Financial Strategy of Riot Games - Literature review Example

Literature review of financial strategy of Riot Games

Table of Contents

Introduction and background of the company3

Strategic financial management and performance of the firm4

Capital structure and firm’s financial strategies7

Working capital management and firm’s financial strategies10

Conclusion13

Reference List14

• Introduction and background of the company

Riot Games is a pioneer in developing and publishing video games and is headquartered in Los Angeles, California, United States of America. The firm has multiple offices located in Hong Kong, Dublin, Mexico, New York, Brighton, Moscow, Taipei, Sydney, Singapore, Seoul, Tokyo, Shanghai and Istanbul.

Riot Games attained their fame when they launched the ‘League of Legends’ in the year 2009 in Europe and North America. The latest game launched by the firm is Blitzcrank’s Poro Roundup which it released in the year 2015. This game is supported in both Android and iOS. Riot Games was founded in the year 2006 as an indie game developing firm by Brandon Beck (also known as Ryze) and Marc Merrill (also known as Tryndamere) in Los Angeles. In the year 2008, the firm announced that League of Legends: Clash of Fates or simply the League of Legends has been officially launched (Riot Games, 2016).

The company was facing problems to manage its financial resources properly and it could not raise finance from investors and banks until the success of League of Legends in 2008. After the tremendous success of League of Legends, the company was able to raise funds worth $7 million by venture capitalist firms FirstMark Capital and Benchmark Capital. This was a remarkable feat for the firm and in 2009, it was able to raise another round of funding from existing investors and Chinese technology giant, Tencent Holdings. Tencent Holdings were so optimistic about Riot Games and their business plan, that it ultimately acquired majority stake in Riot Games in the year 2011 (Gaudiosi, 2015). In the interim report of Tencent Holdings, it was found that the deal was worth over $ 230 million (League of Legends, 2016).

• Strategic financial management and performance of the firm

According to Richard, Kirby and Chadwick (2013), financial strategies in corporate firms are formulated on the basis of the leadership skills of the management and work environment. Successful corporate financial strategies depend on effective integration of resources, work environment and leadership skills. In relation to the arguments of Chun et al. (2013), the connection among these three variables has been observed in different settings in both developed and developing countries. The authors who believe that financial strategies of a firm depends on organisational structure, leadership and environment, hold the view that financial management constitutes critical part of overall strategic management.

According to Lechner and Gudmundsson (2014), corporate finance and corporate strategy are inter-related and helps a firm to attain competitive advantage. Corporate finance helps both small and large firms to manage their financial resources so that the value of the firm is maximised or the risk of the firm is minimised (Wan, Lähtinen and Toppinen, 2015). Riot Games will have to integrate corporate financial strategy into their business model to synchronise strategic decision making process in relation to long-term goals of the organisation. This includes financial strategies involving management of firm’s liquidity, activity, solvency, profitability. These are the critical areas in financial management which affects the wealth of the shareholders and should therefore be managed properly by the firms to attain long-term objectives (Lucas and Noordewier, 2016).

Yu, Ramanathan and Nath (2014) stated that, one of the main concerns of the firm is to add value to shareholders’ wealth. Riot Games will be able to add value to shareholder’s wealth by balancing between profitability and liquidity. According to Shaw, Park and Kim (2013), liquidity of assets and profitability are inversely proportional implying increase in liquidity will minimise profitability and vice versa. Riot Games will have to ensure that excess profitability does not affect the liquidity of assets and vice-versa. Suppose that the firm decides to invest $1 million from its surplus profits in prospective new technology which will yield minimum 12 percent annual returns, however, this decision will have two effects. Firstly, the profitability of the firm will increase by 12 percent to $1.12 million at the end of one year; secondly, the liquidity of the company will reduce by $1 million at the same time. The possible implication is that if the company urgently requires paying the creditors then it could fall short of liquid assets. Thus, it is important for Riot Games to formulate a financial strategy that will balance liquidity and profitability (Rothaermel, 2015).

According to Bharadwaj et al. (2013), firms having higher cash flows or profits have more potential to grow their business in future. However, it is important to adapt successful financial management strategies and address key issues including stakeholder management. The financial performance and competitive advantage of a firm depends on how the company devised strategies to utilise assets and plans to raise finances from external or internal sources (del Mar Alonso-Almeida and Bremser, 2013).

Wagner, Grosse-Ruyken and Erhun (2012)opined that, there could be variety of factors which can affect the performance of Riot Games like relationship with suppliers, demand for games in the market, competition, differentiation strategies in product offerings and so on. According to the arguments of the authors, these factors have been the major cause affecting the business environment of developing countries. Zook and Allen (2013) noted that the global financial crisis has affected the economically advanced economies as well and companies operating in the US and UK are also facing various issues in the domestic market. In order to remain profitable and drive consumption, firms in the developed economies are scouting for alternative investment strategies that will help to expand business and acquire new customers or markets (Brush, 2015).

