Will the game industry slow, or is it just getting started?

I’m giving a speech today in Berlin, Germany at the Quo Vadis game conference. I was asked to talk about the state of the game industry and the prospects for game startups. Here’s an abridged version of the speech for those who want an overview of investment in games.

I love games. I played the original Pong when it first came out. I played Wing Commander in the early 1990s until my right arm became too tired to hold the joystick. When that happened, I did what any good gamer would do. I switched to the left arm.

I still play games. I love games like Halo 3, Killzone 2, and Call of Duty 4: Modern Warfare, where I made it to the rank of major on multiplayer. I play games on the Wii with my kids. Since I work all of the time as a blogger, I don’t get enough time to play, but I can play match three games like Trism on the iPhone. (I scored 7 million on the flight over here). Game companies can target me the way that Disney targets families with their movies. They create entertainment for generations families, with animations to please the kids and  inside jokes that only the old people can understand. As I grow older and continue to play games, and as I raise my children to play games, I am participating in the broadening of the video game market. It is this constant expansion that prompted VentureBeat to give its recent GamesBeat 09 conference the theme “All the World’s a Game.”

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Games are busting down borders. 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. The term Funware refers to the use of game mechanics in non-game applications. ARA, a defense contractor, just recently acquired the serious game maker Virtual Heroes in order to make games about being an astronaut, medicine, and other training subjects. 3D depth cameras from Canesta, with software from Softkinetic, could make it so that you don’t even need a controller to make gestures in a game. 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.

I’m so glad that this explosion of gaming has given me a multi-decade career. Games have kept me busy. I’ve written two books. Opening the Xbox was about the original team that created Microsoft’s first game console. The second book was The Xbox 360 Uncloaked, about the making of its second console. And in September, I wrote an 11,000 word article about the history of the defects in the Xbox 360. If I could remember any of that stuff right now, I would be a highly qualified speaker.

About three years ago, I gave a speech that asked why there was so little venture investment into games. I was angry that so many brilliant game designers couldn’t get money to do big-budget titles. But money is now flowing. A year ago, when I left my job as a columnist at the San Jose Mercury News to join VentureBeat, I thought I’d write very little about games, but I was wrong. It turned out that 2008 was a banner year for game startups. The point is, every time I thought that the game industry was going to run out of steam, it took a very interesting turn and gave me more things to write about and more reason to stay employed as a game writer.

The question that many startups face right now is this: How optimistic should we be? How scared should we be? And how do we plan for the future if we don’t know what’s happening?

I can’t answer these questions. But as a journalist, I can give some perspective. It is a scary time for the global economy. I have never seen so many scary economic catastrophes, all piled up, one after another, in my life. Lehman Bros. AIG. The auto industry bailout. The housing and stock market crashes. And Tabula Rasa (right) shut down. Don’t laugh about that. Lehman Bros. was just one company. But with Tabula Rasa, we lost a whole galaxy. In Silicon Valley, we were in a state of shock in October. At VentureBeat, we started writing daily stock market stories because that was what everyone was talking about. Unemployment in the Valley is now at 11 percent.

After that series of bad news, it made sense that the fundings of all companies, including game companies, would slow down. And if you look at the first nine months of 2008 and the last three months of 2008, you find a definite slowdown. In the first quarter, it was disastrous. Only $3 billion went into 549 companies, according to the National Venture Capital Association. That was down 47 percent from the fourth quarter in dollars and down 61 percent from a year earlier. It was in fact the lowest level of VC investment in 12 years. Accordingly, I have seen game company fundings slow down as well, at least anecdotally.

Yet I’m amazed at the resilience of entrepreneurs. People are still starting companies. VCs are still funding companies. I write about them every single day. Even though there is terrible economic news, startups are still coming to life.

You entrepreneurs already know the odds of success are low. It’s crazy to start a game company, but you have to do it anyway. Because you love the business, and you love games. This is your dream. And you have a chance to be the next Will Wright (right), who, as you may know, decided to leave Electronic Arts to create his own game and toy startup, called the Stupid Fun Club. Everybody is rooting for startups because they are the source of innovation, originality, and the independent spirit that makes so many games successful. We’re in an age of indie revival, a fact that’s evident from the more than 5,000 games on Facebook.

