Startup Review

Xfire Case Study: Successfully changing product direction

written by Nisan Gabbay, posted on November 19th, 2006

Why profiled on Startup Review

Xfire provides a free instant messaging service designed for online gamers. Xfire enables gamers to detect what games their friends are currently playing and allows unobtrusive IM communication from inside the game. In May, 2006, Xfire was acquired by Viacom’s MTV Networks for $102M in cash. Launched in January 2004, Xfire now has 5.6 million registered users, with ~300,000+ joining each month.

Interviews conducted: Early employee who chose not to be disclosed.

Key success factors

Successfully changed product direction

When the founders of Xfire first set out to create a service for online gamers, the IM service which is today Xfire was not their original product. Xfire was actually the second product launched by a company originally called Ultimate Arena, a service that hosted online gaming tournaments. Ultimate Arena users would pay a fee to compete in a tournament or game with other Ultimate Arena users and the winners would collect their prize, while Ultimate Arena collected a “rake” of sorts for facilitating the action. After just 6 months, and despite some initial user success, the Ultimate Arena management recognized that the business would not flourish. Although they were able to attract users to the Ultimate Arena service, not many stuck around because, quite simply, users lost money when playing Ultimate Arena. Users recognized that they couldn’t beat players with more advanced skills and hence there was not a strong enough value prop for the vast majority of users. Ultimate Arena appealed to gaming pros, but not mainstream gamers for this reason.
About a year after launching Ultimate Arena, the team re-launched the company as Xfire, with the new IM service as the core product. The speed at which the management team was able identify the weakness in the Ultimate Arena service, commit to a new market opportunity around communication, and successfully develop a new product was a critical success factor for the company.

Provided a better solution for a large niche (gamers)

Prior to the Xfire service, there were clearly a number of pre-existing IM services (Yahoo, AOL, MSN). In fact, gamers were already using these services to communicate with each other while playing. So how was Xfire able to attract so many users? Wasn’t the Xfire service just another IM service?

Xfire offered just the right combination of features to solve the pain points that gamers had with their existing IM services when playing games. Existing services didn’t tell them which of their friends were playing what games and where. Sure gamers could IM a friend directly and ask, but that required a lot of effort on the part of the user. Other IM services detracted from the gaming experience by not having the right form factor. Xfire’s IM window was customizable, smaller, and could blend-in with the game being played. Xfire also integrates other features like voice and group voice/text chat and auto-patching of games/maps. They have a growing content site and a P2P digital content delivery system, which helps to address the full range of needs of its user base.
Proved revenue model using new ad format

Xfire showed great success in creating a product that users wanted, but equally important in my opinion was proving that they had created an ad product that advertisers valued. Xfire’s premium exit valuation can be partially justified by the fact that Xfire had “de-risked” the business model by demonstrating that advertisers would pay a meaningful CPM for a unique ad spot. The majority of Xfire’s revenue is generated from a small static image ad that sits within the IM client window while a user has the service running (and presumably playing the game). This ad format was neither of standard size nor had typical banner ad characteristics.

Xfire made a wise decision in hiring an ad sales person early in its lifecycle to help educate advertisers about the Xfire service and value of the ad spot. It is a challenging proposition to sell a non-standard ad format with an unknown brand. Furthermore, Xfire did not have the benefit of a third party service like ComScore or Nielsen to validate the usage metrics on its client. The Xfire sales team did a good job of getting high CPM rates (~$10) for a relatively unknown product. Luckily the Xfire ad spot could be highly targeted and the ad impressions easily tracked.

Management credibility

In general I have stayed away from pointing out management as a key success factor in the Startup Review case studies because with any successful company the team should be given credit. However, in Xfire’s case I felt it was worth pointing out for a few reasons. CEO and co-founder Mike Cassidy’s successful track record made it possible for the company to shift gears from Ultimate Arena to Xfire while maintaining support of its investors. A less experienced CEO would have been unlikely to pull off such a move. As a co-founder of Direct Hit (sold to Ask Jeeves for $532M) Mike was able to attract quality people and maintain employee and investor confidence through a difficult period. Dennis Fong’s celebrity status in the gaming world was also important in generating promotional spots for the company and building credibility with users. Xfire’s technical team also did a great job in quickly launching and scaling a distributed web service.

Launch Strategy

Xfire’s success in attracting users can largely be attributed to viral marketing and word of mouth. The company had its initial launch by seeding the service with a few thousand of its previously registered Ultimate Arena users. The service spread quickly because for any one user to derive value from the service, their friends had to be on the service too. Xfire took great care to reduce the friction points in the user registration process. For example, they did not even require e-mail validation to register, nor did they ask for any information beyond user name and password.

