How to Make Video Games a Real Business

Historically it’s been difficult to transform game studios into long-term sustainable businesses. Why? If you look this from the lens of an investor (see criteria for attractive acquisition), a few reasons become clear:

Most game studios have….

  1. Small EBITA margins
  2. A lack of stable contractual relationships
  3. Huge landscape risk
  4. Short product life cycle

In the following post, I’ll try to expound on some of these problems and suggest some possible solutions.

Small EBITA Margins

Gaming, similar to other entertainment industries such as movies and music, is primarily hits driven. What does this actually mean? It means that revenue is distributed in the form of a power curve, as seen below. The vast majority of the wealth is generated by the top 10 games. This lopsided distribution creates a scramble for the top.

However success and reaching the top, as in most knowledge-based firms, is dependent on human capital. For example leveraging a game designer capable of designing something uniquely fun… or a programmer able to deliver a novel interactive experience.

Which creates the following phenomena: the distribution of wealth compels studios to strive for at least a top 50 hit, which means they need to hire and grow an expensive team to get there. But if they don’t succeed, these teams suffer from tiny or even negative EBITA margins.

Solving for higher margins then essentially boils down to cost management of human capital. How do you source talented people to produce a top hit? And how to pay for them cost effectively?

I’ve organized the main options for sourcing talent into the following matrix:

Finding talent

Low cost High cost
Internal Core team has all skills Hire full time positions
External Outsource development Rent talent per project

Without question, the best approach for most Indies is if the core team is self-sustaining and has all the necessary skills for game development. But if you don’t have a self-contained team, other options do exist. You can outsource development using a service like elance or odesk. However production quality is often an issue as the people hired may not be of the highest caliber. More established companies or independently wealthy individuals can hire qualified people full time, but this is expensive.

One option that I haven’t seen much use of, but which I believe has the greatest upside, is to borrow from Hollywood and become flexible renters of talent. Hiring game designers, producers, engineers, artists etc on a per project basis. Quality is accounted for by sourcing professionals, but cost is limited through contract and duration.

Why would industry professionals ever want to do this? Product creators would receive more recognition as they are elevated to a status similar to directors and producers in the movie industry. Product creators would also be able to negotiate stronger financial incentives with larger salaries or even revenue shares based on track record of success. As in the movie industry, other roles would then be filled on a contract basis, mainly attracted to the opportunity of working with star talent and building a portfolio of success.

I believe this would work even in today’s live service gaming environment, as turnover is already high and we would essentially only need a 1 year contract to determine if a title will be a hit before transitioning to a more stable live service model for the remaining years of shelf life, at which point the creative talent is free to pursue the next blockbuster.

Main options to pay for talent can also be broken down into a similar matrix.

Paying for talent

Low cost High cost
Internal Redirect cashflow from future rights or existing venture Self fund
External Crowdfunding VC, publisher, strategic financing

The most publicized form of funding in the games industry is external financing, usually in the form of VC’s, publishers, or strategic investments. Kristian Segerstrale has an awesome presentation on the subtle differences between these options.

However dilution, loss of control, and the loss of intellectual property (occurs with publisher financing) make these options less attractive and a last resort only. Self-financing is of course viable if you are independently wealthy, or can convince your team to live off savings by eating instant ramen every day. However I’d like to explore two even lower cost options: crowdfunding and the redirection of cashflow.

Crowdfunding over the last two years has shown mixed success, mainly limited to small-scale productions. It was only until I saw the breakout success of Broken Age by raising $3.45 million via kickstarter that I saw the real potential in crowdfunding.

Leveraging cashflow from future rights/existing business to fund new game development may sound like an obvious choice, but the creative application of this tactic is challenging. I’ve seen very few examples of this done successfully. The poster child for this approach is Lionsgate, the film company, which funds movies, such as The Hunger Games, by pre-licensing international rights to its films in advance. This way Lionsgate has no more than $15 million at risk for a film that may cost several times this amount to shoot.

Lack of stable contractual relationships

The second big problem in games development is it lacks stable contractual relationships, which is another way of saying it lacks steady paying customers. Here is again the same two by two matrix showing major options for customer acquisition.

Low cost High cost
Internal Virality / cross promotion Paid acquisition
External Platform feature Strategic partner with platform eg. LINE

An editorial feature by major platforms, iOS or Google Play, is the option with lowest cost and highest gain. But getting featured is usually a one-time deal. Furthermore, featuring is not really something you can control unless you have some preexisting relationships or a popular brand.

Of the remaining options that can be managed in-house, a strategic partnership with a platform such as LINE or Tango can be a viable source of user acquisition. But similar to publisher financing, these companies usually take ownership of intellectual property (IP). I believe IP is one of a game developer’s greatest assets and a requirement for long-term success, so I would only explore this option as a last resort.

Paid acquisition is a popular choice, but with rising cost per install (CPI), this option can get expensive very quickly. Many smaller developers also lack the sophistication to make good lifetime value estimations based on early payer data, which can make the return on paid install campaigns risky.

I believe the bigger opportunity for user acquisition is in cross promotion. Cross promotion usually pertains to companies that already maintain a stable of products, and describes the shuffling of existing users from older titles into newer games. However it’s possible to do this type of network engagement even without an existing portfolio; you just need to forge partnerships and make trades with other like-minded firms. Certain ad networks such as Chartboost, also provide basic network engagement capabilities in their ad tech platform. The challenge with cross promotion is how do you do it correctly and at scale. This requires some sophistication in quantitative marketing, as you don’t want to siphon off a high quality user in one of your existing games only to give them to someone else at less than fair value.

Huge landscape risk and short product lifecycle

The last two points that I want to highlight have, in my opinion, pretty similar solutions so I’m lumping them into one category.

Gaming, as in all consumer-facing industries, is subject to huge landscape risk due to fickle consumer preferences and the cyclicality of fads. Many games also suffer from short product lifecycles. Depending on the genre, some games have lifecycles that only last 6 months. Even the most popular games are eventually sunset in 3-4 years.

So how do you run a business with this level of unpredictability? I think the main solutions can again be explored using a 2×2 matrix.

Develop Acquire
Organic FIFA / Madden Books, TV, movie IP
Created  Warcraft, Starcraft, Diablo Mod team for TF2, DotA 2

Robert Kotick, CEO of Activision Blizzard, once said (not the most eloquently) the solution is to focus on franchises because they “have the potential to be exploited every year on every platform with clear sequel potential.” While I certainly don’t agree with Kotick’s phrasing, the idea to transform a volatile hits driven industry into a stable predictable one makes sense.

Blizzard has clearly done very well with this strategy, focusing on delivering subsequent hits from existing franchises, such as Warcraft, Starcraft and Diablo. Electronic Arts has also leveraged their portfolio of existing or acquired brands to deliver franchises. It also helps that EA is the market leader in certain genres such as sports, which lends itself to natural franchises due to the seasonal renewal.

However it can be really difficult to develop unique franchise IP from scratch, which is why I’m particularly interested in opportunities that allow you to acquire franchise IP.

Valve did this quite successfully by buying the IP of a popular mod; removing landscape risk by looking for mods with market traction, then hiring the team that made the content. Valve was then able to deliver hits such as DotA 2 and Counter-Strike as full-fledged games.

Another area that I haven’t really seen fully explored is acquiring more unique IP from books. Within gaming it is fairly popular to make games off of popular TV shows or movies. Yet many of the most popular TV and movie franchises are originally based off of literature, so it makes sense to me that games should begin to draw from the same well also.

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