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Gilman Louie, the founder of Spectrum Holobyte and now a partner at venture firm Alsop Louie, says now is a great time to start a company because you can steal talent easily. If you look at young social game companies such as Zynga and Social Gaming Network, they’re recruiting top executives now from firms such as Electronic Arts and THQ.

The economy also moves in circles. If you are starting on something now, it may be two years before you finish. By that time, the odds are good that the economy will be good. And if you are a very small company that can finish a game in a few months, you don’t have to worry about the economy. All you have to worry about is making a great game. Look at 2D-Boy, the company created by two men who had no office. They squatted in cafes in San Francisco until they finished their game, The World of Goo, which went on to become a huge indie hit on the PC and on the Nintendo Wii. When you hear stories like that, you just have to believe anything is possible.

Entrepreneurs are amazing people. In the United States, venture-backed companies account for 9.1 percent of all U.S. jobs, or 10.4 million, according to the NVCA. They account for 8.6 percent of all U.S. sales, or $2.3 trillion. In 2008, VCs invested $28.3 billion in 3,800 companies. Silicon Valley accounts for 40 percent of that. About $2 billion went into media and entertainment companies.

The game industry falls into the same larger pattern as the technology industry. Only the news for game companies had been faring better. Our data showed that more than $885 million went into 93 game and virtual world companies in 2008. We know our numbers are incomplete since there were many foreign fundings that we just didn’t track. I’m looking forward to finding someone who is much better at tracking this. The amount for games and virtual worlds in 2008 is much smaller than the amount of money that went into cleantech, which generated $4 billion in investments in the U.S. alone.

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We didn’t track the numbers before. But, anecdotally, game company financings really didn’t happen in past years. VCs were afraid of their ability to pick hits. The odds of investing in a good game were about as bad as investing in a hit movie. Game developers received funding from game publishers. The industry was too immature and small to deal with more advanced types of funding enjoyed by the Internet startups.

There was a period of opportunity cost for game entrepreneurs. If you started a game company, you probably were not going to become rich. And you were going to pass up an opportunity to become rich at an Internet startup. This was true during the time from 2003 to 2007, when Web 2.0 startups such as YouTube, Facebook, and MySpace were born. People who were part of the game industry probably felt pretty bad, like they made the worst decisions of their lives by staying in the game industry.

But times have changed. Many major venture capital firms are now firmly entrenched in game investments. Kleiner Perkins. Mayfield Fund. Lightspeed Venture Partners. Blue Run Ventures. Best Buy Ventures. Time Warner Ventures. Trinity Ventures. Granite Ventures. These are just a few of the names that have put money into game investments. They are actively meeting companies and funding them.

In China, 9You (right) raised $100 million. BigFish Games raised $83 million. Trion World Network raised $70 million. Real-Time Worlds raised $50 million. Turbine raised $40 million. And here in Berlin, Game Duell raised $17 million. The game fundings did not end in October.

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When VentureBeat held its GamesBeat 09 conference on March 24 in San Francisco, it drew in more than 400 people –- game executives, VCs, investors, entrepreneurs, journalists and marketing people.

We had executives from companies such as Marvel, Nickelodeon, Disney, Sony Online Entertainment, Microsoft, Gazillion, Outspark, Playfish, Zynga, SGN, Ngmoco, Nokia, Nvidia, Intel, AMD, Raptr, EA, and others. The press came from the New York Times, the Los Angeles Times, G4TV, SpikeTV, and the game trade press. There were 50 companies that applied for the seven finalist spots in the game startup competition. We did a survey of the attendees and our web site audience. About 160 people responded. When we asked them in mid-March about whether the fundings for game industry startups had reached the peak in 2008, they said no.

How is that for optimism? As you may know, game industry sales were going strong. The U.S. industry growth has slowed from 33 percent in the first half of 2008, but it managed to grow 19 percent and hit $22 billion in 2008, according to market research firm NPD. In January and February, sales grew 13 percent and 10 percent. Finally, in March, weakness began to show as game sales in the U.S. fell 17 percent. That number was alarming, since it marked the first time we’ve seen big drops in hardware, software and accessories altogether. But I expect sales will bounce back in April because of the launch of the Nintendo DSi. But we’ll also have hard comparisons to 2008 because of the anomaly of Grand Theft Auto IV’s launch last year.

