The top 12 trends of the video game industry

It’s good to step back and get a good look at the various cross-currents in the games landscape. Over the last few weeks I’ve been surrounded by game developers at the Login online games conference in Seattle and the Quo Vadis game developers event in Berlin, both events where I was invited to speak, and have seen several trends emerging — some good, some bad. Here they are:

1. Game startup financings have slowed from last year. Everyone in the game industry is aware that sales for U.S. console games in March slowed by 17 percent and another 17 percent in April. That’s not too alarming, since a year ago the launch of Grand Theft Auto IV was a huge event, and it’s hard to beat the numbers from a year ago. But it’s the first sign that the game industry can’t work miracles in the midst of a recession.

Along with that, financings have slowed. So far this year, 25 companies have raised $126 million, according to our calculations. Game and virtual world fundings for 112 companies hit $936.8 million in 2008 by our count. That compared to $613 million raised by 62 companies in 2007, according to Jussi Laakkonen.

It looks like 2009’s game venture fundings are not going to exceed last year’s totals. The biggest funding so far this year was Offerpal Media, which monetizes social games with special offers for users. It raised $15 million. By comparison, the biggest funding last year was $100 million raised by China’s 9You. While the funding environment’s not as good as a year ago, it isn’t so bad that game fundings have dried up.

2. The broader game industry continues to expand, command more respect, and draw outsiders. This isn’t a contradiction to No. 1, in part because game startups are still a relatively small slice of the overall industry. Pricewaterhouse Coopers says the global game market will grow from $42 billion in 2007 to $68 billion in 2012. DFC Intelligence says online games will grow from $3 billion in 2005 to $12 billion in 2011. There’s no question games are gaining market share on other forms of media, which is why the industry is drawing big investors, from USA Network to Time Warner.

While funding may drop for game startups this year it’s interesting to see how far they’ve come. Five years ago, no respectable VC wanted to make a bet on hit-driven businesses. They stayed away from it the way they stayed away from Hollywood movies. But now the active VCs this year include some of the best-known in the venture capital industry: Charles River Ventures, Mohr Davidow Ventures, Kleiner Perkins, Norwest Venture Partners, Draper Fisher Jurvetson, D.E. Shaw, and Oak Investment Partners. Among those actively looking are Trinity Ventures, Lightspeed Venture Partners, Blue Run Ventures, and many others.

The ecosystem is healthy, and the reason is that games are constantly expanding their borders. The Wii has done a great job recruiting new gamers. But the monthly NPD sales numbers haven’t captured the explosion of games on the iPhone, Facebook, casual games on the web, and PC online games. Even more immeasurable is Funware, which refers to the use of game mechanics in non-game applications. Other industries are recognizing that games are so engaging that they’re trying to make their own products more game-like.

As Jordan Weisman, founder of 42 Entertainment, once said, “Games are like oxygen. They are part of every activity, from reading to toys to TV to any kind of experience. They can be played on any kind of platform,” beyond the consoles. The broadening of the game market is why games can be somewhat resistant to the recession, even as other retail products suffer.

3. Competition is heating up and driving prices toward zero. Of course, if too many competitors enter the market, profits can tank and prices can crater. One of the bad things about having so many fundings last year is that, if you’re raising money this year, you’re going to have to compete with those 112 companies who, because of the way the recession is playing havoc with pre-recession business plans, are likely going to have to raise new rounds of money.

Even scarier is the rise of free games. There are a couple of thousand free games on the iPhone. There are thousands more on social networks and casual web portals. Perhaps 90 percent of players on the web are choosing to play games for free when they have a choice between a free version or a paid version. And the quality of the free games is getting better and better.

What happens when the user decides that free is best? This is the same problem that newspapers, movies, music, and other producers of content are facing as the Internet undercuts the traditional barriers that have kept prices high, as conveyed in Chris Anderson’s upcoming book, Free.

4. Advertising in games has taken a hit. Free gaming was supposed to be supported by advertising. In-game advertising, where the ads run inside a game as players play, got off the ground in 2004, picked up momentum in 2006 when Microsoft paid a lot of money for Massive. A bunch of rivals entered the market, including Google. The peak of the market had to be when the Obama campaign ran ads on billboards inside a racing game. Then the recession hit. Ad budgets began to dry up. Now IGA Worldwide, an in-game ad company, is up for sale, and Microsoft’s Massive in-game ad division just laid off 28 percent of its staff.

