the publisher business model and uk third party video game development: challenges, effects,...

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CONFIDENTIALITY STATEMENT

This project has been agreed as confidential between the students, university and

sponsoring organisation. This agreement runs for two years from September, 11th, 2006.

STATEMENT OF AUTHENTICITY

I have read the university regulations relating to plagiarism and certify that this project

is all my own work and does not contain and unacknowledged work from other sources.

WORD COUNT (12,841)

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THE PUBLISHER BUSINESS MODEL AND UK THIRD PARTY VIDEO

GAME DEVELOPMENT:

CHALLENGES, EFFECTS, STRATEGIES AND TACTICS.

A O’DEA

KEYWORDS

Video Game

Computer Game

Publisher

Business Model

Value Chain

Strategic Analysis

Distinctive Capability

Competitive Analysis

ABSTRACT

UK Third party video game developers face significant challenges. These challenges

and their affects are explored and presented. Operational profitability of major UK third

party video game developers is analysed. The impact and affect of the industry standard

business model (Publisher) is examined. Alternative business models (Hollywood and

Outsourcing) are explored. Benefits, affects, effects, advantages, and disadvantages of

extent and alternative business models are presented through value chain analysis.

Opportunities, strategies, and tactics for improved financial, operational, and

competitive performance of third party video game developers are presented.

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THE PUBLISHER BUSINESS MODEL AND UK THIRD PARTY VIDEO

GAME DEVELOPMENT:

CHALLENGES, EFFECTS, STRATEGIES AND TACTICS.

By

Alan O’Dea

Management Project submitted to the Bradford University School of Management

in partial fulfilment of the requirements for the degree of Master of Business

Administration

2006

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PREFACE

The ambition of this project is to provide a piece of work that has a direct benefit to the

UK video game industry, specifically to UK third party video game developers. This

report is not envisioned as a final and definitive solution to the significant challenges

facing third party UK video game developers, but as a start point for continuing

research, debate, dialogue, and problem solving regarding the industry’s list of

considerable challenges.

THANKS

I would like to thank the people that helped me in the production of this project. Fred

Hasson, CEO, Tiga, Dr. Rana Tassabehji, Lecture in Information Systems and E-

business, Bradford University School of Management, and Professor Stuart Sanderson,

Associate Dean, Postgraduate Programmes, Bradford University School of

Management.

DEDICATION

This management project is dedicated to my mother Theresa O’Dea and father Tony

O’Dea. Through their life long example of hard work, dedication, perseverance,

honesty, and professionalism they have instilled in me a continual respect for education,

self improvement, entrepreneurship, and the drive to pursue and make true my dreams.

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TABLE OF CONTENTS

PREFACE ......................................................................................................................... i

TABLE OF CONTENTS ................................................................................................. ii

LIST OF TABLES .......................................................................................................... iv

EXECUTIVE SUMMARY .............................................................................................. ii

1 INTRODUCTION ........................................................................................................ 1

1.1 Tiga ........................................................................................................................ 1

1.2 Project Rationale .................................................................................................... 2

1.3 Terms of Reference ................................................................................................ 3

1.4 Project Methodology .............................................................................................. 4

2 CHALLANGES ............................................................................................................ 6

2.1 Challenges Facing Third Party UK Video Game Developers ............................... 6

2.1.1 Console Sophistication .................................................................................... 6

2.1.2 Console Life Cycle .......................................................................................... 9

2.1.3 Industry Structure .......................................................................................... 11

2.1.4 Industry Practices .......................................................................................... 13

2.2 Effects of Challenges Facing Third Party UK Video Game Developers ............. 32

3 INDUSTRY ANALYSIS ............................................................................................ 34

3.1 Industry Analysis ................................................................................................. 34

3.2 Industry Structure (Value System) ....................................................................... 36

3.2.1 Licence Holders ............................................................................................ 38

3.2.2 Platform Holders ........................................................................................... 39

3.2.3 Publishers ...................................................................................................... 40

3.2.4 Developers..................................................................................................... 42

3.2.5 Distributors .................................................................................................... 43

3.2.6 Retailers......................................................................................................... 44

4 DEVELOPER ANALYSIS ......................................................................................... 45

4.1 Performance Analysis (UK Third party Developers)........................................... 45

5 PUBLISHER MODEL ................................................................................................ 50

5.1 The Publisher Model ............................................................................................ 50

5.2 Failures in the Publisher Model ........................................................................... 50

5.3 Value Chain Analysis ........................................................................................... 53

6 CONCLUSIONS AND RECOMMENDATIONS ..................................................... 61

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6.1 Conclusions .............................................................................................................. 61

6.2 Recommendations ................................................................................................ 63

BIBLIOGRAPHY .......................................................................................................... 71

TERMINOLOGY .......................................................................................................... 77

APPENDIX I FINANCIAL RECORDS ........................................................................ 78

APPENDIX 2 MANAGEMENT PROJECT PROPOSAL ............................................ 87

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LIST OF TABLES

Table 2.1 Cost Assumptions for Console Title, (6th and 7th Generation) ....................... 7

Table 2.2 Console Hardware Technical Specification Comparison, (6th and 7th

Generation). ...................................................................................................................... 8

Table 2.3 Breakeven Analysis of Multiple Generation Console Platforms. .................... 9

Table 2.4 Generalised Breakdown of Revenue from a $50 Console Game................... 19

Table 2.5 Profit Model of a Video Game Product ......................................................... 28

Table 2.6 Selected Mergers and Acquisitions within the UK Computer and Video

Games Industry, 1993-2006. .......................................................................................... 30

Table 4.1 Selected UK Third Party Video Game Developers List. ............................... 46

Table 4.2 Selected UK Third Party Video Game Developers Financial Results

Comparison, (2003-2005) .............................................................................................. 49

Table 5.1 Value Chain of Third Party Video Game Developer (Publisher Model) ....... 55

Table 5.2 Direct, Indirect & Quality Assurance Activities. ........................................... 60

Table 6.1 Profit Comparison of a Video Game Product (Advance vs. Self Funded). ... 65

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LIST OF FIGURES Figure 2.1 Video Game Console Product Life Cycle(s). ............................................... 10

Figure 2.2 U.S. Cumulative Hardware Unit Sales. ........................................................ 11

Figure 2.3 Video Game Industry Structure .................................................................... 12

Figure 2.4 Financial Share of Sale Revenue per Value Chain Agents........................... 18

Figure 2.5 Sales Curve for Games Based on Original Intellectual Property ................. 26

Figure 3.1 UK Value of PC and Console Software Markets, 2001 (£m) ...................... 35

Figure 3.2 Breakdown of Employment by Sub-sector ................................................... 36

Figure 3.3 Video Game Industry Structure - Value System .......................................... 37

Figure 3.4 Position of each Entity in the Product Path for a Console Game ................. 38

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EXECUTIVE SUMMARY

The aim of this project is to explore the cause and effects of the publisher business

model on UK third party video game developers.