On the bright side, games are still a relative haven. Other retail sales and entertainment sales are suffering even more. That means games are a gaining market share on other forms of entertainment, such as movies or music. More kids are playing games. More people are buying consoles due to the popularity of the Wii, which has reached 50 million consoles sold faster than any other game platform. Nintendo has sold more than 100 million DS units and it is now selling lots of new DSi models (right).

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Games can offer offer good value for the entertainment dollar. I recently took my family to Disneyland. I calculated that we paid $25 per minute of ride time. You can play a $50 game for many hours. And games are a good distraction during a time of stress.

The venture capitalists aren’t completely stupid. They have figured this out. The opportunities have dried up elsewhere. Web 2.0 companies are very capital efficient, but the investments in that sector may have played out their course. Cleantech companies have been hurt by the fall in oil prices. So games as a sector for investment looks even better in the recession.

Has it slowed down? Yes. In the past month or so, there haven’t been any really large game company fundings, though some previously secret companies came out of hiding. For two quarters, there were no technology IPOs. Finally, last week, Rosetta Stone, a maker of language learning software, went public. Virtual Worlds Management said about $101 million went into virtual world companies in the fourth quarter. That’s a lot less than in prior quarters.

There are still startups getting money. Recent fundings include Stupid Fun Club, Playdom, SuperSecret, RotoHog, Locomotive Games, and Offerpal Media. And Wall Street saw the successful IPO of China’s ChangYou, which raised $200 million and then saw its stock rise 25 percent in a day.

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I don’t want to paint the picture too rosy. In the larger venture community, there is pain. Only 40 venture funds raised $4.3 billion in the first quarter. That was the smallest amount of money raised in a quarter since 2003. There were only three new funds among the 37. From your perspective, that shouldn’t matter. You don’t need $5 billion for your startup. And there were way too many venture funds in the first place. Some shake-out is good.

At the same time that new startups are rising, there have been thousands of jobs cut by Western game publishers. Electronic Arts, THQ, Nexon, Flagship Studios, Sun Inc., and others have closed studios. John Riccitiello, chief executive of EA, indelicately said that downturns are good because they get rid of all of the riff raff. The bad ideas die.

But the closing of studios isn’t completely alarming. Rather, it shows where the winners are and where the losers are. The fundings of new game companies are not just happening the traditional markets such as the U.S. The winners are in markets such as Korea and China, where the virtual goods models are generating billions of dollars in revenue. DFC Intelligence noted that profits have shifted from the West to the East.

That brings to mind the theory of Regional Advantage, which was the title of a 1996 book by UC Berkeley researcher Annalee Saxenian. She noted how the fate of the technology industry depended on the anchor companies in particular regions. In Boston, the industry was vertically integrated around companies such as Digital Equipment Corp. Silicon Valley was horizontal, with companies that made pieces of the technology solutions. While Boston’s companies were closed, Silicon Valley’s were more open. Companies such as Intel thrived, while the vertically integrated companies like DEC collapsed. This is why Silicon Valley surpassed Boston as the epicenter of technology. In 2007, Saxenian wrote another book, The New Argonauts, (right) that talked about regional competition on a global scale. How can software jobs stay in the U.S. if engineers in India can do the same work for a tenth of the cost?

This is very similar to Thomas Friedman’s warnings to companies and regions in his book, The World is Flat. I think the lessons should apply to the game industry. The strategy that makes sense is geographic arbitrage. Simply put, that means you take advantage of what your region is good at. 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. India and China engaged in a kind of geographic arbitrage by enabling low-cost game art to be done in their countries at a much lower cost than in the high-cost regions.

The Koreans and the Chinese had the problem of having very weak game console industries. They suffered from terrible game piracy. They focused on the PC, and that became an advantage as high-speed broadband became available in Internet cafes. Online game companies such as NCSoft, Shanda, and Giant arose. These companies spawned others that pioneered new online-oriented digital distribution and virtual goods business models. Now those companies are trying to export their games and business models to the U.S. They are likely to be buyers of many startups and bigger companies during the next wave of consolidation.

