From his office in the building above the Chicago Planet Hollywood Restaurant, Howard Tullman, President and Chief Executive Officer of Imagination Pilots, Inc. was contemplating his company's next move. The company he founded in 1993 had released several critically acclaimed and commercially successful educational and entertainment CD-ROMs over the past several years. However, two previous strategic alliances with larger technology and entertainment companies had ended with promises unfulfilled, while IPs current alliance with the Warner Music Group seemed to be headed for a corporate divorce. Tullman wondered what to do about the Warner alliance - should he make another effort to preserve the deal? If not, should he test his luck with a strategic alliance with a fourth company? One thing was a certainty: whatever decision Tullman made was sure to have an impact on the future prosperity of his fledging company.

RESEARCH ASSISTANT SAMUEL Li, MBA2, PREPARED THIS CASE UNDER THE SUPERVISION OF PROFESSOR TOBY STUART AS THE BASIS FOR CLASS DISCUSSION.

The Educational and Entertainment Software Industry

Imagination Pilots produces multimedia computer software on CD-ROM. The company focuses on educational and entertainment software -- industry segments that share many of the characteristics of other entertainment content industries, such as film, books, or music.

The market for computer software on CD-ROM was largest in North America, followed by Europe and then Asia. In North America alone, entertainment software sold $649.1 million in 1995, while educational titles generated $571.6 million in sales. Growth in the former segment was 42.7% during 1994, while growth in the latter segment was 1.0%. In part because technological improvements had dramatically lowered the cost of powerfully equipped personal computers, multimedia had become the fastest growing segment of the software industry. For the first three quarters of 1995, CD-ROM software sales amounted to $932.7 million, a 255% increase over 1994 sales during the same interval. These sales were garnered from many thousands of different software titles (a "hit" title in the entertainment segment, for example, was considered to be sales of two hundred thousand units).

The CD-ROM Production Process

There are five stages in the production of a multimedia CD-ROM. Although a few firms performed more than one of the stages from production through distribution, most CD titles were produced by "passing off" the product to a different company at the next stage of the value chain.

Content Source

The content source simply licenses a copyrighted name, character or story to the firm who then developed the licensed asset into a multimedia title. For example, the Mayo Clinic licensed its name and data to be used for a medical reference product (The Mayo Clinic Home Health Guide), and MGM/UA licensed the rights to Blown Away (an action film) to IP to create a computer game of the same name. Content sources typically did not become involved in the development process. In the usual license contract, the content source may get roughly 5% of the retail price of the title as a royalty fee, some of which is paid upfront and the remaining portion is typically guaranteed.

Multimedia Software Developers

Software developers produce the content for CDs. Companies at this stage of the value chain follow one of two strategies. First, some firms converted text into CD-ROMs, with relatively minor multimedia embellishments. Often, these firms developed (rather than licensed) the text for their products. Second, firms such as IP typically produced full interactive narrative products. Sometimes they develop their own storylines, but more often they license content and then make myriad and usually radical changes to port a story to the CD-ROM medium. The process could be likened to creating a film from a novel -- the key is the ability to edit and alter a story to optimize it for the new medium. Typically, a good CD-ROM product involves substantial changes to build upon and improve the licensed content.

As in other segments of the software industry, the business of developing entertainment and educational content was highly fragmented. No one firm controlled anywhere near a dominant market share, and many enterprises amounted to little more than an individual working out of a basement or garage. However, as consumers demanded more sophisticated products, the cost of creating a new hit title had steadily risen. For full stories, the average development cost alone for a new CD (excluding marketing and advertising expenses) was between $1 and $2 million.

Publishers

CD-ROM publishers performed three functions. First, because many content developers were small companies, the publisher would often advance the production costs of a new title, recouping development costs from royalties on sales of the product. Second, once a software title had been completed, the publisher duplicated and packaged the product. Third, publishers typically marketed and promoted a CD-ROM title; average marketing budgets ranged between a quarter and a half million dollars, depending on the type of product.

Together, the publisher and the content developer typically received about 25% of the retail price of a CD-ROM. The usual contract called for a 60/40 split of this revenue between the two parties in favor of the publisher. There were a number of major CD-ROM publishers, including Cirius and Davidson & Associates.