In-game advertising may turn out to be a great market. But this is what happens when expectations race too far ahead. Back in the days of the building of the transcontinental railroad, everyone was optimistic about railroad companies. But many of them went bankrupt, just like a lot of the companies that poured money into the dotcom market. From the point of view of venture investors, the in-game ad market has “jumped the shark,” a phrase I’m told means passed its peak. It just means that the people who are going to make big money here have already invested, and there’s no way you can make money by chasing their exhaust. Or so the thinking goes.

While in-game ads may be suffering, other ad-based game businesses can still grow. Video-based wrapper ads are growing so much for Wild Tangent that the company posted 65 percent growth in its ad-based revenues in the first quarter. Analyts Edward Hunter of market researcher comScore disagrees with me that in-game ads are sinking. He notes that in-game advertising will show faster growth if it’s measured properly by independent media trackers. And he notes that while total ad views on the Internet dropped 20 percent in December of 2008, in-game ads saw a rise of 8 percent. Once the advertisers catch on, they may pile into this sector, he says. But in the meantime, the layoffs suggest there is a big reset in expectations happening.

5. Virtual goods are benefiting from the weakness in ads. Virtual goods businesses are taking off on Facebook and at other companies such as China’s Tencent. My colleague Eric Eldon estimates that virtual goods micro-transactions could generate $500 million in revenue for game and app makers on Facebook this year. Zynga, which makes games such as Texas Hold ‘Em Poker, has become the top third-party company on Facebook. It looks like such games are creating real, sustainable businesses on Facebook. Zynga is reportedly on a run rate to make $50 or $60 million. Playfish and Playdom are likewise on track to make tens of millions of dollars. Their games get real cash, albeit in small chunks of change, from users. They’re spending real money on virtual items like poker chips or a better weapon. When you have 12 million active monthly users like Texas Hold ‘EM Poker, the change adds up.

PlaySpan has stepped into the market to provide everything from a payment system to handle virtual goods to in-game virtual goods sales processing to retail game cards that let kids who aren’t old enough to have credit cards purchase virtual goods. Some of the games are getting pretty clever at integrating virtual goods. You can buy a virtual race car in Upshift Strike Racer, a racing game on Gala-Net. Then, after you put some miles on the car, you can sell it as a used car to another player. PlaySpan’s chief executive, Karl Mehta, predicts the company will handle a billion transactions, worth a total of $100 million, this year.

Other companies in the larger space of monetization include Twofish, LiveGamer, Fatfoogoo, Offerpal, Super Rewards, Viximo, and Jambool. Outspark, which is importing free-to-play games to the U.S., has said 10 to 13 percent of its users are buying virtual goods. And of those, the average revenue per user is $45. That’s so high that those players would be better off paying a subscription. This virtual goods wave has swept through the whole world. It’s wonderful that the game industry is returning to that micro-transaction currency that’s served it so well in the past: the quarter.

6. Don’t believe too much of the hype about Chinese game companies taking over. Will the rise of new business models in Asia, and the rise in game company valuations, enable them to take over those in other territories?

Virtual goods started thriving as a business model for companies such as Shanda in China a few years ago. Online games thrived in China because they enabled operators to authenticate users and thereby beat rampant piracy. World of Warcraft did great in China’s Internet cafes, but the free-to-play model is taking over, according to market researcher Niko Partners.

Will this become a global advantage for the Asian companies that have embraced this business model first? It was a couple of years ago that Shanda said it would switch all of its games to virtual goods models. And now Shanda is the biggest online game company in China with $500 million in revenues. In my speech in Berlin last month, I brought up the topic of geographic arbitrage. I noted that a couple of books by Annalee Saxenian, Regional Advantage, published in 1996, and The New Argonauts, published in 2007, showed how differences between regions could make a big difference in terms of who thrives and who doesn’t.

Geographic arbitrage means that you exploit your region’s advantage. For a time, the French stock market overvalued game companies. That gave rise to Infogrames, which used its valuation to buy other game companies. One of the most symbolic occasions of the French invasion of the video game industry happened when Infogrames bought Atari. DFC Intelligence has noted that much of the profits of the game industry have migrated from the money-losing Western companies to the Far East.

In Berlin, I all but predicted that the Koreans and Chinese would take over here. But we’ve seen some abortive attempts at crossing borders. NCSoft made a fortune with Lineage in Korea and tried with Destination Games in the U.S. But NCSoft’s Tabula Rasa failed and was shut down. And Perfect World has launched a couple of games in the U.S. but hasn’t yet acquired anyone. The whole Chinese online games market is expected to be $3.8 billion in 2009, according to Niko Partners. It is growing at a rate of 38 percent.