Outspark, based in San Francisco, is an example of a startup that is engaged in geographic arbitrage. It is creating free-to-play MMOs with virtual goods models. It started by licensing online games made in Korea and adapting them to the U.S. market. Right now, the company has six MMOs. Its portal draws 5.4 million visitors a month. About 10 percent to 13 percent of the users actually spend money. And among the spenders, the average revenue per user is $45 to $49. There are some families that have spent up to $20,000 buying virtual goods for the Outspark games. Yes, that is quite insane. The Koreans should have been the ones to succeed in the U.S. But they didn’t have the easiest time making games that could be appealing on a global scale.

If you want to succeed in the future, you can’t just target local markets. You have to think global. And no single region has a lock on cheap capital or inexpensive resources for a long time. Some other country is always moving up the food chain. And no region has a lock on creativity. You have to constantly make your work more innovative. Here, you have to honestly look at yourselves and ask, what can we do that no one else can?

One of the lessons is that geographic arbitrage is always happening. If you want to be on the leading edge, you have to stay ahead of it. Right now, there is a proliferation of new game business models. Our GamesBeat survey showed that people were most excited about micro-transactions that enable virtual goods, which 66 percent of our respondents marked as most the interesting new model.

We have also seen the rapid rise of new platforms. As mentioned, Facebook has more than 200 million users and well over 5,000 games. Social networks MySpace and hi5 have also seen their game businesses grow rapidly. In the game console business, the biggest news of the spring of 2008 was the launch of Grand Theft Auto IV. But there was something much more dramatic that happened.

The iPhone was probably the biggest source of excitement about opportunities for game startups. Our second most-popular game story in 2008, after our history of the Xbox 360 defects, was a piece about how the iPhone represented a threat to Nintendo’s portable game business. About 61 percent of the people who participated in our GamesBeat survey felt that the iPhone was the game platform with the most potential. Kleiner Perkins started its $100 million iFund to fund iPhone companies. Bing Gordon, the chief creative officer of Electronic Arts, left his job in the spring of 2008 to join Kleiner Perkins. Neil Young, a vice president and 12-year veteran at Electronic Arts, left to found Ngmoco, an iPhone-only game startup, in June. In July, he got funding from Gordon. Since that time, Young has lived an accelerated life.

By late March, the company had launched 10 games and five of those were bestsellers. Nine months after ngmoco was started, it received its second round of funding, another $10 million on top of its $5 million first round. It is like living in dog years, where seven years pass by in the course of 365 days.

Just look how fast this is happening. On March 23, there were more than 6,700 games on the iPhone. Now must a month later, there are more than 8,349 games. As I was writing this speech, I had to update that number three times. Back in November, when I wrote our story about how Nintendo should worry about the iPhone, there were 1,500 iPhone games. Clearly, this is some kind of bubble. But I am not sure where it will end. More than 30 million iPhones and iPod touch models have sold. The iPhone 3.0 software will make virtual goods and other game-related features more popular. The iPhone is gathering momentum. The veterans are coming on board. John Carmack took a couple of weeks to do a Wolfenstein 3D iPhone game that even his boss didn’t know about.

RIM has just created its own BlackBerry app store. Nokia is about to launch its Ovi store. Google’s Android has launched an app store. In Silicon Valley, we have written stories about how developers believe that the iPhone is the only platform worth investing in. They believe those copycats are going to fail, and it will be a reversal of the PC vs Mac competitive battle.

The companies that have to worry are Nintendo and Sony. They used to own the portable game market, but now they have to deal with an invader on their turf. Trip Hawkins, the founder of Electronic Arts and the CEO of Digital Chocolate, told me that he thinks the traditional game companies are freaking out about the iPhone’s game success. He said that his company makes as much money on an iPhone game as it does by publishing the same game on 100 handsets.

The iPhone games share much in common with the games on MySpace and Facebook. They are produced via iteration. You create them. You test them. You see how they work. If they don’t, you tweak the game. That is how Playdom was able to create eight of the top 25 games on MySpace. It just constantly rewrote its games. One player asked if he could get a certain truck in a racing game. Two days later, the truck was inserted into the game. That’s just good customer service.

Reggie Fils-Amie, president of Nintendo of America, says that Nintendo has a completely different approach to making successful games. It focuses on a few titles that are high quality. It creates signature games made by seasoned professionals such as Shigeru Miyamoto, Nintendo’s top designer. It is worth pointing out that Sony, which is in third place in the console business, is generating $6 billion a year from games. Nobody in the iPhone business is making anywhere near that amount. But everybody should be aware. The company that gets the units will eventually get the dollars. Or euros.