Publishers and platform holders have used their industry wide scale, power, and control

to marginalise third party video game developer operational capabilities forcing them to

become little more than video game manufacturing factories. Third party developers’

work under extremely unprofitable operational conditions, developing licensed video

game products for publishers and platform holders.

In return for the funding necessary to produce video game products, third part

developers sign away ownership rights to their Intellectual Property, and the usage

rights to their technology, assets (art, charters, stories, and backgrounds), code, and

other components of the video game projects they produce.

In this manner they sign away most of the intrinsic value contained within their

organisations and subsequently their ability to remain profitable, create long term

sustainable competitive advantage, and the financial reserves necessary to reinvest in

growth opportunities.

The existing publisher business model and the combined effects of numerable other

challenges facing third party video game developers limits the long term operational

pathways available to UK third party video game developers. Developers are forced into

closure, sell themselves to a publisher or platform holder, or remain unchanged within

an industry that is straining under the pressure of an inherently detrimental and broken

business model.

Publishers are led by an unrelenting search for hit products, profits, and cold hard

business objectives. They are huge publicly listed companies with a primary objective

of returning value to their share holders. In most cases even the best and most well

wishing publishers use their industry dominance to squeeze profit margins from third

party developers and the video game products they produce. This pressure has had a

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dramatically detrimental effect on the operational capabilities, structure, and financial

performance of third party video game developers.

Publishers are not entirely to blame. It is only now that the industry is beginning to

crack under the weight of twenty million dollar development budgets that the inherently

broken publisher business model is beginning to strain, buckle, collapse, and affect all

major agents of the video game industry (licence holders, platform holders, publishers,

developers, distributors, and retailers).

Developers have allowed publishers and platform holders to take control of the industry

year by year, project by project, and contract by contract. Their lack of vision, planning,

foresight, strategies, tactics, management, and business skills have left them in this

harrowing state of affairs.

Third party developer’s inability to seek alternatives to the publisher model throughout

the years has seen many famous UK developer’s permanently close their doors, others

have been sold to publishers or platform holders, and the remaining few struggle on

against a growing body of challenges, struggling to operate in a continually harsher

operating environment.

If developers do not seek to address the effects of long term exposure to the detrimental

publisher model and seek to find new, alternative, strategies, tactics, and business

models no less than the long term survivability of UK third party video game developers

is at stake.

Chapter 1 presents a background of the project sponsor, UK video game trade

organisation, Tiga, along with details of the project rational, terms of reference,

methodology, and literature review.

Chapter 2 explores the challenges facing third party video games developers. This

chapter includes details on challenges resulting from console sophistication, console life

cycle, industry structure, industry practices, and the effects of these challenges on third

party video game developers.

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Chapter 3 explores the video game industry. This chapter included details on the major

industry agents, licence holders, platform holders, publishers, developers, distributors,

retailers and presents an analysis of the UK video game industry.

Chapter 4 explores the UK video game developers. This chapter included a financial

performance analysis of a select group of UK third party video game developers.

Chapter 5 explorer the publisher model. This chapter included details regarding the

publisher model, failures therein, and an analysis of the value chain of an average UK

video game developer under the publisher business model.

Chapter 6 present conclusions and recommendations based on the findings and research

contained in this report.

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1 INTRODUCTION

1.1 Tiga

“The games development industry is one of the UK 's great success stories. It is time that this success story is told to the world at large. But as the DTI “Competitiveness Study” published in October 2002 said – no other major territory has such a high ratio of developers to UK owned publishers. This restricts channels to market and just because retail sales have been going up year on year does not mean the industry is necessarily in good business shape to succeed in a rapidly globalising industry.” (TIGA Website, 2006)

Tiga has agreed to act as the sponsor for this management report.

The Independent Game Developers Association (Tiga) is a UK trade organisation

servicing UK video game developers and the video game industry at large. Tiga’s

overarching objective is to keep developers in the UK and Europe at the heart of the

global games industry, by ensuring that the business environment in the games industry

is favourable. Tiga’s principle benefits to the video game industry and major activities

therein are;

• Research and publish the Best Practice Handbook - including Model Contracts,

Guides on R&D Tax Credits, Outsourcing, PEGI Ratings, UK and EU Funding

& Grants, Privacy and Insurance.

• Liaise with and lobby various government departments including DTI, Treasury,

Inland Revenue, UKTI, DCMS and DfES.

• Promote investment into the development sector.

• Provide networking opportunities at seminars and trade shows at home and

abroad.

• Liaise with ELSPA and publishers – organise Publisher Summits with top

publishers.

• Implement international trade strategies through a dedicated International Trade

and Export arm.

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• Promote Special Interest groups – including a mobile group and an educational

group.

• Work with Skillset and ELSPA to develop skills and competency mapping.

• Negotiate discounts for Tiga members across vital services such as legal, finance

and insurance.

• Publish regular newsletters and updates, documents, and working papers via the

Members area of their website

1.2 Project Rationale

The UK video game industry is facing significant challenges. Development costs for

video games (PC and consoles) have risen dramatically in recent years. Third party UK

development studios cannot finance these development costs themselves, instead relying

on financial investment provided by video game publishers. In return for financing,

publishers expect development studios to sign over Intellectual Property ownership

rights of their game products.

The traditional ‘Publisher Business Model’ by which publishers’ finance third party

developers in return for total Intellectual Property ownership, control of distribution,

marketing and supply channels, and the majority of profits is a detrimental business

model. Consequently third party UK video games development presents itself as risk

laden business activity dependent on external factors beyond their control for success or

failure. In an attempt to explore the outlined challenges and determinable effects of the

publisher models the following research activities are engaged.

The project investigates the significant challenges facing third party video game

developers. An analysis of the video game industry, the major agents within that

industry, and the main sources of revenue of those agents are detailed. The project

provides a performance analysis of a sample of UK third party video game developers.