Distributors

The distributor's job was to get CD-ROM titles to retailers. All of the major distributors would occasionally function as publishers as well. In the CD-ROM software industry, distribution was highly concentrated and dominated by several large firms, including Disney, Time Warner, Viacom, News Corp., and Microsoft. For a typical title, the distributor received about 20% of the retail price.

Retailers

The retail segment of the CD-ROM segment was in flux. In the early days of the computer industry, small stores specializing in computer hardware and software sold most of the educational and entertainment software. However, as computers began to make the transition into small businesses and homes, an increasing number of titles were sold through large office supply chains and computer superstores. Currently, as computers have further transitioned into consumer products, mass merchandisers such as Wal-Mart, Best Buy, Target, and Tower Records have begun to carry software titles. More and more software is being sold by large, nationally-established retail outlets, including a significant number of bookstore chains.

Currently, entertainment titles typically retail for up to $50, while educational titles sell for up to $40. Retailers typically purchase CD-ROM titles at about 50% of the retail price.

Industry Trends

To say that the CD-ROM software industry is in flux is an understatement. One way that the multimedia software business differs from other entertainment content industries is that technological changes constantly alter and outmode the products and vary the industry dynamic. As computer technology has improved, CD-ROMs have been written to take advantage of the latest computing capabilities. Improvements in monitors, sound, microprocessor speed and memory all enable more exciting and realistic CD-ROM products. However, these changes have also greatly increased the cost of developing a state-of-the-art CD-ROM title. For example, IP's newest product is a game based on the hit movie Eraser, starring Arnold Schwarzenegger. The development costs for this project are $1.6 million, compared to $923 thousand for the company's last entertainment project, Panic in the Park.

While the cost of developing a multimedia CD-ROM has grown, the number of multimedia PCs in homes also continues to grow, raising the potential market size for hit products. Growth rates in home computer sales, moreover, are not limited to the US. For example, the number of multimedia PCs in homes in Japan more than doubled to 7 million during the first 11 months of 1995, and the potential markets in Germany, the U.K., France and Italy were also growing quickly.

Changes in the retail segment also promise to bring about significant alterations to other segments of the industry. For instance, selling through mass merchandisers has the potential to greatly expand both the marketing budgets for CD-ROMs, as well as the scope of coverage. Moreover, with the continuing development of commerce over the Internet, the possibility exists that entertainment and educational titles will one day be sold and downloaded over the World Wide Web, completely eliminating the need for a traditional retailer.

Also, there was an emerging market for software to be packaged with hardware in Original Equipment Manufacturer (OEM) bundling arrangements. For instance, Intel Corp. has agreed to distribute IP's Eraser game with its next generation MMX microprocessor chip because the game can "show off' the capabilities of the new chip. Even more consequential, there is always the possibility of major changes in the way that games are played. One potential development was that a semiconductor manufacturer would produce a chip in a settop box so that games could played on the television (obviating the need for a home computer).

Howard Tullman and Imagination Pilots, Inc.

In many ways, Howard Tullman was an unusual man. Mr. Tullman did not possess the "typical" appearance of a highly successful businessman. His long hair and casual look would seem to make the 51-year-old entrepreneur more at home at the Planet Hollywood restaurant on the first floor of the 640 N. LaSalle building -- a property that housed IP and a building that Tullman owned. Yet, this exterior belied a prominent business man with important political connections. Tullman's office wall was blanketed with pictures of outings with governmental luminaries, including the President of the United States. His strong ties to the Democratic Party resulted in an invitation to a State Dinner with the visiting President of Brazil, and he is a member of the National Steering Committee for the Clinton/Gore 1996 Reelection.

Unlike many others in his field, Tullman did not begin his career as a software engineer or even as a dweeb with a basement filled with soldering irons, circuit boards, and Hostess snack products. A 1970 honors graduate of the Northwestern University School of Law, Tullman specialized in Federal litigation for ten years. Following that tenure, he founded and headed several start up companies that specialized in providing computerized information to individuals and businesses. One company he founded, CCC Information Services, was the fastest growing company in Illinois from 1981 to 1985. Inc. Magazine also named the firm, which provided automobile valuations to the 200 largest insurance companies, to its 100 fastest growing companies in 1986 and again in 1987. Tullman was selected as the "Entrepreneur of the Year" by Peat Marwick & Crain's Chicago Business in 1986 and by Venture Magazine and Arthur Young & Co. in 1987. Eventually, Tullman took CCC public, subsequently selling the company for about $94 million.

