Game investing is still going strong, even though it did take a hit during the recession. We calculated that game companies raised $600.5 million in 2009, down 36 percent from the year before. But game-savvy venture capitalists are still bullish on games. We did a roundtable Q&A with some of the best-known investors, in conjunction with the launch of Interactive Age, a new magazine focused on the business of games. The magazine is edited by N. Evan Van Zelfden, who has written for us, and will debut around the time of the Game Developers Conference in March.
Here’s the transcript of our talk with Bing Gordon from Kleiner Perkins Caufield & Byers, Tim Chang from Norwest Venture Partners, Jeremy Liew from Lightspeed Venture Partners, Greg Richardson from Elevation Partners (which invests in later stage companies, including BioWare/Pandemic). A lot of the issues they talk about are bound to come up at our conference, GamesBeat@GDC, on March 10 in San Francisco.
Dean Takahashi: Can you bring us up to date on the state of venture capital investments in game companies?
Bing Gordon (pictured right): The high number of entrepreneurs starting game companies has certainly surprised me. Of course, I probably see most of them, given my background. I am actually more interested in entrepreneurs who are focused on the “video-gamification” of other lines of business from education to ecommerce, advertising to health. These areas seem less obvious, but offer more room for innovation.
Jeremy Liew (right): I think it’s hard to answer the question without addressing categories. 2005-to-2007 was mostly about virtual worlds: largely social environments, with some lightweight game play incorporated. There were also some folks trying to build World-of-Warcraft-killers: AAA heavyweight client based MMOs. Mostly big swing against big visions, with $5-to-$15 million put into development before you see a product, and success predicated on a single game or world being awesome (Turbine, Second Life, Habbo, Red5, Trion, etc). 2007-to-2009 has mostly been about smaller swings and faster iteration against what users tell you. Call it the “Web 2.0-ification” of the games industry – launch fast in beta, iterate based on user behavior. This applies to both the folks importing Asian MMOs and the “social gaming” companies. In each case less than $1 million gets you a shot on goal and you get multiple shots on goal with a venture round. Success is predicated on repeatedly putting out games that have a shot at making millions versus tens-of-millions (Zynga, Playdom, Playfish, Outspark, K2, etc).
Greg Richardson: Our perspective will likely be a bit different as we don’t look at early stage opportunities. What’s changed in our view is the shift away from retail publishing and development which has matured as a business and slowed in growth. The movement towards digital content and publishing models is creating investment opportunities. To Jeremy’s point, there is a further shift away from hardcore-focused companies and games which are capital intensive to more mass market content offerings with lower capital requirements. The big question is how you build scale against the digital opportunity? What are the barriers to entry for the more successful startups on the digital side?
Jeremy Liew: I think the key point that Greg highlights is how you scale. To me this means how can you repeatedly build (or license) games at volume? It means building a game factory — which is quite different from the artisan-like approach to making games that the industry has drifted towards as time-lines got longer and budgets got bigger. Then how do you repeatably solve the discovery problem in a noisy and crowded environment (which is by definition the environment where it doesn’t cost much to build a game)?
Tim Chang (right): Historically, Gaming 1.0 has been a challenging investment area for VCs because of the “hit content risk.” Hence, new publishing, distribution, and service-oriented models around new platforms tended to garner the most attention: “we want to be the EA of ____ (mobile, MMO, social games, etc.)” pitches tend to arise whenever new platforms arise. Studios and tools deals abound, but these types of companies typically have less interesting exit outcomes from a VC perspective. When retail-based distribution of Gaming 1.0 was dominant, friction to market entry was at its highest, and hence content/hit-risk was extreme.
Web/Online started to shift the distribution landscape, starting with internet in mid-to-late 90’s – this allowed for the first attempts at basic MMOs and Virtual Worlds (remember The Realm, anybody?), but broadband penetration wasn’t well enough established yet. Pogo was an early foray into early browser-based and downloadables casual games.