The project reviews the current publisher model and evaluates its effects on third party

UK development studios. Finically the project presents a listing of recommendations

and a conclusion of the research finds.

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1.3 Terms of Reference

”Every firm is a collection of activities that are performed to design, produce, market, deliver and support its product. All these activities can be represented using a value chain. A firm’s value chain and the way it performs individual activities are a reflection of its history, its strategy, its approach to implementing its strategy, and the underlying economics of the activities themselves.” (Competitive Advantage, 2004:36)

Micheal Porter (1985) provides a model for evaluating, assessing, analysing, and

comparing the activities that provide firm’s competitive advantage and profit generation

capabilities. This model is called the ‘Value Chain’ and it has gained wide acceptance in

the field of strategic analysis for its ability to clearly delineate and detail factors

responsible for competitive success, profitability and value within a form.

In terms of analysing third party video game developers, the lack of demonstrable

profitability, and the effects of challenges facing these firms the value chain represents a

valuable tool for understanding how these firms have structured their operations to

remain operational, generate profits, adapt, and develop competitive advantage under

pressure form the detrimental publisher model and other challenges facing these

organisations.

Porter states that the relevant level for constructing a value chain is a firm’s activities

within in a particular industry (the business unit). An industry - or sector – wide value

chain is too broad, because it may obscure important sources of competitive advantage.

(Competitive Advantage, 1004:36).

Thusly in an analysis of third party video game developers using the value chain we

should address the analysis of a single firm within an industry and thusly for the

purpose of this report use an imagined standard or generalised firm. Since we cannot

analyse all individual firms we must look towards a more generalised value chain that is

in representative of generalised features of third party UK video game developers.

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The value chain displays the total value, and consists of value activities and margin

within a firm. Value activities are the physical and technologically distinct activities a

firm performs. These are the building blocks by which a firm creates a product valuable

to its buyers. In competitive terms, value is the amount buyers; in this case (publishers

and platform holders) are willing to pay for what a firm provides for them, in this case

the completed video game products. Value is measured by the total revenue, a reflection

of the price a firm’s product commands and the units they can sell. A firm is profitable

if the value it commands exceeds the costs involved in creating the product.

(Competitive Advantage: 2004:38)

1.4 Project Methodology

The report is an applied piece of business research exploring and analysing the

relevance, advantages, disadvantages, strengths, weaknesses, and effects of the

publisher model on third party UK video game developers.

The research is descriptive in nature, focusing on identifying, classifying, and

characterising the publisher business model, video game industry structure, practices,

and the challenges therein.

The primary objective of the report is to explore the publisher model and determine its

effects on sustainable competitive advantage, financial, operational, and organisational

performance of third party UK video game developers.

Primary quantitative data has been gathered on a sample of third party UK video game

developers through direct financial data sources. Secondary quantitative and qualitative

data has been gathered from various sources; financial reports, industry reports, extent

academic, business, and industry literature.

This data presents an exploration of financial and non-financial advantages,

disadvantages, strengths, weaknesses, and effects of the existing publisher business

model using the value chain as a framework to present certain of the findings.

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The secondary objective of the report is to explore a number of additional challenges

facing third party video game developers due to console sophistication, console life

cycle, industry structure and practices.

A tertiary objective of the report is to present a toolkit of alternative opportunities,

strategies, and tactics for third party UK development studios to assist in strategic

business decision making, Intellectual Property retention, sustainable competitive

advantage, and profitability.

These opportunities, strategies, and tactics are gathered from secondary sources such as

financial reports, industry reports, extent academic, and industry literature.

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2 CHALLANGES

2.1 Challenges Facing Third Party UK Video Game Developers

“Unless something is done, developer’s share of the value chain is likely to decrease over time”. (IGDA, Developers Business Summit Proceedings. 2005:4)

Third party UK video game developers face significant operational, organisational, and

financial challenges working in the global video game marketplace. These challenges

can be categorised throughout the following areas;

Challenges

• Console Sophistication

• Console Life Cycle

• Industry Structure

• Industry Practices

2.1.1 Console Sophistication

“In this context, it is hardly surprising that industry consolidation should progress unimpeded. Once-prominent companies like Acclaim have fallen into bankruptcy, and with production budgets expected to reach the average of $20 million or more for an AAA title in the 2005-2008 console cycle, all but a handful of companies are going to experience mighty hardships.” (IGDA, Developers Business Summit Proceedings. 2005:6)

Principle among the challenges facing UK third party developers is the increase in

technological sophistication of console hardware. The technology powering 7th

generation console hardware (e.g. Xbox 360, PlayStation 3 and Wii) allows for

enhanced, high definition, game content, gameplay, and interaction.

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This increase in technical sophistication in turn leads to higher cost contributors, which

include larger team size, content creation (graphics, audio, programming, physics and

video) and development timeframes, tools, technology, and R&D expenditure,

development, training, and management overheads, Q&A, localisation, and skill

development. These extra costs affect all aspects of developer value chain activities.

Profit margins and the factors necessary for sustainable competitive advantage within

the marketplace are thusly affected.

“He noted that it "takes about twice the effort and development cost to develop for a multi-threaded CPU," compared to a single-core CPU. Even more than that, according to Epic's analysis, fully exploiting the PS3 Cell chip "required about 5 times as much cost and development time than single-core." (Sweeney Talks Cell Difficulties, PS3 Online Inclusivity, 2006)

Kathy Schoback, (2005), demonstrates the dramatic increase in the average

development budget of a console title (Table 2.1). An average increase of $5 to $20

million is a significant jump in the development costs for a video game product.

Consoles (6th) Consoles (7th) Development Spend $5,000,000 $20,000,000 Marketing Spend $3,000,000 $ 6,000,000 Developer Royalty/Unit $8 $10 Wholesale Price $32 $38 Source: The Economics of a Next-Gen Game, (2005)

Table 2.1 Cost Assumptions for Console Title, (6th and 7th Generation).

(Table 2.2) demonstrates the significant technological advancement between 6th and 7th

generation hardware.

