EA made an offer PopCap couldn’t refuse

July 13, 2011, 5:36 AM UTC

Why PopCap Games chose EA over an IPO.

Electronic Arts Inc. (ERTS) today agreed to acquire PopCap Games, a Seattle-based maker of casual games like Plants vs. Zombies and Bejeweled.  The deal is valued at upwards of $1.3 billion, including $750 million up-front ($650m in cash) and up to $550 million in multi-year earn-outs based on financial milestones.

PopCap has been around since 2000, but didn’t raise outside funding until a $22.5 million investment in 2009 led by Meritech Capital Partners. I spent some time on the phone earlier tonight with Rob Ward, the Meritech partner who led the deal and sits on the PopCap board of directors. What follows is an edited transcript of our conversation.

Fortune: Was PopCap games headed toward an IPO?

Rob Ward: The answer is yes, it absolutely was well under way. Right after we invested, they hired Bob Chamberlain as their first real CFO, and he had been CFO of Watchguard and F5 Networks and a number of big, public Seattle-area companies. Then they added Rick Fox as audit committee chair and Steve Raymund, former CEO of Tech Data, as compensation chairman. So they had made those changes to the board, and also changed auditors to get their books in order.

The plan was to file for an IPO in the second half of this year, and go out in Q4 if the SEC was willing or in Q1 of next year if they were less helpful. Then they did a market check like you always do, and found themselves in a situation where they got a compelling enough offer from the right partner.

PopCap CEO Dave Roberts expressed concern that the tech valuation bubble could put Popcap in the untenable position of justifying an inflated valuation in the public markets. Legitimate worry?

It’s a very fair question and one we talked about a lot at PopCap board meetings and other portfolio company board meetings. How I’d frame it is: I don’t think it’s the best thing in the world to have your IPO value get ahead of the true intrinsic value of your company. IPOs are supposed to be financing events, not the end game. The problem with having your stock go from $15 to $100 in T+1 trading days is that you’ve got to bring in new employees with option pricing way out of line from where it should be. And it’s different than what existing employees have, which can create strange issues internally.

The challenge is particularly tough with digital media and consumer-branded companies, because that strong retail component often drives the post-pricing pop. Ironically a lot of companies decide to have smaller deal sizes to avoid scarcity, get a good pop and trade up. I think that if you’re a recognizable consumer brand, you need to have a larger IPO to mitigate that effect.

So it was absolutely a concern, but it wasn’t the overriding reason why the sale to EA is happening.

So why is it happening?

Rob Ward

PopCap went out to a small handful of folks that it made sense to do a market check with, and everyone on that list either formally or informally came back at them with an offer to buy the company. It’s not really shocking, because this is one of the last great franchise companies in the casual gaming space, with some of the best brands like Bejeweled.

Until now, the company had always said no to takeover offers. Sometimes it wasn’t the right cultural fit or they didn’t think the buyer had enough appreciation for great game developers or it just wasn’t the right time for PopCap.

But this was a very compelling offer. Not just from a financial standpoint, but also the way that they’ll be allowed to operate inside of EA. At the end of the day, this is a great chance to build a preeminent digital gaming company across all these different distribution platforms and geographies. PopCap is about great brands and great games, which makes them a fit with EA.

Well it’s clearly a strong move into digital by EA, following the Playfish purchase.

I think it’s a masterstroke by [EA CEO] John Riccitiello. How many times do you see a 1.0 company turn into a 2.0 winner? It can happen, look at Apple, but it usually ends up more like Yahoo. This puts EA at the front and center of digital gaming.

This deal involves a lot of earn-outs. When biotech VCs get an earn-out, they usually expect to see around 20% of it. How do you forecast a gaming earn-out? 

I wish I could be that formulaic. For us it’s much more deal-by-deal. One of the things that gave us a lot of comfort here was how EA dealt with other acquisitions recently, including Playfish. That deal had similar components and not only has turned into a very nice financial returns for Playfish investors, but a lot of those senior execs are still running important parts of EA’s business. So we’re banking on seeing lots of that money.

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