What I call “Gaming 1.5” has been driven by online growth across 2 vectors: 1) AAA or “heavy client” MMO/virtual world (inspired by the success of Ultima Online, Eve, WoW, Second Life, etc.); 2) online casual (increasingly browser-based, vs. Gaming 1.0 casual models of only downloadables: Real Arcade, WildTangent, Mini-Clip, King.com, iWin, BigFish, etc). Gaming 1.5 is marked by reliance on client download SW for MMO/VW, as well as ad and paid download based models on the casual side.
Around the same time on the other side of the world, Asian or Asia-influenced casual MMO/Virtual Worlds started leveraging free-to-play and virtual goods models, primarily distributed online (often via PC cafes), typically built with smaller budgets and then localized to foreign markets (Nexon, K2, etc). Many of these were also client-SW based but innovated on the business model side – often out of necessity (e.g. lower penetration of credit cards in China).
Gaming 2.0 (in-line with Jeremy’s point on Web2.0-ification) is marked by a shift towards pure browser-based, targeting mass audience on newer platforms like social networks, iPhone, general web. Free-to-play and microtransactions are the de facto business model, which align perfectly with a lower-cost basis for development and faster time to market. Gaming 2.0 is also about bringing gaming to the mass market (and not focusing the smaller percent of the population who are self-identified gamers…and who also tend to be demanding customers and costly to please). Combining “frictionless” gaming (no download, no upfront registration or payment) with more open social platforms (sometimes affording an element of viral distribution) and free-to-play/microtransaction business models is the killer combo, and has fueled fast growth in social gaming. Representative companies: Gaia, IMVU, Zynga, Ngmoco, Playfish, etc.
Gaming 3.0 is about leveraging game mechanics and models to re-invigorate other markets: humans are inherently geared towards addictive behaviors and biases that can be exploited through game mechanics like points, achievements, and leveling up. Gaming + Commerce = Swoopo. Gaming + Music = Red Octane, Harmonix. Gaming + Healthcare = Lumos Labs. Gaming + Local Search/LBS = FourSquare. I often joke that “gaming will rescue us all.” I don’t mean that we all become hardcore WoW players, but that we can utilize game constructs to perhaps revive other industries which no longer monetize as effectively via macro-transaction or advertising.
Dean Takahashi: What are the hot categories within the game market this year? How would you rank various categories, pointing out the hottest categories and the weakest? Think about them in terms of where startups are drawing the most attention from VCs.
Greg Richardson (right): It’s difficult to classify segments or categories in gaming right now. Are casual game portals like Pogo or Real really representative of the “casual” market or are they primarily serving 30-to-60-year-old women? What is an MMO? World of Warcraft? Runescape? Free Realms? Maple Story?
Social gaming feels like a new “category” but in the long run is it really unique content or just a different distribution/publishing platform? Mobile seems ready to come of age and a lot of the content we currently see through browsers or social networks feels equally relevant to smart mobile devices. The challenge there is for the platform holders to create ecosystems that are content friendly. Will they support multiple price points and biz models? Will the platform holders control all the transactions? Can developers and publishers market and merchandise their games?
Bing Gordon: I have seen game company pitches across the board in the past twelve months. I have seen game publisher proposals for mobile, music, social networks, consoles, casual, education and health. I have seen publisher proposals for game companies in India and China, as well as across North America. I have seen platform company pitches for virtual goods, virtual worlds, avatars, virtual card games, and MMOs. I can’t tell you what categories are considered hottest by the universe of investors, but Kleiner Perkins has invested in just ngmoco and Zynga in the West.