You can choose which side you want to fight for in the war. Or you can play a different game. Some companies have figured out where they can fit into this larger trend. I like the approach taken by ScoreLoop, which is based in Munich. They have created tools for a social gaming platform for the iPhone. They are not betting on making a successful game among the 8,000-plus iPhone games. They want to sell their tools to iPhone game developers. That is like selling shovels to gold miners.

What’s important now is not to just create a single hit. Now you have to create a series of hits to be successful and to be noticed. Playfish received a lot of attention because four of its first five games were in the top 20 on Facebook. That’s not easy to do, considering there are so many games on Facebook. But companies have done it. I mentioned Playdom’s track record on MySpace. Digital Chocolate created four No. 1 hits with its first four games for the iPhone, even though the company started by Electronic Arts co-founder Trip Hawkins was late to the iPhone party.

Jeremy Liew, a game investor at Lightspeed Venture Partners, said that he looks for game factories. Many people believe games are an art form. They can’t be mass manufactured like cars. But somehow, certain companies come up with hit after hit. Those are the companies that Liew and every venture capitalist wants to find early. They are willing to pour money into those companies. That’s why Playfish managed to raise $17 million, even though it might cost only a few hundred thousand dollars to create a Facebook game.

I am an old timer in this industry. I can be very jaded. But I love surprises. Gazillion, co-founded by Rob Hutter, was hiding right under my nose. He and his team built a company in San Mateo, Calif., with 300 game developers and managed to keep it secret. He bought Net Devil and the Amazing Society, and managed to get started on multiple MMOs at the same time. Gazillion shows what you can undertake when you marry the veteran talent of the game industry with the financial resources to make big visions come true.

I was also very pleasantly surprised with the winner of our GamesBeat startup competition, Exponential Entertainment, which is making movie-related casual games on the web. The company, founded by the creators of the SceneIt? DVD trivia game, have approached their startup in a methodical fashion, creating cool games, lining up film licenses, and figuring out interesting ways to make money.

One of the most exciting startups I’ve ever seen in the video game industry is OnLive, a company founded in 2002 that came out of hiding on March 23. OnLive proposes to turn the game distribution world upside down with a broadband-based video games on demand service. I believe that services such as OnLive are just the beginning of many efforts to create digital download/server-based games that will disintermediate retail.

This company illustrates a few things. First, it always pays to keep track of the serial entrepreneurs. Steve Perlman was one of the original members of Apple’s QuickTime team. He founded WebTV, which Microsoft bought for $425 million back in 1998 and used as hardware team for the Xbox and Xbox 360. He founded an incubator, Rearden, to fund long-range research ideas. OnLive came from one of those experiments. Mova, which did facial animation capture, was another. Perlman told me about OnLive for the first time more than two years ago. I kept quiet, as did many other game publishers.

Perlman (pictured, right side) approached the problem of creating a games on demand service methodically. He hired smart people then tried to figure out how you could compress data and speed its flow through the Internet so that you could stream a game that was being processed on a server to someone’s home and make it happen so fast that the user would think that the game was being processed on the machine in the living room.

People say this is impossible. But Perlman has applied for scores of patents and had 16 games from nine publishers working on the show floor at the GDC. People were so incredulous that they were spreading a rumor at GDC that OnLive was fake and that there was no Internet connection to the OnLive booth on the show floor. I checked this out. That was not true. OnLive needed more bandwidth so it arranged to have its own broadband lines piped into its booth.

Critics, including Cevat Yerli at Crytek, just don’t want to believe it. Reggie Fils-Aime takes solace in the fact that OnLive is never going to have Mario. But Perlman has backers such as Electronic Arts and Epic Games. He expects to launch a games on demand service in the fall that is very much like Xbox Live. You will be able to play high-end games on low-end computers. That’s unbelievable. Many people have reacted to this by saying it is impossible. But it is no more impossible than 2D-Boy creating The World of Goo and getting a bestseller out of it. OnLive doesn’t have to kill the console makers to succeed. It will become a wildly successful company if it can simply establish video games on demand as a viable channel. And even if OnLive itself doesn’t make it, it is almost inevitable that game cloud computing will thrive.

That’s why it’s such an exciting time to be part of the game industry.