Norwest’s Tim Chang explains why virtual goods are so hot in social games

Tim Chang, principal at Norwest Venture Partners, has immersed himself in the online games sector for some time and he says that the hottest business model for game startups in 2009 is virtual goods. With the virtual goods business model, game companies let users play online games for free. But they charge them when they want to upgrade to new capabilities such as cool clothing or better weapons. This model was pioneered in Asian online games, but it has only recently been embraced in the U.S. While ad-based games have cooled off in the recession, virtual goods is finally taking off in the U.S., with revenues expected to hit $1 billion this year. We asked him about the state of the game industry and the role of virtual goods in this interview. Chang will be a speaker at the Virtual Goods Summit, which takes place this week on Oct. 28 and 29 in San Francisco. Look for our coverage of it.

VB: What’s the state of affairs for virtual goods?
TC: Virtual goods is like the new mania, just like advertising was for web sites. Everybody talks about virtual goods now as the new business model. It shows that a lot of companies abandoned advertising and turned to virtual goods as a panacea. I think 2010 will be an interesting time to learn where virtual goods will work and where it doesn’t. In 2010, we’ll see how much of this is fad and how much is a lasting business model.

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VB: There are very different views around virtual goods. Nexon has been saying virtual goods is real for a decade. Others say that it works well in Asia, but not the U.S. And the Inside Virtual Goods report asserts that virtual goods is already a $1 billion industry in the U.S. Can you put that into perspective for us?

TC: It depends on how you define virtual goods. Technically, every song sold on iTunes is a virtual good. Yeah, it could be $1 billion. The way I size it is to focus on the top three companies in the U.S. The run rate just in the U.S. for Zynga, Playdom and Playfish equates to about $350 million a year now. And if you add the rest of the long tail developers on Facebook and MySpace, it’s quite credible to say that the U.S. market for virtual goods for social games is already at half a billion. If you were to include free-to-play online games (where you play for free, but purchase goods in the game through micro-transactions), and if you include casual massively multiplayer online games (MMOs), then I think you could tally it up to over $1 billion. Internationally, Tencent’s QQ virtual goods business is already over a billion dollars by itself in China. So, yes, it is already a multibillion-dollar market worldwide. One point I would stress is that virtual goods is representative of micro-transactions, and micro-transactions is the bigger story. Micro-transactions are the perfect way to monetize content that has been disrupted and fragmented by the Internet. You don’t buy a CD anymore because you get the right song you want on iTunes. You don’t buy a $50 game. Now you can play a game for free and upgrade with items as you play. The social web, Facebook, and mobile can fragment and unbundle the content. Content is becoming snack-sized and micro-transactions are the perfect way to pay for it. That’s why I think it is here to stay and it is not just a fad.

VB: The big companies and brands can look at virtual goods and say it’s still a tiny market. They probably get 95 percent of their revenue from traditional means. Why should they get excited about it?

TC: They have to defend the legacy businesses they have, so I understand that. However, it’s exactly the same as rewinding 10 years ago and the music labels saying there was no money in MP3 songs. Little did they know that in five to six years that the record business would be less than half the size it was. The shift in the audience will happen in less time than they expect. The shift is going to be tough for the big game companies. Console game sales are still $20 billion. But console sales are dropping 20 percent year over year. That’s the same declline rate that music and CDs had, and look where they are now. Same goes for TV and movies. They are seeing the same shift of audience attention to online and social media. Today, it’s less than 10 percent of console revenues. But, five years from now, they have half lost half of their revenues in consoles.

VB: If you look at the number of people who are playing social games or free games, I suppose you could conclude that there is a loss of those users for the console industry? You can conclude that it’s not just the recession, but an actual loss of users?

TC: I think it’s all additive. The recession is hurting them. But the people who are playing games are not all gamers. They are casual players who don’t own consoles. The growth is coming from the 90 percent of the population who are not self-identified as gamers. They are drawn into the social games because they are frictionless. They are light and they are social. You are expanding the pie. The whole world is going social. You don’t have to be gamers to play these games. Meanwhile, the recession is eating into hardcore game sales. More gamers are buying used games and doing secondary game trades. More people are simply not going to retail to buy goods anymore. It’s the same for packaged CDs.

VB: I heard John Schappert, the president of Electronic Arts, give a talk about how he thought there was a social gaming bubble and that in the next couple of years, he thinks the hype will deflate and brands will make gains in social games.

TC: I think that’s correct, but only through acquisitions. They’re going to pay through the nose to buy a Playfish or somebody. I don’t think they will be able to do it through their organic growth. Look at the efforts of Ubisoft and others who have created branded social games, only to find they couldn’t get big distribution of them. I think the traditional publishers are learning painfully now that social games are a completely new distribution method. Legacy methods of advertising and publicity don’t work. It’s a whole new state of the art and a three-legged stool required to succeed. That is real clever Facebook ad spending, virality of games, and very skillful cross-promotion into your daily active user base. Those are the things that Zynga, Playdom and Playfish are figuring out now and that EA, Ubisoft and these others don’t have a clue on how to do.

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VB: How do you interpret the growth of Zynga’s hit games, FarmVille and Cafe World, which are the fastest growing social games ever? Does it mean that Zynga is unstoppable?

TC: These might be the first case studies that validate the argument I made earlier. It’s not just content, but a whole new kind of distribution here. Zynga is proving there is a new kind of distribution muscle when it comes to social games and that’s why EA and others can’t do it. EA and the old guys know how to do it on retail, but on Facebook, it’s a whole new playbook. Zynga has shown that you can basically target a rival’s game, iterate on it, and make it slightly more innovative. Then, through the power of virality and cross promotion, you can make it enormously popular in a couple of weeks.