Tim Chang: Games as packaged media or “fire and forget” downloadables is R.I.P. Games-as-a-service (GaaS) and Cloud Gaming are the inevitable new paradigms. This is an early case study for the shift of media on the whole towards Media-as-a-service, meaning that content creators have to fundamentally rethinking how they design their offerings to be ongoing relationships with their users…and often with only half or less of budgets spent on “launch” and increasing portions used to “operate” the ongoing service (community management, expansion packs/dynamic content updates, microtransactions, virtual goods refreshes, etc)
The holy grail business model for Media-as-a-Service will be inspired by the gaming industry, and is neither purely ad-supported, all virtual goods, nor subscription-based, but rather a complementary blend of revenue streams for a hybrid business model: free-to-play (85% of users – show them ads, but how else can you “put them to work” to create indirect value and enrich the community or offering as a whole?), microtransactions (15% of users) and tiered-subscriptions/premium memberships (1%-to-3% of users).
Games as a service will drive new needs at both the infrastructure and services (managed services, payments, loyalty, etc.) layers. Examples of enabling technologies and services here include OnLive, Gaikai, Otoy, Metaverse Mod Squad, Viximo, Vindicia, etc.
Dean Takahashi: Today, the latest research estimates that virtual goods will become a $1 billion industry in the U.S. in 2009 and it will hit $1.6 billion in revenues in 2010. Do you agree with those estimates?
Jeremy Liew: I think the 2009 estimate is probably about right if not a bit high, but 2010 is probably too low. I think we’ll see a lot more growth in 2010 than just 60%. Social games are driving a lot of this growth and I would expect many of the social games companies to expand to destination websites by 2010. With the new iPhone billing platform, virtual goods is becoming natively supported for iPhone games (versus the hack of buying a new game identical except that you now have the virtual good), and with more pre-paid cards at retail, I think we’ll see at least a doubling in revenue in 2010.
Bing Gordon: I assume you are talking about market size outside of Asia, where virtual goods market has already surpassed these numbers.
I agree directionally with Jeremy that virtual goods will have hockey stick growth in 2010 in the West. Maybe more than 100%. Free-to-play with virtual goods takes share from existing PC game and casual game markets, and adds new users.
Dean Takahashi: Will the social games with free-to-play business models start to take market share away from console video games in 2010, or will both industries continue to expand at a good clip?
Jeremy Liew: Free-to-play is definitely going to grow but because it is attracting a different audience (non gamers). I don’t think that it will take share from console video game revenue. With consoles, I think the key driver will be new platform release schedules and game release schedules, so will be orthogonal to the drivers of free-to-play growth. I defer to people smarter than me about consoles as to whether that means it will be up or down this year.
Bing Gordon: I also agree with Jeremy that console games on TV continue to run on their own life cycles, but that iPhone/iPod Touch and other smart phones could start to hurt handheld game sales.
Jeremy Liew: Bing, I think that’s a great point. iPhone is going to hit handheld game sales hard.
Dean Takahashi: Zynga’s Cafe World has garnered more than 17 million users in less than two weeks on Facebook. What does that tell you? Can anyone catch up with Zynga in social games?
Greg Richardson: Zynga’s success tells us that social gaming is a real market with dynamic growth prospects in front of it. Clearly, Bing and Mark and the team have done a tremendous job in establishing a leadership position with Zynga. It’s going to be exciting to watch how things evolve from here. What happens when Facebook introduces its own currency or when it once again changes its policies on publishing updates (e.g. when can a user ask to opt out of updates by application)? What impact will be felt by more established game developers like EA and Sony landing on the social networks with branded and franchise games? In general, it feels like we’re early in establishing the type of content that fully addresses the audience’s interest and the unique aspects of the social network platform. It doesn’t feel obvious that we’ll look back on MobWars or FarmVille as the applications that defined a market.
