Venture capitalist Tim Chang describes the white-hot landscape of game investments

The emerging landscape of games is attracting a lot of money, thanks in part to excitement about Zynga’s upcoming initial public offering and some recent acquisitions such as Electronic Arts’ $750 million purchase of PopCap Games. Tim Chang, a partner at Norwest Venture Partners, has kept his finger on the pulse of the game market for years and spoke about the opportunities in games at the recent Casual Connect game conference in Seattle.

Chang has street cred on games because he has been part of some of the biggest exits of the past year, including Disney’s $763 million purchase of Playdom and DeNA’s $403 million purchase of Ngmoco. Those exits helped land him on the 2011 Forbes Midas list of top VCs. Other big gaming deals included Tencent’s $400 million or so purchase of Riot Games; Visa’s $190 million purchase of PlaySpan; eBay’s $240 million purchase of Zong; and Google’s purchase of Jambool and Slide. With Chinese, Korean and Japanese companies hungry to get into the U.S. game market, you can expect that acquisition spree to continue.

[aditude-amp id="flyingcarpet" targeting='{"env":"staging","page_type":"article","post_id":312211,"post_type":"story","post_chan":"none","tags":null,"ai":false,"category":"none","all_categories":"business,games,mobile,social,","session":"C"}']

“Darn you, PopCap, for keeping valuations in games frothy for the rest of the year,” Chang said. “But even the enabling layer for games has seen successful exits here.”

Chang has also made new bets on games and is a part of a $12 million investment in web gamification firm Badgeville, a $32.5 million funding of brain game maker Lumosity (Lumos Labs) and a $9 million funding of health gamification firm Basis. He also invested in MyYearbook, which merged with Quepasa last week.

What to do about the gaming bubble?

In his talk, Chang said that the PopCap-EA deal and the Zynga IPO will keep the game market frothy for the next six to 12 months; but that frothiness it won’t last. That means game entrepreneurs should load up on funding now and prepare for the day when it will be a lot harder to raise money. At that point, companies that don’t have enough cash will be bought. The other strategy is to sell out while the market is hot.
As a result, it’s both a tougher time for investors and a frothy time. Valuations are very high and costs are going up as the path to success becomes tougher.

“Expectations for valuations are extremely high, but we’re also facing a pending consolidation,” Chang said. “We are reaching this breaking point as companies expect higher values while their marketing and distribution costs are going up. …We are starting to see the sun set a little bit. There is a big question mark about how long these frothy valuations will be sustained.”

What else is hot out there?

He also said he invested in Badgeville as a leader in gamification, even though there has been a lot of backlash in the past year as people say that gamification is overhyped. Chang said he is also excited about SocialVibe, a company where he is a board observer. SocialVibe provides measurable engagement marketing for social media campaigns.

Chang said that Kixeye (maker of Battle Pirates — pictured right — on Facebook) is raising a giant round at high valuations, and so is Kabam, the maker of hardcore Facebook games that already raised $85 million this spring. These are so-called “mid-core” companies, where they’re not as intense as console games but are heading in that direction.

[aditude-amp id="medium1" targeting='{"env":"staging","page_type":"article","post_id":312211,"post_type":"story","post_chan":"none","tags":null,"ai":false,"category":"none","all_categories":"business,games,mobile,social,","session":"C"}']

“They are pursuing the notion of next-generation social gaming, instead of the standard FarmVille copycat,” he said. “They are bringing deeper game mechanics such as real-time strategy games and proving that you can get higher ARPUs (average revenue per user) even though you may not have a higher user base.”

Mobile gaming is also hot, with Rovio, TinyCo, and Pocket Gems all raising rounds. They have more hope to grow, since Zynga doesn’t dominate mobile as it does Facebook. After Ngmoco’s acquisition, a number of VCs have jumped into the market to find the next hit maker. The makers of hot pet, farm, fish and city-building games are aggregating large user bases and are turning around to create distribution power. There’s lots of copycatting in this space.

Another new category is “mosolo,” or mobile social local game companies that are doing things such as gamifying Twitter or Google Maps with augmented reality overlays. A number of Android games have launched because Google finally launched in-app purchases this summer (Apple had them in the fall of 2009). While the in-app purchases are still clunky on Google, Chang said many companies are finally investing in Android games, rather than spending time tweaking iOS games.

