ATARI SELLS ITS SELF TO SURVIVE SUCCESS
Warner Communications is the buyer -- and provider of backing for expansions

Business Week Magazine
November, 1976

When a small company invades a big market, success can be almost as hard to cope with financially as failure. "It takes a lot of cash to build a $20 million inventory for a three-month [Christmas] selling season," reflects Nolan K. Bushnell, a 33-year-old computer shit who turned an idea for a video ping-pong game into a company that almost outgrew itself. Bushnell's company, Atari Inc., of Sunnyvale, California, survived success by becoming as clever at playing financial games as at designing electronics ones. And last month, chairman Bushnell made his shrewdest move yet: He sold Atari -- which earned $3.5 million net on sales of $39 million in the fiscal year ended last May – to Warner Communications Inc., the cash-rich conglomerate. He thereby netted some $15 million for himself and provided the financial backing for Atari to grow even faster.

"Atari’s problem is a cash problem," says Emanuel Gerard, an executive vice-president of Warner, which paid $28 million in cash and debt securities for Atari, and money is not a problem for us." Even with its cash nest egg of $250 million, though, Warner may be hard pressed to finance all the growth Bushnell is aiming for. By pioneering the coin-operated video game market and then developing a game attachment for home TV sets, Atari grew tenfold in the last three years. But the home video game is still in its infancy. By some industry estimates, Atari could be in theory selling some 15 million units a year, with a value of nearly $500 million, in three years' time. Caught short. On its own, Atari could not hope to take full advantage of this opportunity, and until Warner came along it faced the prospect of watching a replay of its experience with "Pong," the first successful coin-operated video game. Unable to meet the demand stimulated by Pong's success, Atari watched licensees and competitors walk off with most of the spoils. "We sold fewer games of the Pong type than anybody else," Bushnell says, "because we didn't have the cash to produce what the market demanded.

Indeed, it was only through some ingenious financial bootstrapping that Atari was able to share in the market at all. Just three years out of the University of Utah, Bushnell founded Atari's forerunner, Syzygy Co., in 1971 with $250 from a savings account. To get some cash flow going while he developed Pong, Bushnell first started leasing pinball machines from other manufacturers. "You can finance them with virtually nothing dawn," he explains, "and revenues in the first few months are usually well above your monthly payments."

Together with a consulting sideline, the pinball machines brought in about $1,000 per month in positive cash flow, which Bushnell poured into research and development. And a $50,000 line of credit on receivables from Wells Fargo Bank's special industries group, which lends to high-technology companies, gave Atari the wherewithal to start manufacturing.

Bushnell managed to pay the bills by tracking inventories closely. "With expensive parts, such as cabinets, we tried to get them out the same day they came in," he says. "And we made sure that 75% of the cost turned over in less than a week." Atari also took advantage of the soaring demand for Pong by insisting on cash payments from distributors instead of going along with the longer terms common in the coin-operated game industry. Even though competitors quickly moved in, Atari was able to rack up sales of $3.2 million in fiscal 1973.

The next year, though, Bushnell learned the danger of betting a company on just- one product. Pong sales were dropping, forcing Atari to count heavily on a new race car game called Gran-Trak 10. But manufacturing bugs stalled production of the machine long enough to inflict a loss of $500,000 -- as much as the company had made the previous year. "We cut the company back by almost half," Bushnell says, "but we did it about three months later than we should have." As one result of the mishap. Bushnell turned operations over to the president of a subsidiary, Joseph F. Keenan. "He's a brilliant hard head," Bushnell says of Keenan. "Atari has made money in every quarter since he tool over."

Getting Capital. The loss also started Bushnell thinking about diversification. "We looked at both electronic pinball machines and consumer games," he says, "and the latter turned out to be ready first." furthermore, Bushnell discovered, the consumer market would require huge cash outlays because of its seasonal nature. That meant increasing the capital base of the company to support the short-term loans it would require. "We decided it was time to shore up the company financially and groom it for the public market," he says. The first step was to put together a venture capital syndicate with backers from various parts of the country, a job taken on by Donald Valentine, who heads the venture capital arms of Los Angeles-based Capital Research & Management Corp.

By the summer of 1975, Time Inc. and the California-based venture capital Mayfield fund had each agreed to match the $600,000 that Capital Research was putting into Atari, and toward the end of the year Valentine landed an additional $300,000 from Boston's Fidelity Venture Associates added to retained earnings of $2.5 million, the new money gave the company a capital base of about $4.5 million, enough to back bank lines totalling $10 million. Straining resources. Even the enthusiastic Valentine, however, failed to appreciate the growth potential in consumer games. It was far greater than Atari had bargained -- or capitalized -- for. "The market got bigger quicker than I had envisioned," he says. As 1976 began, Bushnell and Valentine -- now on Atari's board -- began a frantic search for additional capital. But early optimism in discussions with potential underwriters faded along with the rally in the stock market. "They weren't so much pushing the price down as wondering whether an offering could be done at all," Valentine says.

Meanwhile, the manufacturing build-up for this year's Christmas season was under way, and Atari was straining against its capital limitations. "We decided that it might make sense to merge, Bushnell says, "so we listed three companies with some synergies." One of the companies on the list was Warner. Capital Research Vice-President Gordon Crawford was acquainted with the company through Capital Research's mutual fund holdings of Warner stock. Crawford approached Gerard, who responded quickly and positively to the idea of acquiring Atari.

In a series of negotiations over the summer, Warner soon came to terms with Bushnell and Valentine. The Atari negotiators were armed with a book of scenarios prepared by Wells Fargo's corporate finance department, which ran the company's prospects through a computer and came up with dozens of possible price ranges, based on various assumptions about Atari's growth and Warner’s aspirations. "The $28 million price is close to our scenario II," says Wells Fargo Vice-President James M. McTaggart. "That assumes an 18% annual return to Warner based on a 20% annual growth of earnings for Atari."