Jeremy Liew: Zynga is doing a great job of leveraging their scale for cross-promotion and media buying to be able to launch new games to the top of the charts. The combination of their speed to launch games into categories proven popular by other developers, virality and launch support in the form of advertising dollars and cross-promotion from their other games is very powerful. However, the games industry is not a winner-take-all market. Unlike enterprise software, where a customer only buys one product from the category, in social games, people will play more than one game. As a result, there is room for a number of very valuable companies to be built in the space. As a parallel, among Chinese MMO publishers, the leader is worth $5 billion, but there are 5 or 6 companies worth more than $750 million. So it isn’t really necessary to catch up to Zynga to create a lot of value. That being said, the games industry is still a hit-driven business, and so it is always possible for one of Zynga’s competitors to catch and pass them if Zynga has a run of poor games and/or a competitor has a run of very good games.
Tim Chang: Zynga has definitely demonstrated the power of scale in “breaking” a new title on Facebook. The lesson here is that distribution muscle does matter: if content is king (as Hollywood and media 1.0 folks like to think), then distribution is God Almighty. Killer game content + lack of distribution muscle = critical acclaim. Crap content + distribution muscle = lots of units still sellable (look at JoWood volumes in Walmart for deer hunting games). Distribution muscle + ability to quickly copy or iterate good content at cost-effective levels = major new disruptive force.
That said, the approachable market for social games is potentially gi-normous. Assume: half of the world will be on social networks within next couple years, half of social network users will try a social game, and up to half of active social game players may be monetizable.
A healthy, large market can support multiple big winners. The traditional console game industry also has shown an interesting market share structure: the top publishers rarely command more than 16-to-19% market share, but (used to) garner valuations and multiples akin to leaders in other industries with much larger market share percentage. Hence, you can have a relatively fragmented market with 2-to-4 big dogs that get great market premiums, yet still have enough room for little players if the market is large enough. The question here is that social gaming distribution landscape follows different dynamics than retail, and is still being shaped in real-time.
It does appear that the Big Three have solidified their leads so far: Zynga, Playfish, Playdom. I’ve looked at many top 20 Facebook social game developers beneath this tier, and they are order-of-magnitude smaller on a monetization basis.
Dean Takahashi: If you were running a traditional game company, and you saw these trends in the emerging game market, how would you respond? How quickly do you react to the trends and what strategy will succeed for you?
Greg Richardson: The big game publishers face the classic innovator’s dilemma. Even if they intellectually see and understand the shift from packaged goods games targeted at a sub-segment of the 12-to-35-year-old male audience to digital game services for the mass market, it’s going to be difficult for them to execute against it. They still see the vast majority of their revenue coming from packaged goods which can’t help but focus attention and resources away from the emerging opportunities. The development studios that were so well positioned to create AAA hits aimed at the console market will not easily make the transition to games with lower production values, simpler gameplay mechanisms and shorter play sessions. The obvious path for the big publishers is to acquire the Zyngas of the world and try and pivot off their market position and cultural DNA.
Jeremy Liew: I agree with Greg. However, I think that it will be hard for many traditional game companies to acquire the Zyngas of this world, if only because there are more traditional game companies – especially if you include casual games companies in this mix – than there are at scale social games companies. Everyone adjacent to social games is eyeing the category and trying to understand what it means for them. I suspect that some will look to buy smaller social games companies and try to use that as the nucleus for expansion in the space.
Tim Chang: Traditional publishers have attempted to launch their own social games based on existing and new IP – these have largely been met with weak DAU growth and monetization (similar to big media firms who tried to launch Facebook apps, only to end up asking for help from RockYou types). Old-school game companies will tend to over-design their products, and either miss out on the proper virality characteristics (e.g. building for one-to-one play behavior vs. one-to-many), or else focus too much on production value and eye-candy, which actually scares off most of the social game audience (who are not self-identified gamers). One analogy I think of is all the Club Penguin knockoffs who looked at CP and said “this looks like crap – I can build a better looking one, and add educational content to appeal to parents too!” They learned that kids couldn’t care less about educational content, and more often than not got lost trying to navigate full 3D environments. Your typical social game player is akin to a youth player: short attention span, aversion to complex interfaces, need to get into the action quick!