But here’s the reality check. The revenues for Shanda are still only about an eighth of the revenue at Electronic Arts. ChangYou had one of the only IPOs in the past few months. The Chinese company raised $200 million in its debut on the NASDAQ. The Chinese companies are not yet in a position to come into the U.S. market and take over. The wave could happen someday, but not just yet.

The market capitalization of the top eight Chinese game companies is about twice that of EA’s That will get bigger. The Chinese companies are scouting now in anticipation of buying more later. Maybe they’ll do better than the Koreans. But troubled U.S. companies can’t look to the Chinese as saviors.

7. Social gaming is spreading beyond the borders of game platforms. Social gaming has caught on along with virtual goods because it’s a lot of fun to play with your real friends with real identities on social networks such as Facebook. There are now more than 5,000 games on Facebook.

Companies such as Zynga, SGN, and Playfish are thriving on Facebook. They’re taking advantage of the ability to spread games in a viral fashion to stand out. If you can get your users to spread your game for you, then you don’t have to worry as much about marketing costs. Thanks to viral marketing, it’s possible for small titles to get noticed in the long tail of thousands of games all competing on the Facebook platform, which has 200 million users.

Zynga, SGN and other Facebook companies are moving to the iPhone. Playdom is moving from MySpace into Facebook games. One of these days, somebody is going to build a cross-platform social games empire.

8. Creative destruction rules the game job environment. Are these new businesses with new business models going to grow up and threaten the big console companies? Michael Pachter, an analyst at Wedbush Morgan, said he thought there were a lot of cool companies in the space. But he doubts that the startups will overtake the traditional console startups anytime soon. It will be interesting to see if jobs created at the new companies can compensate for jobs lost at the old ones.

Wanda Meloni of M2 Research came up with some interesting data about this last week. She said that since July, 2008, 60 game companies/studios have publicly announced layoffs that have eliminated 8,450 jobs. Most of those are in North America, where there are an estimated 53,900 people working at game companies, according the Game Developer Census. She calculates that roughly 12 percent of the whole game industry has been hit by the layoffs. That sounds awfully depressing.

But there are thousands of people now jumping into iPhone game development, or development of games for smart phones. Moblyng just announced last week that it developed games that could be quickly and easily ported across all smart phones. Just as some big companies die, new ones are being born.

People call it creative destruction when one thing collapses and another takes its place. The big companies cut back, and the game startups form to fill the void. 3D Realms, the maker of Duke Nukem, closed its doors the same day WonderHill announced it raised $7 million. The lesson of 3D Realms is, don’t take more than 13 years to develop your game.

9. Apple and Nintendo are at war. There were only 1,500 games on the iPhone in December. Five months later, there are more than 9,000 10,110. Clearly, some of those unemployed game developers are trying their hand at striking it rich by uploading a game or two to the AppStore. At the very same time that many companies are crumbling, we’re witnessing a Cambrian explosion of indie game companies. These companies are all capital efficient, which is music to the ears of recession-ravaged investors.

Nintendo has sold more than 100 million DS units since 2004. Apple has sold 37 million iPhones and iPod Touches in little less than two years. At that rate, Apple is likely to overtake the Nintendo DS. Maybe that’s why Nintendo lowered its forecast for DS games in the coming year. I don’t know. But it’s worth pointing out that DS games sell for $30, while at least half of Apple’s games sell at 99 cents. Jeremy Liew of Lightspeed Venture Partners estimates that the whole AppStore has generated no more than $45 million in revenue for Apple. As you can see from the price difference, it’s going to be a long time before Apple knocks out Nintendo.

The difference in approaches is going to be a fascinating experiment in capitalism. Nintendo deliberately limits its own games on its platforms and closely regulates what games can be published for the Wii and the DS. There are only dozens of WiiWare downloadable games on the Wii, whereas Apple has opened the floodgates. Apple clearly offers its consumers more choice in games, but iPhone developers may have a terrible time getting noticed on the iPhone and keeping hits alive for more than a couple of weeks. Nintendo says it prefers to have healthy developers on its platform. The suggestion is that Apple’s platform won’t truly take off until it provides ways for developers to make money. If you know who’s going to win, tell me.

Apple has a popular and fast-growing platform. With the iPhone 3.0 software, it’s going to have new game-friendly features such as virtual goods. But it is leaving the game development to its developers. At some point, it would be great to see dueling keynotes between Nintendo CEO Satoru Iwata and Apple’s Steve Jobs at E3.

