Analyst Talks Investing in the MMOG Space

A new report from analyst group DFC Intelligence's David Cole looks at recent trends in heavy investment in the MMO space and wonders how it might upset traditional publishing and retail distribution models. The full text of Cole's report, which was released on the analyst firm's official website, follows below: "Since the early 1990s, the interactive entertainment industry had settled into a standard funding model for new games. When a developer had an idea for a new game, they would approach a retail publisher like Activision or Electronic Arts and ask for money to begin the project. As time went on and the game hit its development milestones, the company would get more money but also lose control of the game. Deals could be structured in all sorts of ways, but by-and-large, the publisher received the lionshare of revenue and had nearly dictatorial control over the game’s marketing, retailing, and release dates. After all, video game publishers are often publicly listed companies that need to meet the demands of their investors and satisfy the amorphous Wall Street. While many have decried the system, most bought into the publishers notion of how the content developer and publisher relationship should work, largely because the publishers had the money. There were other reasons as well. For one, it worked pretty well. Games got made, the industry grew, star developers emerged, etc. The emergence of a dominant platform (Sony PS One/PS2), importance of retail power, waning of single player PC gaming, and slower than expected rise of broadband penetration all combined to make partnering with a traditional publisher very advantageous. Of course, the industry doesn’t have to be structured in this way. The movie industry utilizes a variety of funding mechanisms. Studios sometimes fund projects but just as often private investor groups come together to finance a film. In short, the producer of a film has more options in how they find money than your average game developer. Times are changing for interactive entertainment. Almost all of the foregoing material factors which configured the value chain of the industry have experienced considerable change. Broadband has gained widespread penetration and the Internet is steadily growing as an entertainment medium. Growth drives investment and Internet revenue is growing again, this time with more solid footing than during the Internet boom/bust of the late 1990s. So obviously, investment in the Internet sector is also starting to grow again. Combined with notable successes in the massively multiplayer online games (MMOG) arena like Habbo Hotel, Runescape, and World of Warcraft, a substantial amount of funding is now available to game developers with an online hook. As Jeff Horing of Insight Venture Partners was quoted in the Wall Street Journal discussing Runescape, “in my view, they've picked up on the convergence of social networks and entertainment.” Benchmark Capital general partner Bill Gurley also tapped MMOG as a hot area in a Business 2.0 article saying he was interested in investing in “anything where people are entertained massively together.” What these investors are telling us is that online games are part of two sectors: the Internet and media. Internet content has often started small and grown exponentially leveraging the real/imagined network effects of tell-a-friend marketing. Traditional media like movies, music, and video games have relied upon big marketing efforts for a limited amount of products; from creation to retail, there are tons of gatekeepers, the least important of whom are consumers. The Internet provides small companies the opportunity for absolutely explosive take-off that they themselves reap the benefit of. That type of possibility is what brings investors running. Games, specifically, offer the exciting possibility that they will combine the high entertainment value of traditional media (i.e. customers will pay for them) with the highly viral distribution and recurring revenue that the Internet provides. After all, in comparison to other online media forms, games, specifically hit MMOGs have actually proven worth a subscription to consumers. Runescape, developed by Britain’s Jagex and never released at retail, has 300,000 more subscribers than the New York Times online. Venture capitalists need look no further than the $400 million that World of Warcraft made for Vivendi Universal Games in 2005 to justify their investments. The chart below shows some of the many deals since the beginning of 2005 that private investors have struck with companies devoted to developing massively multiplayer online games (MMOG) or technologies for those games. Recent Funding Deals in the MMOG Space

Developer	Funding	Date	Amount
Sulake	Benchmark Capital, et al	Jan-05	$23.5 million
Turbine	Tudor Ventures, Columbia Capital, Highland Capital, Polaris Venture Partners	May-05	$30 million
Jagex	Insight Venture Partners	Oct-05	Undisclosed
Funcom	Public IPO; Oslo Stock Exchange	Dec-05	$30 million
Terraplay	Cisco, IT Provider, Nordic Venture Partners, VPSA	Apr-06	$3.2 million
Real Time Worlds	New Enterprise Associates	Dec-06	$31 million
Red 5 Studios	Benchmark Capital, Sierra Ventures	Dec-06	$18.5 million
Areae	Charles River Ventures, Crescendo Venture	Dec-06	Millions