2010 will be marked by “Hollywood meets Zynga” dynamics of co-development, license, white-label partnerships driven by various buy/build/outsource strategies that each large game and media company will try. Some smaller development teams will get bought, one of the Big Three will probably get taken out, and we’ll probably see consolidation in social gaming overall.
Dean Takahashi: Where are the best game markets now, in terms of investment opportunities, on a global basis?
Greg Richardson: Everyone plays games, from newborns to senior citizens. The best investment opportunities are companies that can create compelling games for everyone: products and services that connect people together, that give them a reason to interact with friends and family and that can be played anywhere and at anytime without a huge investment of time and money.
Jeremy Liew: From a VC point of view, games that are cheap and fast to make are easier to invest in than games that have long development timelines and big budgets. More shots on goal for the same money is better, given the hit driven nature of the industry. That’s why social games – or free to play in-browser games more broadly – and publishers importing MMOGs from other geographies are seeing VC investment.
Tim Chang: Free-to-play MMOs that are delivered in-browser, and leveraging much lower cost-structures – think Nexon as opposed to Trion, Blizzard, etc. Augmented or Alternate Reality Gaming. Cloud gaming enablers. Micro-payment infrastructure and services. As retail continues to decline, white-label digital download/streaming/delivery stores. “Meta-gaming:” the application of game mechanics on to other industries – FourSquare for music, nutrition, fitness…
Dean Takahashi: What are your predictions for the future of venture investments in games? And what will the game industry be like in five years?
Jeremy Liew: The social games space is already starting to see movement up the cost and complexity curve. Partly on technology, more on art and marketing costs. I think that within 12-to-24 months the winners in that space will have been established. There is still a window for new entrants to get to scale, but it is not unlimited. After that, it will be hard to see more venture investment until we see a new development that can drive cost and cycle time back down in some other popular medium. This might be something like Unity and other game engines, or greater understanding of western game design in China and India.
Bing Gordon: Let’s not forget that most of the investment in games comes from publishers rather than financial investors. Billions spent annually in game development.
One of the bets EA made in its early days was that distribution matters. Even for a publisher with a broad portfolio, it is difficult to deliver predictable returns without having a distribution advantage. So the best venture investments in media will unlock distribution leverage, as well as supporting cool products. I predict that the best venture investments in games will depend on disruptions in distribution, rather than predictions of the next creative genius. I would bet that more than 1/3 of total consumer spending on games will be for digital downloads within 5 years. I hope the games business doesn’t follow the newspaper and music businesses in “trading nickels for dollars.”
Greg Richardson: I agree with Bing that distribution matters even in a digital context although I’m not sure it’s as defensible as EA’s retail presence was in the 90’s. While there are similarities in the investment and scale necessary in building a retail presence as well as a big audience online, there are big differences. In a digital world there is infinite shelf space, allowing consumers to more easily find and choose the content they want. The high-order bit in the digital world will be creating compelling content and once you have it, distribution leverage will be created.
Our view is that the best game investments are going to be companies who can get scale across multiple digital segments – MMO, Social Gaming, Mobile, etc – and do so by combining distribution strength with great content. I believe we’re going to see game content created in the next three to five years that is completely different from what we’ve seen historically. I can’t wait to see what great game designers will create once they look beyond young males as their target audience and are thoughtful about how great gameplay can be married to casual social experiences.
Jeremy Liew: In a Facebook or other digital environment where shelf-space is infinite and there is no chokehold on reaching customers, discovery is more important than distribution. In FB that’s facilitated by the feed, by cross promo, and by good old fashioned advertising.
Tim Chang: “Gaming will rescue us all” – monetization concepts like free-to-play + microtransactions + tiered-subscription will be successfully applied to all facets of consumer internet and media. Engagement currency and meta-game point systems will drive Behavioral Economics optimization in all markets. Notions of “operating your content” will be inspired by online games: episodic delivery, mod-able experiences, snack-sized sessions, etc.
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