Xfire also grew its user base through business development deals and PR, but none of these generated immediate, huge spikes in user acquisition. These deals were responsible for adding a few thousand users in a week’s time, but no single event made the company. Xfire was able to secure some distribution by being bundled with games, most notably the popular America’s Army. During its first year, Xfire got three or four such deals. Xfire also leveraged the gaming celebrity status of one of its co-founders (Dennis Fong) for well-targeted promotion spots. One such promotional spot was an appearance on a German TV show for gamers that resulted in an immediate spike of 2,000+ registrations and kick started the viral growth in Germany. In fact, even today Germany is the second largest user population for Xfire, which can be largely attributed to this initial TV appearance.

Food for thought

I think that there is a lot that can be learned from Xfire’s success. The team did a remarkable job of transforming the company from Ultimate Arena to Xfire in a relatively short time period. The team didn’t fall in love with its initial product and strategy and was able to quickly adapt to serve the needs of its users. They scrapped Ultimate Arena as the focus after just 6 months despite having capital in the bank to continue refining that model. Entrepreneurs are given credit for being tenacious in pursuing their vision, but it is equally important to remain flexible and open-minded to what your customers, users, or the market is telling you. The shift in product was also made possible by the fact that the team had adequate funding to continue operating despite a monumental shift in the company’s strategy. For all the recent discussion around bootstrapping a Web 2.0 company, having some capital in the bank affords the flexibility for a wrong turn, course correction, or just normal product iteration. Having money in the bank doesn’t mean you should spend unwisely, but having some funds for a rainy day is a valuable thing and can greatly improve the likelihood of success.

A second interesting observation is how important the initial user base can be for the success of a company dependent on viral marketing. The fact that Xfire became so successful in Germany because of one TV appearance shows just how unpredictable user acquisition patterns can be with social Internet services. One of the companies I was involved with while at Sierra Ventures was Piczo, a teen-oriented photo sharing and social networking community. Piczo’s strength in certain geographies could largely be traced back to the initial users in those geographies. The lesson learned here is that the initial users are critical to defining the characteristics and growth patterns of the community.

Exit analysis

In May 2006, Viacom closed its acquisition of Xfire for $102M in cash. With some stock considerations, the total size of the deal is probably closer to $110M. Xfire had about 4M registered users at the time of acquisition and has since grown to 5.6M in 6 months. While I don’t have exact revenue numbers for the company, the valuation multiple was at a huge premium to revenue – much greater than a 5X revenue multiple. Xfire could have been breakeven 2 years after launch, but is not profitable today given extra investment in resources since the Viacom acquisition. Was such a premium valuation on current financial metrics justified? Xfire is in a good position to expand its offerings into becoming a leading social networking and content site for gamers. Its IM service has an array of interesting data that can be used to further build its online community. Thus, there is a good potential for future growth.

The motivation for the acquisition by Viacom’s MTV Networks unit is fairly straightforward. MTV’s target demographic is spending more time online and playing games, and less time watching TV. MTV Networks realizes that they need to beef up the digital side of their offerings to both users and advertisers. Given the impressive growth rate of Xfire, did the company perhaps sell too early? To date, Xfire had been faced with little direct competition. However, they are in a market with very large potential competitors like Microsoft, Sony, Yahoo, and AOL. Microsoft has an install base of Xbox 360 users and their 360Live service could be a good platform for launching a competing service to Xfire. Given the competitive risks, Xfire decided it was time to align itself with a larger company. Xfire’s investors made a good, but not spectacular return on their investment of ~$10M - $15M. The management team did a good job negotiating strong valuations for the company and minimizing equity dilution, this was in large part due to their previous track record. With a different team, the investors would have captured a much larger portion of the equity.

Reference articles / Further reading

“Is Xfire the next MySpace?”, Fortune, February 17, 2006
This article provides details on Xfire’s advertising model and some insight on its success.

“Xfire marks the spot”, Twitch Guru, February 23, 2006
This article provides a good overview of the Xfire product and how it is used by gamers. Just the right amount of detail.

“Xfire interview”, Firing Squad, April 25, 2006
This interview with Xfire CEO Mike Cassidy has some good questions around motivation for the Viacom acquisition and future strategic direction for Xfire.

“Reaching the unreachables,” Business 2.0, October 2005
Article has some nice insight to the ad market that Xfire addresses. Speaks to the Xfire ad model and provides specific CPM rates.

“Try, Try Again: Can Xfire Massively Monetize Multiplay?”, Electronic Gaming Business, June 16, 2004
Article has a good description of Xfire’s monetization strategy. Also provides some detail on the shift from Ultimate Arena

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