In regards to Riot Games, there can be two applicable financial strategies to manage firm’s financial performance:

Resource-based strategies – According to the views of Bentley, Omer and Sharp (2013), resource-based financial strategies helps to optimise specific capabilities of a firm to create value. It is important for the organisations in contemporary era to understand that material and financial resources of a firm are limited. If the assets of the organisation is not utilised properly, then it will lead to financial losses (Bentley, Omer and Sharp, 2013). In case of Riot Games, which specialises in developing gaming software, the firm will have to decide whether or not it should outsource some of its business segments. The gaming company has a technical department which develops software codes used in gaming. There is another department, which test the codes built by software engineers by executing the software in trial runs through a process known as software testing. If the firm decides to keep a dedicated in-house software department team for developing gaming solutions, then it is likely that the cost of recruiting, training and retaining the software engineers will be very high. Consequently, the administrative expenses of the firm will also increase disproportionately leading to minimised profits. According to Chandra (2013), many firms often outsource their in-house capabilities to offshore software development units through a process called software outsourcing. In general, the main objective of software outsourcing is to minimise the cost of operations and increase profit margins. There is a great opportunity for Riot Games to outsource some of the business activities in emerging markets like China because of the availability of skilled yet cheaper labour. Structure based strategies – According to Buchko (2015), the structure based views are industry specific and depends on core issues and structure of the firm. Studies show that contemporary software companies tend to have flat organisational structure which is very different from the traditional hierarchical organisation. The main advantage of flat organisational structure is that Riot Games will be able to minimise communication gaps and increase efficiency of the firm.

• Capital structure and firm’s financial strategies

As stated by Campello and Giambona (2013), capital structure refers to the resources generated by the firms through internal and external sources of finance of the company. The traditional views on capital structure theories suggest that corporate financial strategies of a firm do not depend on capital structure as the composition of capital structure has no influence on the overall market value of the firm. According to the arguments of Alcock et al. (2013), in case the capital markets are efficient and that tax benefits are applicable, then it will be possible for the firm to increase its market value owing to tax benefits of debt financing.

In the opinion of Berger and Bouwman (2013), there has been a debate regarding capital structure theories in the world of finance regarding optimal capital structure. There is one school of thought that suggests that optimal capital structure is attainable and market value of the firm can be improved by including debt funds in the capital structure. The positive views regarding optimal capital structure is supported by the relevance theories, while the views which do not agree with the optimal capital structure are known as irrelevance theories.

Riot Games have initially raised capital from venture capitalists which was already in the previous section. Venture capitalists are risk takers because investing in new start-ups involves significant risk and since the performance of the new companies such as Riot Games has not been proven, there are high chances that the investor could lose their money if the product is not successful. It is not uncommon to find venture capital investment in software firms because their market values are not proven and from the company’s financial strategic perspective, it is not possible to raise capital during the initial stages from banks or primary market (Brigham and Ehrhardt, 2013).

The main internal sources of finance of firms are reserves and surplus and equity issue. In order to raise funds from issue equity capital, it is important that the firm has three years of consecutive profits and sufficient assets to manage liquidity. In case of new firms, it is very rare to enter the primary markets because most of the firms do not have the required experience and financial resources to manage internal capabilities. Hence, one of the best alternatives available to companies is to either use their retained earnings or look for venture capital funds (Feld, Heckemeyer and Overesch, 2013).

According to Rosenbusch, Brinckmann and Müller (2013), venture capital can be issued in the form of equity or debentures. In the first case, the investors (or venture capitalists) will have significant authority over management and decision making. The venture capitalist will be able to convert their investment into equity shares after five years or specific time period depending on the terms and conditions of the contract. For example, in case of Riot Games it has been observed that the Chinese venture capitalist, Tencent Holdings, initially invested in the firm for growth but later acquired majority shares of the company in order to get more power in decision making process. The main features of venture capital are:

• This type of investment is very common for innovative projects
• The benefits of this type of investment are generally realised in the long run
• Suppliers of venture capital funds mainly prefer to invest money in the new start-ups through equity capital so that in the later stage they get the chance to control the operations of the firm.

Hence, from the above discussion, it can be said that Riot Games was able to raise capital during critical stage of company’s growth with the assistance of venture capitalists. However, in the long run, it had to pay the ultimate price by diluting management stake to external parties. This highlights the importance of modifying existing financial strategies (Rosenbusch, Brinckmann and Müller, 2013).

One alternative for the gaming firm to raise funds is through debt capital which is also cheaper than equity capital (Campello and Giambona, 2013). According to the arguments of Alcock et al. (2013), it is important for firms to analyse the cost of capital before taking long-term financing decisions. This is because, the cost of capital plays an important role maximising the value of firm. When the cost of capital is less than the returns of the new project then the shareholders’ wealth will increase. There is another option for the firm which is internal reserves and surplus. According to Campello and Giambona (2013), growing companies like Riot Games generally reinvest their earnings into the business so that the company grows into a bigger organisation. Riot Games can follow the pecking order theory to finance its business expansion. In relation to this theory, the cost of capital reduces with asymmetric information. That is, if the market finds out that the company has sufficient internal resources to finance operations then investors will show confidence in the company. The main assumption of this theory is that the relationship between corporate performance and capital structure is negative. Once the internal resources are utilised by the firm, it can resort to external sources starting with debt capital (which is cheaper than equity capital) followed by equity capital (Berger and Bouwman, 2013). By following this capital structure financial strategy, Riot Games will be able to improve its financial performance, increase profitability and maximise the value of the firm.

