 on a competent lawyer who can get contracts done correctly: All of the panelists said poorly designed contracts can kill an acquisition if the entrepreneur isn’t careful about how they’re structured. “Even some kind of invention agreement can seem really innocent, but come back to hurt the company later,” Zynga’s Olsen said.

3) Choose your investors wisely, because they can kill the outcome that you want: This is obvious, but there were some stories from the panel that were interesting.

Otero said KlickNation had raised about $100,000 after unsuccessfully making dozens of Facebook apps. In retrospect, the terms were bad because they gave Otero’s angel too much power over potential exits. It was a convertible debt investment with an interest rate and a minimum that ultimately gave KlickNation’s angel 10 percent of the company. (I reported that the company was sold for $35 million in December, including retention. Based on the structure of the deal, the angel likely had a 20X return. While Otero didn’t name names, the only angel in the company that was publicly known was Robert Simon at Ariva Partners.)

There were also veto rights associated with exits.

“Looking back, I kind of scratched my head. What the hell was I thinking?” Otero said. “I didn’t realize how powerful that veto right was when we were in the process of entertaining term sheets. It had tremendous power. It forced us to look at deals we didn’t want to do. I felt so powerless and helpless.”

At one lunch, he and his angel had such a contentious argument that they started yelling at each other. He said, “I told him I could not do this deal and he threatened me back. We both just walked away.”

Otero said he originally took the investment after several unsuccessful attempts at building basic, “spammy” Facebook apps that didn’t produce meaningful revenue.

“We had 30 failures,” he said. When KlickNation got to its 31st app, it started going into games that focused on more hardcore players — an idea that wasn’t proven at the time since the biggest developers on Facebook like Zynga were targeting casual gamers.

“There were whispers that core gaming would work. But we didn’t know. We just decided to give it shot. We launched in June and never advertised,” he said. “But the algebra began to work. Our topline revenue were was offsetting revenue. This was the Holy Grail.”

But even then, Otero didn’t approach traditional venture capital firms because he didn’t feel confident enough.

He said, “We wanted some validation. We were deeply in debt. It overcame basic common sense. We just wanted someone to let us know we were going down the right path. Here came this guy with a check, a smiley face and a long, impressive resume. We thought that this was our golden opportunity. He did provide good advice and he did help, but in the end, it was very painful.”

Chang added, “There’s plenty of cash out there. You need to be thoughtful about what you take. There are long-term implications of taking capital — sometimes smart, sometimes not.”

He said there was a company EA was interested in acquiring once, but the investors controlled 70 percent of the company while the team had 30 percent. The company’s chief executive told Chang that he wanted to go with EA, but that it was possible the board would go with another buyer that was offering a better price — even if it meant the team would be unhappy and leave.

Chang warned investors that such outcomes can end up being pretty bad for acquirers too and can scare them away from a deal.

“Even if investors have de facto control of the board, you have nothing if the management is not behind you,” Chang said. “If management isn’t coming with the transaction and isn’t going to be happy being part of EA, then we’re not buying the company.”

4) Corporate development folks say you should establish relationships with them early (though I have some mixed feelings about this strategy): Given rampant cloning issues in the industry and the risks associated with revealing too much about your business to a potential competitor, I’m not totally sure this is the best advice. But Zynga’s Olsen said to talk to them “early and often.”

“If you’re a small team with a great product, it’s OK if it’s not launched yet,” he said. “We just want to start a dialogue early. Make sure to keep in contact over time.”

EA’s Chang said his corporate development department often sources opportunities for other parts of the company. “It’s helpful for groups to come to us. We know what different groups inside the company are looking for,” he said.

With the KlickNation deal, EA had started looking at core gaming on Facebook over the past year as the head of the Bioware unit was looking to expand on the social network. Because KlickNation billed itself as the “Bioware of social games” and was profitable, it seemed like a perfect fit.

5) Don’t go out trying to get bought: This is another obvious, but salient point. Liew emphasized, “Companies are bought, not sold. If you’re trying to find a buyer, that’s a difficult situation. If you’re calling EA or Zynga, that’s typically not how these transactions happen. Usually, these guys are reaching out to you. So the real question is how do you get noticed by them?”