Combining those proceeds with outside investments, Tullman started a regional venture capital firm, Eager Enterprises, Inc., specializing in the information industry. In 1991, he became CEO of one of Eager's investments, Information Kinetics, Inc., a provider of computerized databases for job candidates. The product was delivered directly online and by CD-ROM. In the same year, he led an investment group that acquired a significant stake in ICOM Simulations, Inc. ICOM specialized in software utilities, video games, and CD-ROM programs. Both companies were eventually sold to larger corporations: Information Kinetics to National Computer Systems and ICOM to Viacom, Inc. Thus, by the time he founded Imagination Pilots, Tullman was familiar with the fast paced world of software development.

In October 1993, Tullman was approached by two individuals with a plan to form a company specializing in entertainment CD-ROM software. Though full of ideas, the two lacked capital and management expertise. The ability to manage a software concern was a talent that Tullman possessed because of his experiences as an investor and director of two previous software ventures. He decided to put up the capital to start the company (along with a few small capital infusions from passive investors), and he became CEO of the company. At that time, the market for CD-ROMs appeared to be on the verge of exploding.

The company soon rolled out a line of educational titles featuring original art and music under the Professor Gooseberry name. Over 200,000 units of these educational games were distributed, either through retailers or through OEM bundling arrangements. Imagination Pilots was on its way to becoming a successful producer of CD-ROM products. Within the next three years, the company rolled out several new CD-ROMs, including Blown Away (a "sequel" to the movie of the same name); two children's titles under the Where's Waldo? Line; and Panic in the Park (starring over twenty Screen Actors Guild players, including Erika Eleniak, who played roles in Baywatch, Under Siege, and The Beverly Hillbillies). Each won several awards and was featured in articles in different computer magazines.

The eventual departure of his two original partners left Tullman firmly in charge of the company. The business soon grew to twenty-two employees: in mid-1996, the company had six programmers, six production employees, six artists, and four management staff (including Tullman, who was also IP's Chief Creative Officer). By this time, Tullman retained a 40% stake in IP, while 15% was held by IP's CFO, 25% was held by Tim Tennant, IP's head of production, and the remainder was controlled by the original, passive investors.

Despite its growth, IP was able to produce new titles in less than half of the time that was required by its competitors. According to Tullman, "Most content developers were kids operating in windowless rooms filled with pizza boxes and Twinkie wrappers." The long-term prospects of these home-based producers was highly questionable. Tullman believed that, "If you're going to do a number of games a year, you have to systematize the process."

IP's strategy was to bring management discipline and business acumen to the production process. By creating a more efficient structure to develop software, IP was able to greatly reduce the time to market for new titles and control the costs of production. The IP production process was well illustrated by one of the company's recently published games, Panic in the Park. The premise of Panic was that two twin sisters (both are played by Erika Eleniak) inherited an amusement park, but the deed of ownership for the park was Missing. The player meandered through the amusement park, played simulated arcade games, encountered villains, gathered clues -- all to rescue the park by unearthing the lost deed. Tullman personally conceived, designed, wrote, and edited the scripts for the stories; he even directed some of the video sequences. In producing a game, half the challenge was just to keep track of the vast amount of video, music, sound clips, and digitized art that are combined in the ultimate product. To do this, IP developed a proprietary database to track animation, video footage, dialogue, music, and background texture "assets" (the various components of the game). The company held back actual production of the software until the script, design, and asset allocation were finished. This process allowed IP to deliver games quickly and on schedule.

Making a CD-ROM was in many ways like making a movie, only on a smaller scale. Thus, the production process involved myriad decisions that trade off speed, cost and quality. For example, one of the early decisions that had to be made with Panic was who to cast in the lead role, as the game was to be created from scratch. Tullman stated, "We made a list: Teri Hatcher, Courteney Cox, Jennifer Aniston before Friends, Cameron Diaz before The Mask, and Erika Eleniak. Teri Hatcher and Erika have astonishing Q recognition on the Internet. Erika because she's naked all over the place. Panic cost $923 thousand to develop and Erika cost less than 100 thousand." Overall, Panic went from idea to store shelves in just over eight months, an incredible feat when compared to the industry's usual eighteen month gestation period.

