Unity (NYSE: U), a software company best known for developing the Unity game engine, is in a tough spot. Its current business model isn’t sustainable, and a recent pricing change was so poorly communicated that the company was forced to largely roll it back.

Long-time CEO John Riccitiello stepped down in the wake of that disaster, with the company bringing in James Whitehurst, the former CEO at IBM‘s Red Hat, as interim CEO.

While interim CEOs often don’t make big changes, Whitehurst is following a different playbook. He set the stage in the third-quarter letter to shareholders, saying that the company was trying to do too much.

On Monday, Unity announced that it would be laying off about 25% of its remaining workforce. This marks the fourth round of layoffs since mid-2022.

Management shared almost no other details, and it stated that it was unable to estimate the costs and charges involved. That’s unusual, and it speaks to the urgency with which Whitehurst is acting.

A tricky business

Unity is one of the two major commercial game engines that are widely used by developers. The other is the Unreal Engine from Epic Games. However, there is far more competition than meets the eye.

Any developer, big or small, always has the option to go its own way. Big game studios often develop their own engines and tools, and even smaller outfits go that route in some cases. There are less-popular commercial engines, open-source engines, and both commercial and open-source tools that can be cobbled together to form a full solution.

Switching costs are high for developers that are far enough along in development, but for new projects, Unity and Unreal are just two of many possible options.

When Unity first introduced its Runtime Fee in September, which aimed to generate revenue from developers each time their game was installed, the company greatly overestimated its pricing power. It didn’t take long for Unity to scale back that plan by carving out exceptions, allowing developers to self-report, and offering a fixed-percentage revenue share as an alternative.

Story continues

A needed shift

While the Runtime Fee rollout was a disaster that set fire to much of the goodwill Unity has garnered from developers, these types of fees are necessary for Unity’s business to become sustainable.

The current business model involves subscription plans that are priced on a per-seat basis. Any user that passes a revenue threshold must pay for a subscription that starts at $2,040 per seat per year. The problem with this model is that Unity doesn’t benefit much from its customers’ success. If a small team launches a megahit, Unity gets its per-seat fee and nothing else.

By charging a fee based on revenue or installs or some other metric tied to a game’s success, Unity benefits financially when a customer hits a home run. It wouldn’t need this extra source of revenue if it was already profitable, but it’s nowhere close.

In the first nine months of 2023, Unity reported a net loss of $572 million on $1.58 billion in revenue. Boosting revenue will help the cause, but layoffs will be more impactful in the near term. Once the one-time charges for severance and other items pass, cost savings should be significant with roughly 1,800 employees set to depart.

Unity is free-cash-flow positive, but only because it doles out an excessive amount of stock-based compensation. In the first nine months of 2023, stock-based compensation costs worked out to a whopping 30% of revenue. While it’s a positive that Unity is producing cash, this metric is not a good measure of the company’s true profitability.

Unity’s turnaround is going to take time, and the company still needs to find a permanent CEO capable of rebuilding relations with developers.

If those developers start shifting to alternatives for new projects, righting the ship could prove impossible for whomever is tasked with that at Unity.

Should you invest $1,000 in Unity Software right now?

Before you buy stock in Unity Software, consider this:

The Motley Fool Stock Advisor analyst team just identified what they believe are the 10 best stocks for investors to buy now… and Unity Software wasn’t one of them. The 10 stocks that made the cut could produce monster returns in the coming years.

Stock Advisor provides investors with an easy-to-follow blueprint for success, including guidance on building a portfolio, regular updates from analysts, and two new stock picks each month. The Stock Advisor service has more than tripled the return of S&P 500 since 2002*.

See the 10 stocks

*Stock Advisor returns as of January 8, 2024

Timothy Green has positions in International Business Machines. The Motley Fool has positions in and recommends Unity Software. The Motley Fool recommends International Business Machines. The Motley Fool has a disclosure policy.

Unity Takes a Painful Step as Losses Pile Up was originally published by The Motley Fool