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Xbox (6th) Xbox 360 (7th) PlayStation 2 (6th) PlayStation 3 (7th) GameCube Wii (7th) CPU 733 MHz 3 x 3.2 GHz 295 MHz 7 x 3.2 GHz 485 MHz 729 MHz Memory 64 MB 512 MB 32 MB 256 MB + 256 MB 24 MB 64 MB GPU 233 MHz 500 MHz 147 MHz 500 MHz 162 MHz 243 MHz Display 1920 x 1080 (max) 1920 x 1080 (max) 1280x1024 (max) 1920 x 1080 (max) 640x480 (Max) 720x576 (Max) Network 10/100 Mbit/s (wired) 10/100 Mbit/s (wired)

802.11a 52 Mbit/s (wireless)

No 1000 Mbit/s (wired) 802.11a 52 Mbit/s (wireless) Bluetooth 2.0

No 802.11b 11 Mbit/s (wireless)

Audio Dolby Digital 5.1 Dolby Digital 5.1 Dolby Digital 5.1 DTS

Dolby Digital 5.1 Dolby Pro Logic II Dolby Pro Logic II

I/O 1 x DVD-ROM 4 x Controller Ports 2 x Media Card Ports 1 x 100 Mbit/s Port Audio/Video Connector

1 x DVD-ROM 2 x USB Ports 1 x 100 Mbit/s Port Audio/Video Connector

1 x DVD-ROM 2 x Controller Ports 2 x Media Card Ports 2 x USB Ports Audio/Video Connector

1 x Blue-Ray ROM 4 x USB Ports 1 x 1000 Mbit/s Port Audio/Video Connector

1 x Proprietary Optical Media Drive 4 x Controller Ports 2 x Media Card Ports Audio/Video Connector

1 x Optical Media Drive 4 x Controller Ports 2 x Media Card Ports 1 x SD card Port Audio/Video Connector

Media DVD-ROM Memory Card

DVD-ROM Memory Card USB Mass Storage

DVD-ROM Memory Card

Blue-Ray ROM USB Mass Storage

Proprietary Optical Media Memory Card

Proprietary Optical Media USB Mass Storage SD/MMC Card

Storage 8 GB Hard HDD 20 GB HDD No 20/60 GB HDD No No DVD Movie Playback

Yes (Internal Yes (Internal) Yes (Internal) Yes (Internal) No Yes (Internal)

Internet Yes Yes No Yes No No Source: The Economics of a Next-Gen Game, (2005)

Table 2.2 Console Hardware Technical Specification Comparison, (6th and 7th Generation).

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“With the release of each new generation of console hardware, development budgets traditionally increase. Typical budgets for PlayStation 1 titles ranged from $1.5 to $3 million and grew to an average of more than $8 million on the PlayStation 2. These increases were the result of staffing, to take advantage of the power of the new hardware systems, more programming requirements, broader art needs, more complex level designs, and higher production values. Current ramblings are that the next generation of games will push development costs even higher, possibly to the $15 million range.” (Heinecke, J., 2006)

(Table 2.3) demonstrates the comparative breakeven analysis for console video games

on a generation by generation basis.

Fixed Costs PS1-N64

Generation

PS2-Xbox-GC

Generation

PS3-Xbox 360-Wii

Generation

PS3-Xbox 360-Wii

Generation (Higher

Price Point) Game Development $ 3,000,000 $ 8,000,000 $ 15,000,000 $ 15,000,000 Marketing $ 1,500,000 $ 4,000,000 $ 7,500,000 $ 7,500,000 SG&A $ 1,500,000 $ 2,000,000 $ 2,500,000 $ 2,500,000 Total $ 6,000,000 $ 14,000,000 $ 25,000,000 $ 25,000,000 Variable Costs Cost of Goods $ 8.00 $ 9.00 $ 10.00 $ 10.00 Blended Worldwide Wholesale Price

$ 33.00 $ 33.00 $ 33.00 $ 43.00

Breakeven 240,000 583,333 1,086,957 757,576 Increase v Prior Generation 59% 46% 23% Source: Are Big Budget Console Games Sustainable? (2006)

Table 2.3 Breakeven Analysis of Multiple Generation Console Platforms.

All primary (inbound logistics, operations, outbound logistics, marketing, sales, and

services) and secondary (firm infrastructure, human resource management,

technological development, and procurement) value chain activities are affected due to

the significant operational costs arising from increased console technical sophistication.

2.1.2 Console Life Cycle

“The console video games industry is highly cyclical, with sales fluctuating according to the life cycle of succeeding generations of game machines. In each cycle, sales would grow with the introduction and adoption of a new generation of hardware and software, and subsequently decline as market penetration

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increased and consumers began postponing video game purchases due to anticipation of, and uncertainty about, the next generation systems.” (Note on Home Video Game Technology and Industry (Abridged), 2004)

The life cycle of video game console technology within the marketplace is finite and

cyclical. Console hardware typically has a life cycle of 4-5 years within the

marketplace. Technical/customer support, market interest, and new video game product

development for old console hardware diminishes rapidly as industry wide agents

(platform holders, publishers, developers, distributors, and retailers) shift development,

marketing, and production resources from old to new console hardware. (Figure 2.1)

demonstrates the historical life cycles of various console platforms within the

marketplace.

Source: Wikipedia, (2006) Figure 2.1 Video Game Console Product Life Cycle(s).

“The video game market changes over the years as new video game consoles are introduced. This has happened in cycles of about 5 years or so, in which multiple manufacturers release their consoles usually within about a year of each other. Then, the console producers and the video game publishers enjoy several years of game sales until the technology and the market is ready for a new generation of consoles.” (All Experts, Console Life Cycle, 2006)

This industry wide activity enforces ever increasing development cycles on third party

developers, forcing them to grow team sizes, gain new skills, technological, and

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operational competencies in an effort to adapt to the demands of the new generation of

technology. This in turn increases the operational/production overheads, fixed and

variable costs, team sizes, content development, and overall development timeframes

and budgets.

(Figure 2.2) demonstrates the overall growth in console hardware sales generation by

generation in the US. This growth cycle by cycle in hardware saturation rates

exacerbates the problems and challenges resulting from consoles life cycles in the

marketplace.

8-bit 16-bit 32/64-bit 128-bitNext-Gen

0

10

20

30

40

50

60

70

80

1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007E

8-bit 16-bit 32/64-bit 128-bit Next-Gen

Source: Wedbush Morgan Securities, Entertainment Industry Report (2006:26)

Figure 2.2 U.S. Cumulative Hardware Unit Sales.

Primary (inbound logistics, operations, outbound logistics, and services) and secondary

(firm infrastructure, human resource management, technological development, and

procurement) value chain activities are affected due to the changes imposed on

developers arising from rapid console life cycles within the marketplace.

2.1.3 Industry Structure

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“Very few independent development studios could afford to finance their own game projects and, thus, most turned to publishers or platform holders for outside financing in exchange for publishing and distribution rights.” (Note on Home Video Game Technology and Industry, (Abridged), 2004).