• Working capital management and firm’s financial strategies

According to Baños-Caballero et al. (2014), liquidity of assets directly influences the profitability of the firms and therefore working capital management is an important part of financial strategy. In the opinion of Abuzayed (2012), working capital helps the firm to manage risk, liquidity, risk and market value. The concept of working capital management emerges from the difference between current assets and current liabilities in order to ascertain whether short-term assets are in abundant to honour short-term liabilities. Current assets of Riot Games include cash, marketable securities, inventory of unsold games, accounts receivables, etc. The current liabilities of the firm include account payable to creditors, overdrafts from banks and accruals (Bender, 2013).

According to Jayachandran, Kalaignanam and Eilert (2013), firms adapt different working capital strategies and depending on business environment, they can be classified as conservative, moderate and aggressive financial strategies. Empirical evidence indicates that aggressive working capital management will assist the firm to enhance its performance in terms of profitability, but its short-term liquidity will have to be compromised. Contrary to this approach, a firm can also increase its profits by maintaining high inventories and minimising supplier cost, price variation and out-of-stock cost (Bender, 2013).

An important study conducted by Ding, Guariglia and Knight (2013) shows that for small and medium sized organisations, working capital is a ‘blessing in disguise’ because their access to external borrowings and long-term sources of funds is very limited. Hence, another important factor for working capital management is the size of the firm. Riot Games is not a large-scale company and hence, working capital management is a very important financial strategy for the firm. The firm will have to balance its current assets and liabilities so that the gap between current assets and current liabilities justifies short-term borrowings. If the company is unable to oblige the dues in payment for all accounts payable within a year, then it will not be able to win the investor’s confidence. Consequently, the credit ratings of the company will also fall which will also increase the cost of capital of the firm (Brigham and Ehrhardt, 2013).

One way through which that Riot Games can measure the performance of current assets and current liabilities is through liquidity ratios namely, current ratio (current assets per unit current liabilities) and quick ratio (current assets less inventories per unit current liabilities). The main essence of these ratios is that they are indicators of liquidity and working capital management. In the software industry, the value of this ratio should be higher than 1.5, in order to sufficiently manage short-term obligations. If the value of this ratio is less than one then there is high chance that the company will not be able to repay its creditors in time and could also default. It is therefore important for the firm to ensure that cash flows of the organisation are predictable and cyclical slowdowns in business are manageable. In case the firm is unable to manage its short term assets properly, it will have no choice but liquidate long term assets to repay creditors (Ding, Guariglia and Knight, 2013). It may be noted here that software and gaming companies like Riot Games are very capital intensive like manufacturing and real estate companies. The company operates in the service sector and the primary cost of the company is to invest in technological infrastructure, patent acquisition, retaining talented professionals, etc. The short term accounts payables of the company include monthly salary, daily wages of maintaining systems, etc. If the firm is unable to address these issues, then it will have to answer the board of directors (which now also includes external management) regarding the efficiency of the management in utilising assets (Kroes and Manikas, 2014).

According to Baños-Caballero, García-Teruel and Martínez-Solano (2014), financial strategies are more focussed towards long-term strategic decisions such as dividend policies and capital structure decisions rather than managing short-term funds. However, in regards to this argument, Abuzayed (2012) have argued that short-term investment and financial are equally important because they influence corporate performance. Some of the working capital management strategies that Riot Games can apply are:

• Regular follow-ups with debtors who lag behind payment due dates.
• Invest a portion of cash and cash equivalents in the money market securities having maturity period less than 3 months.
• Avoid piling-up excess inventories as the gaming industry is highly competitive and unsold stocks will have to be sold at discount.
• Maintain excellent relationship with creditors, bankers and their representatives and also repay short term loans before due date.
• Conclusion

One of the primary objectives of contemporary businesses is attaining profitability. According to Rosenbusch, Brinckmann and Müller (2013), the success or failure of gaming companies like Riot Games depends on how the firm manages its financial resources. The literature review of financial strategies reveals that in most cases, the corporate strategies depends on organisation structure, leadership skills and business environment. Companies in software and gaming industry generally follow a flat organisation structure in order to minimise communication gaps. According to the resource-based philosophies, the firm will be able to minimise its cost of operations and improve profitability if Riot Games decides to outsource some of its business segments without diluting operational controls. The capital structure theories suggest that it could be possible for the firm to optimise capital structure by including debt capital. Another important area of financial strategy is management of short term funds through working capital management. Riot Games is advised to balance liquidity and profitability considering risk and returns.

• Reference List

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