Important tinyBuild update

Things have taken an unfortunate turn for the worse at tinyBuild. As outlined in their latest trading update, revenues were significantly lower in Q4 than expected due to a number of factors.

First among these was the delay in signing certain large contracts, which as of 6 December remained under negotiation. Several releases have also been delayed, including the highly anticipated Broken Roads - previously expected to make a considerable contribution to Q4 revenue. This was further compounded by weaker than usual sales across the portfolio, that has driven management's full-year revenue expectation down to $40-50m, with the upper end being dependent on the aforementioned large contracts being signed.

Entwined within this was the legal dispute with Steve Escalante, the Founder of Versus Evil, who has unfortunately been running the studio (into the ground) as General Manager since the acquisition. It seems that he has been able to extract a further $3m from tinyBuild for his exemplary service in this time.

This payment settles one of the two claims against the company. The second, related to the contingent consideration cancelled as a result of the studio's underperformance, is being settled with a payment of $500k.

It's disappointing that a payment is being made at all, but from the conversation I've had with management, it seems they were forced into a quick settlement due to the dramatic decline in revenue, and inability to take any strategic action with Versus Evil while the legal claims were unresolved and Steve Escalante was at the helm - he will be departing presently.

In short, the company couldn't afford a lengthy legal dispute - however likely they were to win - and it had consequences beyond the legal fees (not least 3 delayed games at Versus Evil).

Another consequence of the revenue shortfall has been the acceleration of the company's cost reduction plan, which has unfortunately resulted in significant redundancies and the closure of two studios.

At a company level, there's going to be an initial impact from one-off severance charges and further asset impairments, but the actions taken thus far are expected to result in a $5-10m per annum reduction in cash outflow.

The company's cash balance at the end of November was $5.7m, and is expected to decline further by the end of the year, leaving the balance well below the $10-20m previously guided. If the previously mentioned large contracts are not signed, the company is going to run out of cash by the end of January. A $10m equity raise has therefore been proposed, subject to shareholder approval.

Alex Nichiporchik (tinyBuild's CEO and Founder) has expressed his willingness to underwrite this equity raise, but were this to result in him increasing his ownership percentage, it would also be subject to a shareholder vote.

Discussions with management

Myself and a number of other shareholders wrote a letter to management, which was sent the day following the announcement (6 Dec). Two of our number then had a meeting with management on the 7th.

In the letter we raised our concerns about excessive dilution of existing shareholders, unwilling or unable to participate in the equity raise, and presented some potential alternatives and safeguards.

The first alternative was asset sales. Apparently the M&A market is surprisingly active right now, despite game sales having deteriorated across the industry. Unfortunately, given the company's current position of weakness they are receiving very low offers, making asset sales an unattractive option at this time.

We also discussed the use of other securities like preferred equity or convertible debt, but they weren't too keen on these options because of the perceived higher costs and conflicting incentives for Alex as both shareholder and creditor.

When it comes to a common equity raise, there are two main ways they can do it:

1. They use the market price at closing the previous day and apply a discount.
2. They set a fixed price, independent of the market price, to cap the dilution.

We have obviously pushed for the second option as it limits the extent of the dilution to a (hopefully) reasonable level. If instead the first option were chosen, you'd likely be looking at a >50% reduction in the value of your shares, as the price has fallen dramatically since the announcement.

So what would be a reasonable price?

If the price were set at $0.15 (£0.12 at the current exchange rate), 66.67m new shares would need to be issued to raise the required $10m, which would result in the shares losing just under 25% of their current value (based on 203m shares outstanding pre-issuance).

In a scenario where Alex was the only participant at this price and permitted to go beyond his current ownership percentage, he would end up owning 53% of the shares outstanding, making him the controlling shareholder.

Crucially, whatever price is chosen, it needs to be palatable enough to pass the vote. If the dilution is going to be high, shareholders may prefer to take their chances with bankruptcy, given that the company's equity value is far higher than the current market capitalisation.

My thoughts

I am confident Alex won't let the company fail, but less so that he's going to avoid destroying minority shareholders' capital through excessive dilution.

In all honesty, I've already invested a very significant portion of my portfolio into the company, having been assured that this kind of equity raise was not going to be necessary. It's very hard for me to consider providing more capital on this basis.

Were my current shareholding smaller, the situation might be different, and I don't want to dissuade anyone else from participating. Everyone should decide for themselves whether or not they want to increase their exposure, factoring in their own individual circumstances.

I truly commend Alex for his commitment to the company, demonstrated by his willingness to underwrite this equity raise, and I have no intention of selling my holding. I just hope he (and the Board for what they're worth) will consider the minority shareholders when deciding on the price and resultant level of dilution.

A higher price would likely mean Alex needs to put up more of the cash, but it would also go a long way to restoring trust which may prove to be the more valuable currency down the road.