The video game industry is structured as a top down hierarchy of various horizontally

and vertically integrated, large scale value chain agents (licence holder, platform holder,

publisher, distributor, retailer) operating under oligopolistic conditions. These agents

have enjoyed large scale consolidation and enjoy significant economies of scale and

scope due to the structure of their operations. (DTi, 2005:9). The principle actors of the

video game industry value chain are demonstrated in (Figure 2.4);

Hardware Manufacturer

Publisher

Developer (Second Party)

Developer (First Party)

Developer (Third Party)

Distributor Retailers ConsumerLicence Holder

Financial Recruitment Training Legal SupplyServiceSupportOutsource

Source: Compiled from various bibliography sources.

Figure 2.3 Video Game Industry Structure.

“The digital game industry exhibits patterns of organisation and power distribution which loosely resembles traditional media organisations. The STeM research project found that the digital games industry is structured like the movie, book, and music industries: Costs of production are high, and increasing, while demand is highly uncertain. Reproduction costs per CD-ROM are relatively low. Publishing and marketing are critical functions in the overall value chain. The console market is oligoplistic with increasing vertical integration. In all sectors scale is becoming increasingly important. There are significant barriers to entry facing new entrants, especially to the console market.” (Live Life to the Power of PS2: Locating the Digital Games Industry in the New Media Environment, 2003)

13

Large scale industry agents enjoy significant power and control over video game

developers. This power affects developers in terms of access to consumers, market,

retail, sales, and distribution channels. The largest industry value chain agents (platform

holders, and publishers), processing large revenues, product portfolios, financial

reserves, and relationships with other key industry value chain agents (i.e. licence

holders, distributors, retailers, and consumers), marginalise the independent video game

developers in terms of their ability to capitalise on sales, distribution, and retail chain

relationships, and associated financial opportunities throughout the video game industry

and marketplace at large.

Primary (outbound logistics, marketing, sales, and services) and secondary (marketing

and sales) value chain activities of developers are marginalised as relationships with

distributors, retailers, press, advertisers, PR, and consumers are assumed by the platform

holders and publishers leaving a deficit in these key operational areas for developers.

2.1.4 Industry Practices

“For the past two years, the game industry has been mired in what the financial press calls a “consolidation phase”. Despite growing sales for the industry as a whole, not a month goers by without some once-proud publishers announcing drastic cutbacks to its release schedule or being bought out by a more successful one. Countless start-up development studios set up shop, barely manage to survive until the release of their first title (when they manage to at all), and disappear without a whimper. Meanwhile the cost of developing a top-tier title keeps growing, and the marketing budget required to support these releases skyrockets even faster.” (The Game Industry and the Economics of Failure, 1999)

A number of industry practices directly affect and add to the challenges facing

operational and value chain activities of third party video game developers. These

industry practices can be categorised as follows:

• Financial Activities of Industry Value Chain Agents

• Strategic, Business and Operational Activities of Industry Value Chain

Agents

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• Financial Share of Industry Value Chain Agents

• Product Saturation

• Retail Life Cycle & Retail Agent Activities

• Hit Driven Industry

• Intellectual Property Ownership

• Developer Buyout, M&A, and Consolidation

• Closed Market, Sales and Distribution Channels

Financial Activities of Industry Value Chain Agents

“It is my contention that the current economics of the industry, as supported (actively or tacitly) by publishers, retailers, and the gaming press and most developers, is completely and utterly inadequate.” (The Game Industry and the Economics of Failure, 1999)

Video game development is an expensive activity. Large consolidated value chain

agents use power, control, scale, and scope to demand larger shares of revenue from

industry wide activities such as retail, distribution, and manufacturing. Consolidation,

vertical and horizontal integration of the large scale industry agents (platform holders,

and publishers) has marginalised the power, control, marketshare and access to retail,

sales, distribution and consumer channels of third party developers.

“When publishing for game consoles, game publishers take on the burden of a great deal of inventory risk. All significant console manufacturers since Nintendo with its NES (1985) have monopolized the manufacture of every game made for their console, and have required all publishers to pay a royalty for every game so manufactured. This royalty must be paid at the time of manufacturing, as opposed to royalty payments in almost all other industries, where royalties are paid upon actual sales of the product—and, importantly, are not payable for games that did not sell to a consumer. So, if a game publisher orders one million copies of its game, but half of them do not sell, the publisher has already paid the full console manufacturer royalty on one million copies of the game, and has to eat that cost.” (Wikipedia, Video Game Publisher, 2005)

15

This consolidation has allowed the publishers to act as financial agents, funding the

development of video game software products through networks of first, second, and

third party developers.

“The business model currently most widely in use (although there are exceptions) is based upon the music industry model. It involves the payment of development costs by a publisher and a back-end royalty payment once those development costs have been recouped from the royalty. Unfortunately for most developers, recoupment rarely happens. While most developers are careful to build a profit margin into the "development costs" component, only a handful of game titles in any year will actually sell sufficiently to allow royalties to ever be paid to developers. Thus, at most, developers earn a modest profit. More often than not, however, developers are disappointed in the profitability of their game development efforts.” (Part II – The Economics of the Video Game Industry, 2004)

Developers have very little power in terms of production, business, and contract

negotiations. Third party developers are normally contracted in a work-for-hire capacity

and are advanced payments by publishers to cover the costs of product development

with those advanced payments being recouped through predetermined set agreements of

royalty fees based on predicated marketplace sales of the product. It is very rare that

developers receive a financial return on their products due to the lack of market

performance of the majority of video game products.

“More stable revenue streams have assumed greater importance within the industry as the major publishers have become publicly quoted companies. A stock listing presents a different set of financial pressures for publishers to work to, one that revolves around posting positive quarterly results and generating shareholder value.” (New Media and Regional Development: The Case of the UK Computer and Video Game Industry, 2000)

The effects of the financial activities of large scale industry value chain agents on third

party developers operations occurs in the source, nature, and scale of profit margins that

these developers receive throughout their internal value chain activities. Third party

developers have structured their value chain operations with the aim of obtaining and

maximising profit margins through predetermined profit margins sourced from

advanced fees paid to them by platform holders and publishers.

16

The two primary methods of contract financing offered to developers are:

Cost + Margin Deals: Developers pitch a development budget, timeframe, and a

predetermined profit margin to platform holders and/or publishers and opt to forgo

royalty payments based on sales of the product in the marketplace. This deal is less

prevalent than the widely accepted and utilised advance + royalty deal.