6) Look for an acquirer with shared values that you’ll really be happy at: Chang says founders that go to Electronic Arts only to stay for two years and then leave aren’t really that valuable. “That’s a waste of money,” he said.

“We want marriage, not a shot gun marriage,” he said. “I like to tell younger companies that they should be promiscuous. They should find out what it’s like to work at EA or Zynga so they know which one would be the right place to join for a long-term home.” He said two of EA’s most senior executives came through acquisitions, and those are the kind of people he’s looking for.

7) It can be hard to make investors happy with pure talent acquisitions: Liew said “acq-hires” are definitely not what his firm, Lightspeed, is looking for. “We invest because we want to see companies that are worth hundreds of millions, if not billions of dollars. We’re not looking to have a team get trained up, so it can build games for someone else.”

The issue with many talent acquisitions is that the terms can end up being stacked against investors. An acquirer might structure a deal in a way that gives a poor valuation for the company, but gives a huge chunk of retention to the employees.

“What if the buyer wants to give 1 percent to the investors and 99 percent to the employees?” Liew said. “Well, you know what? We may have negotiated a deal where we invested for 50 percent of the company. We have a protective provision not to hurt the entrepreneur but to honor the original deal we made.”

That said, it’s quite common for a company’s trajectory to just miss the mark. And in that case, a talent acquisition is often the best outcome. Liew gave the example of Serious Business, which was sold to Zynga in February of 2010. The company had a popular app back in 2009 called Friends for Sale, but Liew said the game couldn’t really monetize.

“We recognized there were fundamental flaws in the game’s design that wouldn’t help it monetize. So we tried a second game, then a third,” Liew said. “At the same time, Zynga came along and recognized that the team was incredibly talented. Everybody looked around the table and said, let’s do this.”

Liew says he talks with the company’s team about how the proceeds should be split, to make sure everyone is happy with the outcome.

“We try to document everything upfront,” he said. “We didn’t have any shouting matches with Serious Business because we had been working together for a long time. We understood each other. It was a civilized set of discussions that ended up with them being at Zynga.”

He added that one of the co-founders, Alex Le, ended up being the executive producer on Cityville, and the other, Siqi Chen, went to Zynga China. (Chen recently left Zynga after two years.) “We ended up happy as well,” Liew said. “It was quite a reasonable outcome.”

8) A good acquirer will make a fair earnout, that isn’t impossible to reach: “If you set up unreasonable expectations, then folks will stream out,” Chang said. With EA deals, there is usually an upfront cash component, plus restricted stock units and other types of incentives.

Chang also said there are different ways to structure incentives. They can be tied to milestones, like the launch of certain games, or revenue. The risk though is that the industry is changing so fast, that it can make certain kinds of earnouts obsolete.

“In app purchases weren’t really around a year ago. Facebook wasn’t around as a viable gaming platform until the last few years,” he said. “It’s hard to predict changes in the market.”

In the KlickNation deal, Otero got to have a lot of input in designing his own earnout, based on forecasts for his company’s revenue.

“They allowed us to create our own earnout schedule and timeframe,” he said. “When the deal closed, it was very successful for me. So I was really happy there. Plus, the earnout was this additional piece of cake that I really wanted to earn. I wanted EA and Bioware to know that this was a great investment for them.”

Zynga’s Olsen was less specific but he also said that he tries to find ways to make the entrepreneur’s and Zynga’s interests align. “At Zynga, we want to build a network of entrepreneurs and we give them the freedom and incentives to do this,” he said.

Giving the VC perspective, Liew was against earnouts.

“I hate them,” he said. “Earnouts are used because there is a gap in valuation. The acquirer wants to pay X, and the company wants to sell for X+Y. So how do you bridge the gap? Usually, it’s a difference in expectation about what the company is going to do.”

He said that there are often factors beyond the entrepreneur’s control that can destroy their ability to meet an earnout. Liew said there was a company he knew of that missed a quarter of their earnout because their acquirer had a companywide hiring freeze.