Machinima is at a crossroads. Judging by dozens of conversations we’ve had with media executives, founders, investors, and bankers over the last month, the market at large thinks that the company is struggling and is searching for an acquirer. In fact, some people have reported seeing a “book” circulating on the deal, something the several company insiders have vehemently denied, although none were willing to make statements on the record. We're inclined to believe that an acquisition is not core to the company's current strategy, but the perception speaks to its challenges.

Earlier today, AllThingsD’s Peter Kafka reported that the company “wants [to raise] a mega round,” citing the fact that it engaged Allen & Co., the same advisor behind its recent $35 million Series C round led by Google, to lead the offering which is thought to be targeting $70 million or more. That’s all well and good. I want to be an Astronaut. But in both cases, reality is a brutal mistress.

The one thing that Kafka definitely nailed is that the next step for the company will be a bellwether for the YouTube ecosystem as a whole. Machinima, one of YouTube’s largest multi-content networks, has been hailed as the next media giant. So if it exits, anything less than a nosebleed price would be considered a disappointment. And if it's raising, the company will need to command well beyond the reported $190 million valuation of its previous round in order to maintain an image of strength and stability. In both cases, it’s likely to have a difficult time.

Machinima faces challenges common to all YouTube-focused businesses. Namely, once you build a massive audience how do you monetize it? The network has more than 5,000 content partners and generates 2.2 billion monthly video views as of March from over 220 million viewers. But despite all this scale, the company is still unprofitable on $40 million in revenue in 2012, sources say. Now 12 months past its last financing, it’s unsurprising to hear the company may be running low on cash. Given the difficulty it had raising its last round and its current financial state, raising another big round at an increasing valuation seems a tall order.

As one industry expert posited, if Machinima is not profitable at this point, they may never be. With this in mind, it would make sense that investors consider testing the waters for an exit.

But the company is exploring new monetization options. Kafka reports that the new funding round is earmarked for the launch of a Machinima Plus premium subscription product, similar to Hulu Plus. We’ve heard similar information most of which have traced back to creating original content tied to hit gaming franchises. The company already created a "Halo"-branded “Forward Unto Dawn” series, and has other similar projects in mind.

Today's unsightly economics are a product of three factors: expensive content agreements, YouTube video CPMs that have yet to catch up to those of traditional TV or even competing video on-demand platforms like Hulu, and an onerous revenue split with YouTube. Each of these inputs has the potential to change, but nonetheless, it’s not a pretty picture for the company that Sarah Lacy once called “the most impressive in LA since MySpace.”

The one thing that Machinima does have going for it is demographic concentration. As the company proudly states right on its homepage, “one in four males ages 18 to 35 who stream online video watch Machinima.” When you’re trying to sell to advertisers, that kind of targeting is valuable.

Whether Machinima raises another financing round or pursues an acquisition, its best bet in both cases is a strategic partner. In other words, the company’s numbers won’t attract a financial investor or acquirer, and the fundamental challenges facing the company demand access to gaming IP that a media company would be well positioned to supply.

Machinima has seen inbound acquisition interest in recent years, according to multiple industry insiders, although the offers have been described as disappointing. Running down the list of potential strategics, Microsoft seems like the most natural fit. The two companies already have a track record of success together, with the video network launching an Xbox 360 app earlier this year that had one of the best debuts in platform history. With Xbox looking like the most likely king of the connected-living room, there has been plenty of speculation that Microsoft would soon get into the content business to compete with Netflix and the like. In this light, the two companies look like an increasingly good fit.

Another name often thrown around in conjunction with a possible deal is EA, but prevailing wisdom is that the game publisher is out of the M&A game for the time being, at least until it gets a full time CEO in place.

Debevoise’s company isn’t the only MCN getting attention these days, and in some ways that works to his disadvantage. Fullscreen announced a “large Series A round” earlier in the week, which sources indicate was $30 million at a $110 million pre-money valuation. But Fullscreen is profitable today, by virtue of its focus on advertiser-friendly premium Hollywood content and what most observers describe as more generous content agreements than its competitors. The company also built a technology platform around efficiently acquiring and monetizing audience. In both regards, this would be difficult playbook for Machinima emulate in the near term but it remains a standard against which Debevoise’s company will be judged.

Maker Studios, the largest of the MCNs in terms of monthly views, is more similar to Machinima in terms of its economics. The company is unprofitable after raising its own $41.5 million Series B round led by Time Warner Investments in December and turned down a nine-figure acquisition offer in the process, according to sources close to the deal. Given the rising doubt about the MCN business model, this may prove to have been ill-advised.

The conversation around all of these MCNs centers on the question, what is their off-YouTube strategy? There’s something to be said for using the Google-owned platform to acquire audience and then monetize it elsewhere where the economics are more favorable. Machinima’s planned premium service is a direct response to this question.

It’s hard to remember a time with higher levels of excitement and uncertainty around the YouTube ecosystem. YouTube as a company is nearly 10 years old, but YouTube as a platform for professional content creators is still in its infancy. As with the introduction of each new entertainment platform, a learning curve is to be expected.

When tween girls-focused MCN Awesomeness TV sold to Dreamworks in May, the company’s lead investor, Mark Terbeek (who also led the Machinima investment by MK Capital, but has since left the firm), predicted that the next year would get “wild” in terms of YouTube ecosystem M&A. Regardless of Machinima's fate, his predictions are looking more and more prescient.

Machinima leveraged YouTube to build an enviably large audience but now seems somewhat stuck for how to turn that into an attractive business. There is little doubt that the company will need to restock its coffers if it is to continue operating independently. If the company were to sell today, which seems unlikely, it would certainly be a disappointment by most accounts and a black eye for the YouTube ecosystem in general. But, in the right hands, it could also be a fantastic building block for a more compelling multi-platform content network. The company has no shortage of options, but none of them are terribly attractive or easy to execute.

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