Advance + Royalty Deal: Developers receive an advance payment(s) and also receive

predetermined royalty payments after the advance have been recouped from sales of the

product in the marketplace. (Laramée, F., D., 2005:5)1

.

The value chain structure of a third party developer is thusly determined by maximising

the profit margins obtained through advance payments made prior to and during the

production phase of video game software product development. This leads developers to

seek costs savings throughout all production based activities and radically affects all

aspects of their operational activities, financial performance, and internal value chain

structure (primary and secondary).

Since most developers negotiate contracts on a product per product basis with financial

investment being provided for a specific title or product there is limited ability for third

party developers to obtain additional revenues to invest in long term competitively

advantageous resources, capabilities, or value chain based components.

With profit margins literally covering the development of one product at a time third

party developers are faced with the difficulty decision to limit internal investment in

operational components such as primary value chain activities (inbound logistics,

operations, outbound logistics, and services) and secondary activities (firm

infrastructure, human resource management, technological development, and

procurement).

Strategic, Business and Operational Activities of Industry Value Chain Agents

1 How Developers Get Paid: The Retail Market for Games.

17

Publishers and platform holders use their scale, scope, power and control of distribution,

sales and consumer channels to perform a wide range of strategic, business, and

operational activities that are if not entirely detrimental to developers certainly provide

additional challenges.

A publisher can cancel a development project, giving little or no reason for the

decisions and halt milestone payments at anytime. Publishers typically expect third

party developers to conduct a series of competitive pitches which result in developers

competing with other over the lowest priced development spend per game project. This

in turn affects the overall profitability and profit margins on development projects.

“As your size grows dramatically, projects can get behind and publishers may refuse to pay, some may cancel projects, and others may go out of business. When you’re smaller it may be possible to weather these events with personal cash, loans, etc. but as a large developer a “Perfect Storm” of these events can deliver a serious blow.” (Exploring the Business Side of the Business Side of Making Games, 2004).

Other issues are in terms of publisher, platform holder, distributor, and retailer

accountability. Since developers are paying for operational and profit margins out of

advance payments which are recouped from sales based royalty payments, these agents

have been know to take liberties with the accounting of sale figures, records, and

returns. Developers do not have access to the full measure of sales records for their own

titles and must rely on the publishers and platform holders to be honest in their

accountability of true sale figures and royalty payments.

Financial Share of Industry Value Chain Agents

“Assume a game cost $7,000,000 to develop (about average for a new console game) and a 20 percent royalty is to be paid to the developer. The retail price is $49 and the wholesale price is $32. The fees payable to the console manufacture, marketing and distribution average around $11. That leaves $20 to be split between the publisher and the developer. It would take a sale of 1.1 million units of the game to recoup and start paying royalties to the developer.”

18

(Part II - The Economics of the Game Industry, 2004)

The consolidation, growth, and industry power of the large scale industry agents allows

them to maximise a large share of the revenues generated throughout retail, sales,

distribution, and consumer channels through the sale of video game software products.

(Figure 2.3) demonstrates the average revenue split received by each industry agent

from the sale of a video game software title:


Figure 2.4 Financial Share of Sale Revenue per Value Chain Agents.

(Figure 2.3) demonstrates that typically only 10-20% of the sales revenue of a video

game software product eventually returns to the hands of the developer. In most cases

the developer receives one of the weakest shares of the revenue generated through the

sale of video game software products in the marketplace. This lack of financial

performance impacts negatively on the financial performance, market strength, and

operational capabilities of third party developers.

Amount Purpose Paid By Paid To $3 Cost of Goods (CD’s, Cartridges,

Printing) Platform Holder/Publisher

Media Manufacturer*

$7 Publishing licence royalty Publisher/Platform Holder

Platform Holder

$13 Retailer Profit Consumer Retailer $3 Markdown Reserve Platform

Holder/Publisher Retailer

$8 Development Costs Platform Holder/Publisher

Developer

$10 Operating Costs Platform Holder/Publisher

Internal (overhead, freight, c-op, bad debt).

$6 Marketing Platform Holder/Publisher

Ad agencies, press, media buyers, media owners.

Items in bold can be converted to profit through careful publisher cost management. * This can be a vertically integrated component of a platform holder/publisher operation. Source: Secrets of the Game Business 2nd Edition, (2005:101)

Table 2.4 Generalised Breakdown of Revenue from a $50 Console Game

“Funding for a game's development can either come from internal resources or the publishers and, less commonly, distributors of the game. Since the developer

19

does not handle the manufacturing or distribution, it receives a percentage royalty on the net wholesale receipts to the publisher (i.e. gross wholesale price less cost of goods, returns provision - usually 10%-15%, and in some cases distribution costs). This royalty rate can vary from around 10% to as high as 40% (industry average is 15-25%) depending on a number of factors including the following: the extent to which the game has been funded by the publisher/distributor, the saleability of the title, the role of the publisher/distributor.” (Game Investor, The Development Process, 2006)

With such a small share of the overall sales revenue returned to developers (Table 2.4)

there is pressure to adapt operational structures, capabilities, and policies accordingly.

Third party developers focus resources on value chain activities that maximise cost

savings, reduce production and staff overheads, and speed turn around times for product

development. This affects all aspects of a third party developer’s structure, limiting

growth, and development in key competitive capabilities across primary value chain

activities (operations, and services) and secondary activities (firm infrastructure, human

resource management, technological development, and procurement).

Product Saturation

“Furthermore, because of the very large number of games battling for a share of the player’s attention, each title can only expect to receive a minute fraction of the industry’s lofty revenues. While Hollywood releases approximately 100 movies to the theatres every year – some of them in very limited distribution – the games industry launches thousands of titles on multiple incompatible platforms.” (Secrets of the Game Business, 2nd Ed., 2005:5)

The practice within the industry is for the large value chain agents (platform holders and

publishers) to release numerous video game titles into the marketplace (retail and

distribution channels) in the hope that one or two hit products can cover the losses

generated by the majority of loss making titles in the marketplace. This leads to an over

saturation of products competing for press, advertising, PR retail, distribution, and

consumer channel coverage.