Although Imagination Pilots appeared to have mastered the CD-ROM development process, two major barriers remained to a successful operation: money and effective distribution. Therefore, partly to gain additional financing for product development, IP decided to enter into a strategic alliance with a larger company that could fund and/or distribute CD-ROM titles.

Alliance #1: Media Vision Technologies Inc.

Early on, Tullman recognized the need to develop close ties with an established name in the computer business. IP's first venture, formed in late 1993, was with Media Vision Technologies Inc. Media Vision produced audio and graphics computer hardware, which were sold as upgrades. At one time, Media Vision was second only to Singapore-based Creative Labs in revenues from multimedia upgrade kits, which consisted of a sound board, graphics card, and CD-ROM drive. As a major player in multimedia related hardware, Media Vision decided to extend its operation into software, and went so far as to establish a subsidiary with that objective. The move into software seemed like a natural expansion for Media Vision, particularly because the software could be bundled to showcase the graphics and sound capabilities of its hardware.

Tullman, sensing a potential synergy between the two companies, sought out Media Vision as an alliance partner. The two companies eventually signed a deal in which Media Vision agreed to fund and market up to 24 software titles from IP, including the three Professor Gooseberry CDs.

Almost immediately, however, the alliance encountered difficulties. Although Media Vision did bundle many software titles with its hardware, it often packaged older generations of software with the newest hardware. The resulting incompatibilities led to software crashes.

However, the real culprit in the collapse of the alliance was Media Vision's own financial troubles. In the first quarter of 1994, the company reported a "substantial loss" that took analysts by surprise, and it eventually restated its fourth quarter 1993 results to show losses. This led to an investigation by the Securities Exchange Commission and the FBI, the resignation of most of the key executives (including then CEO Paul Jain), and a Chapter 11 bankruptcy filing. The company had apparently inflated sales figures by failing to record returns, selling defective merchandise, and booking fraudulent sales. Returned goods were allegedly kept in a separate warehouse to hide their presence. As part of the restructuring, the company eliminated its multimedia subsidiary and sold its retail product lines to focus on audio chips for the PC and home entertainment markets. Imagination Pilots had just lost its first partner.

Alliance #2: IVI Publishing, Inc.

By May 1994, Imagination Pilots had secured a deal with Metro Goldwyn Mayer, Inc. to produce a game based upon the movie Blown Away. Although it was rare for a content source to become involved in the production of a CD-ROM title, MGM was excited about the Blown Away project and agreed to put up half of the development cost (projected at $1 million).

As Media Vision was spiraling down, Tullman considered forming a new alliance. Imagination Pilots ran across the firm that would become its next alliance partner -- IVI -- when it set out to find a publisher for Blown Away. IVI's executives were very enthusiastic about the project, outbidding Electronic Arts, Spectrum Holobyte, GTE Interactive, and Compton's New Media.

IVI published electronic guides pertaining to health care and medicine. Incorporated in 1990 as Interactive Television, it subsequently changed its name when it began to focus on publishing multimedia encyclopedias. Among its better known titles was the Mayo Clinic Family Health Book, a reference work with stable demand. It had also just recently formed a group to expand beyond its traditional markets. IVI's multimedia subsidiary soon sent its two top executives to seek out potential content providers. It approached IP and offered a deal to fund and distribute IP's titles.

Although IP was reluctant to have Blown Away serve as IVI's launching pad into entertainment software, Tullman ultimately agreed to allow IVI to publish the title. The game was unique in many ways. In order to reduce the cost of producing the title, IP employed several clever devices. First, because the game player takes on the role of the protagonist, the company did not need to hire the film's star, Jeff Bridges. Second, by billing the game as a "sequel" to the movie, it did not require the talents of the film's villain (Tommy Lee Jones), who was killed at the end of the movie. Instead, Imagination Pilots hired a lesser-known actor to portray the villain's disciple, saving a small fortune in production costs. MGM was so pleased with the game that it included trailers for it in the video release of the movie. Critics generally reviewed the game favorably, while magazines bestowed upon it multiple awards.

The first sign of trouble in the IVI alliance arose when IVI realized that, unlike the medical reference software that was published annually and retailers kept copies in stock, entertainment software was a much riskier, hit driven business. When IVI's management learned of the risks and the pace of the entertainment software segment, it began to have second thoughts about the IP partnership, and, more importantly, about the entire CD-ROM entertainment business.