It is interesting to note the big numbers scattered throughout the list. These are not angel investors helping out a friend, these are large deals for the game development arena. Assuming venture capitalists look to make at least 10x the money they invest, this is quite a vote of confidence. What is really important for the online-only firms on the list like Jagex and Sulake, is that they get to work with financiers who are approaching their company from the Internet space, understanding the service-based model. A packaged goods focused company like Electronic Arts is not actually set up to run an Internet service, so developers of online games have to run the service while answering to the norms and expectations of a publisher that probably does not truly understand what they are doing. Online game developers’ turn to private equity could be the start of a longer term trend towards more variable financing arrangements. The long-time dominance of the publisher-developer relationship is far from assured. The so-called console war is especially competitive this cycle, meaning that even smaller publishers and developers can secure decent terms from the platform providers. While retail power for smaller players is still a major question, some venture capitalists are already willing to make big bets. First, Elevation Partners structured the $300 million deal with Bioware/Pandemic to create a large video game developer/publisher. Then, Francisco Partners executed a $150 million deal for independent developer Foundation 9. Developer Destineer, received $12 million from The Exxel Group. Their CEO Paul Rinde summed up the attraction to venture capital for interactive entertainment developers, “The venture capitalists of the videogame industry have traditionally been the large publishers, because they're the ones who have funded most game development until now. But, this new trend of private-equity firms investing in the games industry gives creative companies like Destineer much more flexibility to make games the established publishers are less likely to create." But will it really be so easy? Many have predicted the fall of the retail/publishing model for years. However, instead, the rich have tended to get richer and the focus is increasingly on sequels and big name licensed intellectual property. Often it seems the IP is more important than the actual game. Many investors feel that this time it will be different, because online games are more dependent on development and operational skills and less dependent on licenses and have a way around the retail distribution model. The problem with this thinking is that it ignores many of the market realities and the fact that top publishers bring a very important skill set to the table. Publishers specialize in “sell-in” and “sell-through.” In other words, they are able to get the product in front of the consumer and get the consumer to buy that product. In a world glutted with product this is arguably the most difficult task of all. The most successful revenue producing games are still distributed at retail because it is the primary way to get in front of consumers. This remains true even for all the online game companies that are going after the same rather limited (on cost and interest) number of consumers. Right now, online games are not really an online service business. The vast majority of revenue is still derived from retail products with subscriptions attached. Go into the PC game section of your retail store and you will probably see the shelves overflowing with World of Warcraft products. This is just on the distribution side (sell-in). Online games also still require marketing (sell-through) and that means having the skills to get into all the appropriate marketing channels. It is no accident that many of the best selling games have marketing budgets that exceed their development budgets. A $25 million investment may sound like a great amount, but in today’s market is not nearly enough to take a single product from development into the consumer’s hand without outside help. This does not mean that all these venture funding efforts are doomed to failure. Currently the large publishers are very focused on a packaged goods business. The industry is increasingly adding a service goods component to its required skill set. In the future, success will require both a packaged goods skill set and a service oriented skill set. Publishers who can adapt to the service-based possibilities while keeping their retail strength will be best positioned for success. However, it is also likely that one or two of these online game developers becomes a success and morphs into a publisher by adding some distribution and marketing expertise. South Korea’s NCsoft has already showed how this might work. With the success of Guild Wars and City of Heroes, NCsoft was able to go from a service based online game developer into a more traditional international publisher with a large North American retail presence that just happens to focus on online games. The failure rate for new online game investments is likely to exceed 95%. We think the ones that will be successful will have a clear strategy to eventually add a packaged goods component. Otherwise the best a startup can hope for is that they get lucky and are snatched up by one of the established retail publishers." [Thanks again to DFC Intelligence analyst David Cole for his work reprinted here.]