“And what does that buy you? Four weeks, maybe six. If your product hasn’t sold by then, it is out of there, and don’t expect a second chance either. Even if

20

your product sells reasonably well, it probably won’t stay on the shelves for more than 2-3 months, because their will be other newer games available by then that could sell even better.” (The Game Industry and the Economics of Failure, 2005)

The amount of money needed to advertise and market many comparable, competitive

products in the marketplace drives publishing, distribution, and retail costs upwards.

This in turn adds substantial financial risk for publishers who must make sure that their

products capture as much publicity, PR, and consumer attention in the limited time

frame available in retail channels.

Additionally the Christmas selling season accounts for about half of the industry's

yearly sales of video and computer games, leading to a concentrated glut of high-quality

competition every year in every game category, all in the fourth quarter of the year.

(Wikipedia, Video Game Publisher, 2005).

The effects of product saturation on third party developers occur mainly in pressure to

deliver products within set schedules and seasonal launch windows. This typically

affects third party developers across primary value chain activities (operations) and

secondary activities (firm infrastructure, human resource management, and

procurement).

Retail Life Cycle & Retail Agent Activities

“Rising costs, short life cycle. A video game is typically made for seven different platforms (PC, consoles, handhelds, etc.) and distributed in three major North American markets,… yet its life cycle on the market may only be six weeks. That’s one shot at success, with a very expensive bullet” (The Reality of Video Games, Stanford Graduate School, 2004)

Compared to other popular forms of entertainment such as music CDs and movie

DVDs, games suffer from serious disadvantages in the retail market: retailers don’t

21

stock many titles, games, and game platforms are perishable. (Laramée, F., D., 2005:31-

32)2

.

The retail stage of the production cycle is more and more the preserve of large

supermarkets and specialist chains, particularly in the USA where Wal-Mart,

GameStop, and Best Buy dominate. In Europe independent retailers still constitute a

significant part of the retail sector. (Kerr, A., 2006:65)3

.

“So where does that leave you? With a product that costs you millions of dollars to market and with 60 days to recuperate that investment, assuming you manage to get a decent channel to market. In all likelihood, it won’t work. As a publisher, your strategy is to put a good selection of products out there, hoping that a few will catch fire and more than make up for the money you will lose on the others. Risky business, given that the safest way to conduct risky business is to minimise costs, and knowing that ever-increasing sales and marketing budgets are a fact of life, where do you cut? Why in developer advances, of course.” (The Game Industry and the Economics of Failure, 2005)

Most retail channels have limited shelf, PR, advertising and marketing space. Thusly

when faced with the large amount of annual video game titles presented to them they

must carefully decide which items to stock and for how long. Compounding this

challenge is the fact that there are multiple competing platforms and associated formats

in the marketplace. Retailers must devote resources, shelf time, and space to PC,

console, and handheld products as well as second hand and rental allocations.

“The retail market for games is difficultly for developers, and not much easier for most publishers. Retailers wield enormous power over our livelihoods: they stock few products, don’t keep them on shelves for very long, and reap much of the income the games generate. Yet, alternative distribution schemes (e.g., online sales) have not yet supplanted retail, because of download sizes, consumer habits, and publisher fears over channel conflicts. Learning how the retail market for games works will help developers thrive in this competitive environment.” (The Secrets of the Game Business, 2nd Ed., 2005:34)

2 Secrets of the Game Business, 2nd Ed. 3 The Business and Culture of Digital Games.

22

As the main access point to consumers, retailers can significantly influence the success

of a game through their allocation of shelf space and in-store advertising. As

supermarkets grow in size, they acquire more power to negotiate discounts on whole

sale products and returns to publishers. (Kerr, A., 2006:65)4

. Retailers have significant

power and discretion over what, where, when ,and to what degree they promote a

particular product or range of products for a platform holder, platform or publisher.

“The overwhelming majority of PC games sell fewer than 100,000 units before going out of print; for most professionally developed and published titles, sales will begin to taper off at 15,000 to 40,000 copies, with any remaining inventory being liquidated by the publisher for little more than the cost of printing the box and CD-Rom. The bottom line: the vast majority of game projects lose money for the developer, the publishers, or both.” (The Secrets of the Game Business, 2nd Ed., 2005:29)

This has dramatic effects on the ability for video game products to reach the critical

breakeven point necessary to cover growing development and advertising costs. The

chances that any individual video game product will not be able to recoup its

development costs in the short retail window are limited.

Retailers often charge publishers, market development funds to cover the cost of

posters, end-of-aisle space and other services. (Kerr, A., 2006:65)5. Video games are

sold as consignment items: the retailer will only pay the publishers for copies of the

game that consumers actually buy, the rest will be returned, often at the publisher’s

expense. (Laramée, F., D., 2005:31)6. There is a trend in video game retail channels to

sell pre-owned games to consumers. Publishers and platform holders are not satisfied

with this practice as they do not receive any revenues generated form such sales. Retails

have also adopted the trend of price discounting to drive through and maximise unit

sales and profits. It appears to us that retailers are quick to request discounts, and

consumers have been trained to wait for discounts. (Wedbush Morgan Securities,

2006:64)7

.

4 The Business and Culture of Digital Games. 5 The Business and Culture of Digital Games. 6 The Secrets of the Game Business, 2nd Ed. 7 Wedbush Morgan Securities: Entertainment Industry Report.

23

“Electronic Arts’ UK MD Keith Ramsdale, criticised some retailers for deliberately extending the reach of their pre-owned offers and “making brand new product look worthless. As pressure has increased this year on sell-through and pricing of new releases, so games publishers have become more sensitive about the size of the pre-owned market – which is believed to be worth as much as £50m a year to leading chain GAME and possibly £100m across the market as a whole. Publishers have agreed to discuss privately what action may be possible to stop the trend, either under the auspices of trade body ELSPA or simply via legal protection.” (Pressure Mounts on Pre-owned, 2005)

Product saturation and the various financial practices of retail channel agents have lead

to an overall trend of reduced prices of video game products in the marketplace. This

unduly affects the breakeven point for video game products. This increase the risk

inherent in developing video game products and less chance for an individual product to

sell through to profit in retail channels in the shot allotted retail channel window.

These practices typically affect third party developers across primary value chain

activities (inbound logistics, outbound logistics, marketing and sales, and operations)

and secondary activities (firm infrastructure, human resource management, and

procurement) as they try to adapt their operations, products, and value chain activities to

develop games that maximise profitability and unit sales throughout shortening

opportunities available in retail channels.