VB: You make this point about how easy it is to copycat games. It’s horrifying to game developers who take pride in doing original work.

TC: I think so. But the game industry has always had a history of light copying or iterating. There are so many first-person shooters. In social gaming, there has been more blatant copying, where games look like the other one pixel for pixel. That is to be expected in the early days when there is a lot of low-hanging fruit. The big three are shifting from copying to original games with higher production values. That’s how they will one-up each other. There will likely be premium social games with better graphics. I believe that Playfish is leading the charge on that.

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VB: As I look at some of this from a traditional gamer’s view on taste, I think they suck. Are these games quality games as they are now and that hardcore gamers like me are missing something?

TC: You and I are gamers and we grew up appreciating traditional games based on high production values, extremely immersive stories, long-engagement sessions and old school gamers forget that non-gamers get turned off by the same elements that turn gamers on. Full 3-D graphics scares away non-gamers. It’s two ends of the spectrum. A traditional gamer may look at something and view it as a piece of crap. A lot of people looked at Club Penguin and thought it was a piece of crap. I’ve seen two-dozen pitches trying to beat Club Penguin with full-production values, better 3-D graphics and all this other stuff. When they let kids play it, they find kids get lost. If the kids can’t jump in a mini game, they get bored. Most social game players are more like kids. They have short attention spans. They want to do something quickly and with as few clicks as possible. The eye candy distracts them or turns them off.

VB: What are some of the metrics here on virtual goods when you look at an individual company that you are considering investing in?

TC: There are a few key metrics. The k factor is one. That is, what is the inherent virality of the application. For a new registered user, how many more registered users will that give you? Then you have to look at the quality of users, as defined by the pay rate. How many of the new registered users turn out to be a monthly active user and how many of them are daily active users (DAUs), and what percentage of those daily active users turn out to be purchasers.

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VB: Getting people to pay is the crux of the virtual goods business model. If game companies fail at that, they could have a disaster on their hands with a lot of users and not enough people paying for it. Is there a lot of risk in this model?

TC: There is. This point is very key to the design of social games. And that is the use of compulsion loops. You monitor stats. You get your users addicted. You start annoying them with how long it takes them to get something done. That triggers impulse buys of goods that will save them time. That is at the heart as a good compulsion loop. There are other models like freemium, where you give them the first two levels and charge them for more. That has yet to be proven on conversion rate. And there is episodic content, where you charge 99 cents or so for each new episode. The compulsion-loop based design of social MMOs tend to do darn well.

VB: If free to play is risky, does it make sense for the game companies to embrace three different business models, such as free-to-play with virtual goods, advertising, and subscription?

TC: The future of this whole space is a hybrid tiered subscription model. About 85 percent of your users won’t be monetized. They won’t pay. But you can show them ads, give them lead-generation surveys, and you can view them as icing on the cake. They are not the basis of the business. Some 10 percent of the users can upgrade to micro-transactions. And if you’re lucky, maybe 1 percent will pay for a monthly subscription. The challenge for the game designer is how do you cordon off your game to appeal to those three buckets of players. The value of having the players who are monetized only through the ads is social. They may attract other players. I bet that all three of the business models will be going in parallel for the successful startups in coming years.

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VB: How big has social gaming become, in terms of numbers of companies and their valuations?

TC: The big three have pulled ahead of the rest in monetization. That’s Zynga, Playfish and Playdom. There is a whole tier of smaller shops. Many of them are profitable. So the ecosystem can support multiple profitable companies. They won’t grow to the same scale as the big three. Maybe the big three have already pulled away to escape velocity and none of the others can catch them. One of the key strengths in being a big social games publisher is having a great network for cross promotion. One of the big fears of the smaller social game companies is they will be profitable but won’t have anywhere to go. They will need to be acquired by a bigger player or merge with others to bulk up.

VB: The big three have good valuations, then?

TC: Yes, but since they are profitable, you can argue they deserve the valuations. Even if you apply public company multiples on profits.

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VB: Will they go public or get acquired?

TC: A lot will depend on the next 12 months. You’ve already seen the rumors on EA and Playfish. That makes a lot of sense. It looks like Zynga has a very good shot of going IPO. If they do, that will force the hand of existing public media companies in this space and they may go and buy somebody. We may see one of the big three taken out by an acquisition, and then we may see a lot of the smaller guys acquired too.

VB: It’s very exciting that things are changing so fast.

TC: And here’s the funny thing. Zynga in theory could go public faster than Facebook does. Zynga is built on the back of Facebook. What is ironic here is that gaming rescued Facebook. A third or more of Facebook’s revenue this year will come from social game advertising.

VB: As a platform, do you believe Facebook will be healthy?

TC: It’s still growing. It’s hard to tell for now what the real churn rate will be. Social games have churn rates. You have a hole in the bottom of the boat, but the boat is moving so fast that you don’t see it taking on water.

VB: Will the iPhone have the same kind of success with games as Facebook has had?

TC: This is the big bet that we are all making, that Apple’s shift to a true free-to-play model will make a difference. They just announced that you can do in-app purchases in free iPhone games. That creates a free-to-play model, where you give away the game for free and upsell people to buy virtual goods. We can get some of the same mechanics going on iPhone that has happened on Facebook. The question is how viral will the iPhone games be. We are still figuring that out. I am an investor in Ngmoco, an iPhone game maker. Over time, the iPhone platform will be more like Facebook. A year from now, I believe you will have social games that are successes on both Facebook and the iPhone.