Development, Games as services, Publishing

How online changes everything: new paradigms for games studios

July 2008

Some of the biggest financial transactions involving games companies in recent years have been by traditional media companies buying studios in the online space. Whether it’s Vivendi’s merger with Activision or Disney’s acquisition of Club Penguin, big media companies moving into games have tended to stick with what they know – mass market entertainment. To echo previous columns, big media are worried about linear television’s fragmentation, falling advertising revenues and losing generations of viewers to gaming and the internet. Subsequently, they have invested in online games, targeting huge online communities for which they have paid dot-com valuations.

In parallel, most of the largest financing rounds in the UK’s games industry over the past few years have focused on businesses with strong online presences – Jagex, King.com and Real Time Worlds. Demonstrating steady, predictable revenue flows from online models like subscription or advertising plus a hands-on approach towards customers reassures investors with fingers burnt from backing studios trying to create elusive hits on console platforms via third party publishers.

We often hear that online is the future, but what does it take to operate in the online space and how easy might it be to make the transition? A quick peek at online companies reveals fundamental differences between firms with offline and online models. These deep-rooted differences play out via a range of different objectives, technologies, partners, commercial metrics and risk profiles, some of which are listed here:

Metric Offline studio Online studio
Resources and technology
% staff in development 95-100% of staff work to create a handful of games / year 25-60% of staff work on creating content that is released continually
% staff in support 0-5% work in finance, admin, HR, often these are outsourced 40-75% of staff work in customer support, finance and billing (Blizzard has 75%, Jagex 50%)
Technology Mix of 1st and 3rd party middleware and tools Mostly proprietary tools, servers, customer account and relationship management tools
Partners Publishers are the primary partner, with hardware manufacturers and outsourcers for development More evenly spread between portals, aggregators, serving, support, payment companies
Commercial and marketing
Who funds development / earns most upside? Publisher takes financial risk and lion’s share of upside Online studios commonly self-fund development, and take higher share of upside
Commercial model 1 dominant model – advance + royalty. Few variants are accepted by publishers Varies widely between subscription, premium download, advertising and micro-transactions
Likelihood of overages Rare and unpredictable (12% of largest studios’ revenues in 2006); bigger development costs = lower chance of royalties More common and predictable, with frequency increasing as per title production costs fall
Revenue flow Lumpy: advances at milestones, royalties 3-18 months post-launch (if lucky), with short-medium term longevity in all but a few cases Continuous: revenues start at launch (if self-managed service), may trickle in at start but can be very long lasting indeed
Marketing responsibility and methodology Publisher spends $millions

on traditional above & below the line marketing campaigns

Service provider cuts distribution deals with portals for placement and affiliate revenue shares
Finance
Ability to raise finance Low. The few funding sources are usually reliant on publisher agreements and VCs rarely back traditional studios any more. Medium-high. Self-publishing and control of customers brings steadier revenues from a growing market, driving an investment bubble
Valuations 5-10 times profit – offline studios have been acquired for £2m-£40m 5-10 x turnover – online studios have been acquired for £50m-£350m
Revenues / staff member £45,000 is an average for UK independent studios (large sample group) £185,000 is an average for UK online studios (small sample group)
Success metric Unit sales with strong correlation with average review scores Active monthly user volume and average revenues per user
Strategy
Highest risk point for thecompany Collapse between projects after growing too fast or betting that past success = future success User churn following poor service provision, infrequent content refresh or poor serving following too rapid growth
Levers of success Strength in execution including IP creation, gameplay, technology and production management Strength in customer & community management, building portfolio of games & services and partnerships
Primary company goal Create smash hits and sell to a publisher Create scale (millions of users/month) and sell to a private equity or big media company

A fundamental difference between the two models is the way that they treat games IP. For traditional studios, creating hit games IP is their raison d’etre; for online studios, creating games IP is often secondary to running the service that delivers it. Thus each company rides the hit-driven nature of the games business differently. Services often hedge their bets by placing them on a wide variety of games, so that the high ratio of hits to misses plays in their favour: more games with long tails deliver value over a protracted period of time. Offline studios effectively place larger bets on a smaller number of games, leaving them at the mercy of the same hit : miss ratio, using commercial models that rarely deliver royalty upside and often result in working for hire on someone else’s IP.

To make this exercise more useful, I’ve deliberately raised the contrast levels between the two company models to make the differences stand out. And there are companies that comfortably do both. But making the transition from an offline to an online business is far from easy, requiring a major reorientation in strategy, restructuring of resources and finances. It’s a complicated and far-reaching leap that may explain why there are so few dedicated online games studios in the UK. Arguably it’s a leap that many UK studios will have to make to stay competitive and keep pace with territories not known for traditional games development which are producing some of Europe’s fastest growing and most profitable games companies, most of whom are online and service driven.

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