10. Gesture-based control systems will spread industry wide. Just about everything Nintendo starts turns into an industry-wide trend. The company started the wave of brain-training games with Brain Age. And then it started the fitness craze with the launch of Wii Fit. Now everyone from Lumos Labs to Electronic Arts with EA Sports Active is piling into those markets.

With the Wii, and soon the Wii MotionPlus, it has redefined the game controller and inspired a wave of gesture-based technology companies that include PrimeSense, 3DV Systems (acquired by Microsoft), Canesta, Softkinetic, Omek Interactive, and others. Microsoft is rumored to be working on its own gesture-control system, and Sony will likely go farther with this technology as well.

11. Backfill strategies may work. Companies such as Quick Hit are trying to take on Electronic Arts’ Madden franchise by launching a free-to-play online football game. The plan to attack Madden via the online route reminds me of a strategy I call backfill.

It’s like in real estate. A whole neighborhood gets built out, but there are a few empty lots. Some companies just move on to new neighborhoods because they figure the game is over in the old ones. But then the backfillers go back to the empty lots and build houses on them.

I thought of this strategy when I heard about Virtual Families. This game from Last Day of Work is focused on taking on The Sims, which has sold more than 100 million copies. This category of people simulation has been dominated by Electronic Arts. Most people would, and have, stayed away from this neighborhood. But Virtual Families is shooting to produce a much more casual experience than The Sims.

Along the same lines, Thriller New Media, headed by Wild Bill Stealey and Fred Schmidt of MicroProse fame, are trying to do a backfill in the military simulation space. The market moved away from the hardcore military games as the console market broadened. It no longer made sense to make games that only 100,000 people played. But so many companies left the space that Thriller is trying to go back and replant on old soil. They’re applying new tricks, such as social networking and free-to-play business models, to online military simulations. There is even a generational play here, just like how Disney creates movies that appeal to both kids and their parents. The parents get a kind of retro nostalgia while the kids enjoy something they haven’t seen before.

12. Digital distribution is gathering steam. GameStop has more than 4,000 stores across the country. But retailers had better pay attention to the gathering momentum of Valve’s Steam service, which distributes games direct to users over the Internet. OnLive, meanwhile, dispenses with the downloading. When the company launches its video games on demand service this fall, you can play games that are stored on distant servers as if they were right on your home PC. For a subscription fee, you’ll be able to play fast-action games on low-end machines. This will become a viable distribution channel, even if it doesn’t kill retail, and even if Valve and OnLive aren’t the ones that succeed. It’s like gravity, with the full force of the Internet behind it.

Conclusion: Games deserve the same kind of financial maturity that others have enjoyed. Why should you only be able to get rich -– or lose your shirt — at a Web 2.0 company? Or at an investment bank? Or a cleantech company? Games are a haven from the storm. More venture money is bound to flow into games as VCs retreat from shell-shocked markets into ones that are better off. Big game companies such as Gazillion (which has a license to make Lego and Marvel massively multiplayer online games) and OnLive, which is creating a server-based games on demand service, are tapping the financial community in a big way to get what they need. These are the kinds of companies that have the potential to be home runs.

As VCs pour money into the different markets, some segments will become saturated. Virtual worlds accounted for more than half of the fundings last year. There are now 200 kids virtual worlds in development. But there are promising new areas in brain training, funware, games for health, educational games, music games, exercise games, and sports 2.0. I can only imagine that some more exciting than the iPhone, perhaps a new version of it, will come and blow us all away with its gaming capabilities. And, of course, it’s not too early to start thinking about next-generation game consoles. There are great riches on the horizon, as long as you don’t step into that ditch right in front of you.

Do the trends matter for those starting businesses? Let’s consider the trend related to movie games. Brash Entertainment, a movie game company that shut down in November, was the latest to prove that bad movie games really suck as a business.

Movie games come and go, as does Hollywood’s interest in games. Certainly, they generate a ton of revenue. The latest Lord of the Rings game from Electronic Arts got bad reviews, but it still sold a million copies. Most of us would like movie games to fail, just because they are so cynically piggybacking on something better.

But even inside a lousy trend, it’s possible to build an interesting company. Exponential Entertainment won both the judge’s pick and people’s choice at GamesBeat. They’re making a casual game site with movie-related material. These folks were the makers of SceneIt?, the DVD trivia game that has generated $500 million in sales. Here they are in a new company that takes the same kind of movie trivia game to the web. They’re looking to raise just a small amount of money.

Even though you can be aware of what’s a good trend or a bad trend, you can ignore them when you’re thinking about your own game. What a game really needs is a combination of passion, innovative thinking, and execution. If you have all of that, then you can pull off something great no matter what the trends are.