Despite the positive reaction to the IVI entertainment subsidiary's first offering, the parent company's fortunes were headed South. When, in early 1995, IVI reported a $31 million loss on $7 million in sales, the alliance with IP was dissolved, and IVI summarily fired all of the employees in its Seattle based Entertainment Group. (Blown Away, however, proved to be a qualified commercial success, selling 75,000 units.)

Alliance #3: Time Warner, Inc.

At the same time that IP was producing its product for IVI, it had begun to develop a multi-title relationship with Time Warner. The large entertainment conglomerate had decided to make multimedia one of its strategic priorities. Time Warner was in some ways like a collection of fiefdoms, and each of its five individual divisions was permitted to launch its own interactive software subsidiary. As one of the groups, Warner Music had launched its own multimedia arm to distribute entertainment software, although it did not at first wish to become actively involved in production. Clearly, IP and Warner Music had complementary interests, and the two established an alliance on January 1, 1995.

Warner Music was the country's largest distributor of prerecorded music and home videos. It also operated Ivy Hill Corp., a designer and printer of entertainment industry packaging. Under the terms of the IP-Warner alliance, Warner would package, replicate, and distribute all future IP products. Also, as part of the deal, Warner Music invested $4 million in IP, acquiring one third of the company's equity. IP was not the only multimedia investment made by Time Warner; the company also spent $10 million for a 35 percent stake in Accolade, a company that had produced a large number of interactive games, and it invested in HyperBole Studios, Inscape, LIVE Interactive, and Renegade, which were all relatively young interactive software concerns.

Tullman was initially very excited about the Warner deal, stating, "it validates us. Warner conducted a serious due diligence before making this investment with us." Moreover, he noted, "Warner has only one way to deal with success or failure: pay a lot of money." If the agreement did not proceed as planned, Time Warner would probably just walk away from its investment and return its minority stock interest to IP.

The first two titles released under the new alliance were Where's Waldo? At the Circus, an educational game, and Panic in the Park. However, problems arose even as both of the games earned praise from critics. First, Warner Music recruited a number of individuals to negotiate multimedia alliances, but then brought in an inexperienced corporate executive to manage the new multimedia unit. Unfortunately, the new executive was not involved in negotiating the alliances, and he had little or no experience at managing the promotion and distribution of multimedia software. As a result, Panic, despite being one of the first games to feature well known stars, as well as full screen, full motion video, was not aggressively marketed by Time Warner. Similarly, the Waldo game was not successfully marketed at all outside of the US because Time Warner had entered into a restrictive, self dealing arrangement with another of its international subsidiaries.

Second, somewhat ironically, one of the problems with promoting the two products arose because IP was so far ahead of the industry average in its production speed. In order for Warner to build its new marketing staff and to allow sufficient time to promote a new IP title, it would have to begin to develop a marketing plan at the time that IP began the production stage. Warner executives were reluctant to act this early. They were particularly hesitant to involve their untrained public relations staff in announcing the arrival of a new title before it was near to completion.

Moreover, Time Warner's Music Group was embroiled in internal political struggles with the Studio Group. As a result, Waldo and Panic, which had been expected to be launched in mid 1995, were further delayed until later in that year. Additionally, the internal strife, which had been chronicled on the front page of the WSJ, had lead to the resignation of the head of the Music Group and ultimately the five different interactive software subsidiaries were consolidated into a single entity.

Current Situation

After three years of success, Tullman and his company were at an important juncture. Imagination Pilots had become a leader in the production of CD-ROM entertainment software. The trade press had reacted very positively to many of the titles released by the company. Inacteractivity, a magazine for the multimedia software industry, had even profiled the company's remarkable ability to quickly bring products to market. Yet, the commercial success of the software had not translated into healthy relationships with publishers and distributors, nor had the industry "exploded," as many analysts had projected that it would. Moreover, as customers came to expect more and more sophisticated games, the cost of producing new titles was on the rise.

Moreover, despite three very optimistic starts, the commitments made by each of IP's alliance partners were not fulfilled. In particular, the intensity and quality of the promotion for IP's software titles had not been sufficient to secure retail hits. At this stage, Tullman wondered what to do? The relationship with Time Warner could be terminated, but, if it was, should IP seek a replacement for the media giant and its distribution strength? Or should Tullman heed the old saying, three strikes and you're out?