“At least it’s happening, since before they had in-app purchases, a lot of our companies were saying why bother with Android,” Chang said, although he said Bionic Panda Games (headed by Charles Hudson) is starting to see results with in-app purchases.

[aditude-amp id="medium2" targeting='{"env":"staging","page_type":"article","post_id":312211,"post_type":"story","post_chan":"none","tags":null,"ai":false,"category":"none","all_categories":"business,games,mobile,social,","session":"C"}']

Size matters, distribution matters

Chang also said there are some market inhibitors. The social gaming war 1.0 is over and Zynga won, Chang said. Facebook has clamped down on viral messaging that allowed Zynga to rise rapidly. And the Facebook Credit tax — 30 percent of virtual goods purchases — is now fully in effect. Facebook is also starting to overrun some of the incumbent networks in the rest of the world, such as Brazil, where Orkut has been strong. If Facebook dominates globally, it becomes a monopoly.

Distribution bottlenecks are also holding new game companies back. With less virality, game companies have to spend more on advertising on Facebook to get their games noticed.

Mobile games have never had much built-in virality. Apple made this harder on the iOS when it banned pay-per-install marketing practices, where companies could buy their way into the top 25 ranks, that were used by players such as Tapjoy. Tapjoy’s revenues took a huge hit when that change went through, and now everyone is scrambling for a new model that works for distributing apps.

[aditude-amp id="medium3" targeting='{"env":"staging","page_type":"article","post_id":312211,"post_type":"story","post_chan":"none","tags":null,"ai":false,"category":"none","all_categories":"business,games,mobile,social,","session":"C"}']

“It’s harder for the little guys to break out on mobile now,” Chang said.

Tapjoy is shifting to Android now, and Chang thinks there is still a future where gamers can earn games by performing tasks, rather than buying games. It’s all about lowering the cost of getting new users, and game companies desperately need a solution here.

With hundreds of thousands of apps on Apple, everyone is looking for a way to get discovered or distributed. Some companies have decided to create their own social layers so that their games can be more easily shared or cross-promoted, while others are turning to third-party companies to do that.

“The U.S. market for iOS is noisy,” Chang said. “It’s about distribution power. If content is king, then distribution power is God Almighty. If you can create your own Xbox Live style layer, you can do cross promotion.”

[aditude-amp id="medium4" targeting='{"env":"staging","page_type":"article","post_id":312211,"post_type":"story","post_chan":"none","tags":null,"ai":false,"category":"none","all_categories":"business,games,mobile,social,","session":"C"}']

Tread carefully with cloud gaming and HTML5

OnLive and Gaikai are starting to deliver on interesting demos of cloud gaming, where servers execute a game and deliver it as video to any screen, including small laptops that would never otherwise be able to display high-quality games. Users are playing these games, but they’re not yet converting to paid users in large numbers.

“The market is still not ready yet,” Chang said. “I’m still a believer, but it’s one of those things where the market is going to be ready next year. Then next year comes around and it’s next year again. The question is, when will it finally be ready?”

The same goes for HTML5, the new lingua franca for cross-platform web apps. HTML5 promises to deliver developers from being captive on certain platforms with native apps and closed markets. But HTML5 apps run so slowly that many graphically demanding games don’t work on it. It’s OK for turn-based casual games that don’t require too much movement.

[aditude-amp id="medium5" targeting='{"env":"staging","page_type":"article","post_id":312211,"post_type":"story","post_chan":"none","tags":null,"ai":false,"category":"none","all_categories":"business,games,mobile,social,","session":"C"}']

“It’s getting better by the day, especially at the lower end,” he said. “It’s still not quite ready yet.”

Next-generation platforms such as cloud gaming, 3D browser games — such as those created with the Unity engine — and HTML5 games will eventually gather steam. But timing is going to matter.

The war for talent

All of the competition is creating a war for talented game makers, especially in Silicon Valley. Zynga and other bigger companies have been acquiring companies just to get more talent.

But the demand is shifting toward people who are familiar with games-as-a-service. Art can be outsourced, but the hard part is getting analytics experts, backend programmers, and other service-oriented staff. This is why more platform companies are emerging to supply this kind of talent to game developers, who can then concentrate on game design.

As costs rise, overseas acquisitions are also becoming more popular. Developers are scouring places such as Japan, Brazil, China, Eastern Europe and the rest of Asia to find both development talent and new markets for games.

Whatever entrepreneurs do in the war for talent, they should make sure that they hire the right people and hang on to them. One day, if a company has to sell out, it will likely get a better price if it has an outstanding team.

The international snapshot

In social gaming, there’s a land grab going on beyond the U.S. market. Game companies are scrambling for distribution power, new revenue streams, and new studios. Mobile game companies are racing to expand around the world as well. Publishers are trying to expand in regions where Facebook is also growing fast.

In Japan, DeNA, Gree, and Mixi have all formed gaming ecosystems with players who are spending a lot of money. That has led to billion-dollar revenue opportunities and multibillion-dollar market caps. And that, in turn, is enabling Japanese companies to acquire U.S. mobile and social game companies. Tencent and other Chinese companies are also moving into the U.S. market, as are successful Korean companies such as Nexon.

In terms of local game companies in other parts of the world, Mentez and Vostu are emerging as big players in Brazil, while Kontakti is doing well in Russia. India is nascent, but Chang hasn’t yet seen a breakout hit company in that territory. China’s RenRen, Kaixin001 and Tencent are opening up their platforms. Game companies are pursuing those opportunities, given the overcrowding of games in the U.S.

What’s next?

Chang says we are now in a post-viral era. There’s now a lot of pressure for startups to create their own stand-alone sites and their own Xbox Live-style social layers to help games spread. Facebook is like the equivalent of a retail store, where people will see the game there but can be quickly moved off the site to a stand-alone destination web site. Companies such as Real Networks’ GameHouse are using this strategy. The tricky thing is that ads haven’t really worked well at driving users from Facebook to a destination site.

Now that mid-core games from Kabam and Kixeye are taking off on Facebook, Chang believes they will start taking off on mobile. The gamification startups should also start producing real results, proving that their models work and that there can be some real return on investment for gamification, he said. Chang is not a fan of light gamification, where brands slap a leaderboard on their sites and expect users to come back every day because of it.

Gamification will best take off as an evolution of loyalty programs, behavioral analytics, and customer relationship management tools. Gamification works well when it taps into a basic human drive (one of the Seven Deadly Sins) like greed or lust, Chang said. The question is whether gamification will have to be done one at a time, with a custom consulting model. That doesn’t really scale. Or can it be done with an automated software-as-a-service model with recurring revenue?

“We are in round one of gamification,” he said. “I invested in Badgeville (pictured) because they are a SaaS platform showing large renewals.”

Chang is hopeful that music games will take off, particularly those such as Ubisoft’s RockSmith that teach you how to play a real guitar. He is also optimistic about gesture-based gaming through platforms such as Microsoft’s Kinect motion sensor for the Xbox 360. That will likely spread to smartphones and tablets. Youth edutainment will likely be big, and Chang believes the next Club Penguin (a kids virtual playground now owned by Disney) will happen on a tablet computer.

Chang likes the brain-training games from company’s like his portfolio company Lumosity, which helps people assesses and train their mental capacity. Gamified health applications could also take off, helping people quantify their own health and motivating them to become healthier through measurement and game incentives. With technology such as the heart-rate monitor created by Basis, users can find out who is stressing them out by comparing their heart rates to their calendars.

“There are plenty of business models and social game mechanics left to innovate on,” he said.

Gaming archaeology

Chang said he wants to see the social and mobile game industries move past the copycat genres of pets, city building, fish and farm games. The game industry can do that through “gaming archaeology,” or digging up old titles from genres that have not yet been done on Facebook or mobile platforms. He noted that FarmVille was a copycat of Farm Town, which was inspired by Happy Farm in China, which in turn was inspired by Harvest Moon on the Super Nintendo Entertainment System in 1996.

If you look at Battle Pirates on Facebook today, for instance, you’ll see that it has its roots in real-time strategy games such as Command & Conquer on the PC. There are plenty of other genres and classic games that can be mined for good effect in the modern era.

Chang wants to see more light role-playing games such as The Bard’s Tale from the early PC era. A version of Diablo would likely work well at some point on Facebook, as long as the platform moves forward on speed. Chang would love to see old games such as The Last Gladiator (pictured), Starfleet Battles or Syndicate as well.

“How would you do a game like Baldur’s Gate socially?” Chang said. “How do you wrap them in micro-transactions and virtual goods freemium business models?”

Chang believes that whales, or the tiny percentage of players who spend huge amounts on virtual goods, are a great target for game companies to pursue. Whales spend so much money that game companies really ought to target them and cater to their desires.