Hit Driven Industry

“The video game industry is still heavily hits-driven, with 5% of game titles accounting for roughly 95% of sales, and a publisher who goes without releasing a hit will quickly find itself in trouble. Of course, the odds of publishing a hit increase when a company owns a valuable franchise and has the wherewithal to bring many titles to retail; as a result, the market is more hospitable to publishing giants.” (Secrets of the Game Business, 2nd Ed., 2005:5)

With so many comparatively similar products within the marketplace there is a tendency

for consumers to support the best in category product within a particular genre. This

best in category product can be successful due to gameplay, graphics, characters,

24

franchise, brand name, marketing, advertising, PR, licence, or a combination of some,

all, or none of these factors.

These high selling hit products enjoy super-normal revenue and profits in the

marketplace. These hit products subsidise the substantial losses generated by platform

holders and publishers throughout their sizable product portfolios and account for the

most substantial profit generation centres for all agents of the industry wide value chain.

“There is a consensus in the industry that it has increasingly become more "hit driven" over the past decade, with masses of consumers buying the game that is best in quality and best-marketed in each game genre, and, by comparison, very few buying any other games in that genre. This has led to much larger game development budgets, as every game publisher tries to ensure that its game is #1 in its category.” (Wikipedia, Video Game Publisher, 2006).

The hit driven nature of the industry typically affect third party developers across

primary value chain activities (marketing, sales, and operations) and secondary

activities (firm infrastructure, human resource management, and procurement) as they

try to adapt and develop products, and value chain activities that increase the chance of

achieving hit status and associated sales, revenue, and profits of products in the

marketplace.

Intellectual Property Ownership

“Another challenging and fundamental issue for game developers is the ability to create long-term value in their companies. Typically, a game publisher will attempt to acquire all of the Intellectual Property rights developed by a developer in connection with a particular game project. Even if a developer can hold onto its "development tools" (i.e., the game play or game development engine that can be reused in other games), because of the need to rapidly develop games, many developers are relying more and more on third-party middleware to provide the engine for their games and are not developing those tools themselves. Consequently, developers are often left with little, if any, reusable intellectual property.” (Part II – The Economics of the Game Industry, 2004)

25

Intellectual Property is the true value of the video game industry. With so many

products competing for limited access to distribution and retail channels and so many

games failing to breakeven or achieve profitably in the limited retail timeframes made

available by retail channels the industry relies more and more on content based on

established brand name Intellectual Property as a means of increasing sales,

profitability, cross advertising, branding, and PR opportunities.

“Moore, lamenting the “sequelisation” of the industry, added, “We’re starting to live a bit vicariously through other people’s Intellectual Property. When I look on the reliance on the Harry Potters, The Lord of the Rings, the James Bonds, The Terminator 3s, I worry that the creative juices are drying up.” (The Reality of Video Games, Stanford Graduate School, 2004)

There are three main types of Intellectual Property in the video game industry (Rocca,

J., D., 2005:38)8

Original: games based on Intellectual Property (i.e. story, characters, concept, setting,

world, etc.) created by video game developers or other agents of the video game

industry.

Licensed: games based on Intellectual Property that originates from outside the game

industry (i.e. movies, sports, comics, books, etc.).

Franchise: A game based on Intellectual Property arising from a successful series of

games. These series can be based on original or licensed Intellectual property but may

have substantial success inherent due to prior success and brand name recognition in the

marketplace.

“In the U.S. in 2004, titles based on licensed IP, such as Madden NFL 2005, sold 23% more units than titles based on original content. However, the report's author suggests that short term revenue gains of licensed IP, does not necessarily translate into greater profits, and that licensing costs are rising as IP owners become increasingly aware of the growing importance of the game medium.”

8 Secrets of the Game Business, 2nd Ed.

26

(Survey Analyzes Strategies for Publishing Success, 2005)

(Figures 2.4 and Figure 2.5) show the comparison of sales of games based on both

original and licensed Intellectual Property. (Figure 2.4) demonstrates few games based

on original Intellectual Property make sales at the right end of the curve (i.e. profitable

sales). (Rocca, J., D., 2005:38)9

.

“The problem is control over IP and publisher influence, in the current market, the equivalent of a distributor in the game business is a publisher. The guarantee of distribution has to come from a publisher." (Spector Talks Alternative Funding, 2006)

# T

itles

Less Sales More Sales

Breakeven

Rez

ICO

Deus Ex

Prince of Persia

MarioMystSims

GTA

Source: Secrets of the Game Business 2nd Ed., 2005: 39.

Figure 2.5 Sales Curve for Games Based on Original Intellectual Property.

(Figure 2.5) demonstrates that a much larger percentage of games based on licensed

Intellectual Property fall in the breakeven area of the curve. Whilst a great deal of

licensed games still fail in terms of overall profitability a significantly larger amount

than games based on licensed Intellectual Property manage to place on the right hand

side of the curve (i.e. profitable sales). (Rocca, J., D., 2005:38)10

.

9 Secrets of the Game Business, 2nd Ed. 10 Secrets of the Game Business, 2nd Ed.

27

This trend also leads to a lopsided generation and accumulation of wealth. For every

game based on licensed Intellectual Property, the publisher must pay a licensing fee.

This fee is money that flows out of the games industry and cuts into the profitability of

publishers and developers. (Rocca, J., D., 2005:40)11

# T

itles

Less Sales More Sales

Breakeven

E.T.

Cat-Woman

Matrix

Spider-Man

Tony Hawk

Madden NFL

.

Source: Secrets of the Game Business 2nd Ed., 2005:39. Figure 2.6 Sales Curve for Games Based on Licensed Intellectual Property.

“For games that are successful, the business case becomes considerably more attractive. Assuming a premium quality console title is sold into retail at around £20/unit, around £7 is spent on manufacturing and distribution (including the console manufacturer's royalty), leaving the publisher with net receipts of around £13. Of course, the speed with which the publisher recoups the advance is dependent not only on sales but also the royalty level agreed with the developer; the higher the royalty the quicker the advance will be recouped. The process is also made more complicated by multi-tier and cross-collateralised royalty deals.” (Game Investor, 2006)

(Table 2.5) demonstrates the profit model for video games and the revenue generation

and loss that can be received through the development of a video game product.

Unit Sales

Total Development Costs: £2,500,000 Marketing and Other Costs: £2,000,000

Total: £4,500,000

11 Secrets of the Game Business, 2nd Ed.

28

Net Revenue @ £14/ unit 150,000 (Low) (£2,400,000) 300,000 (Medium) (£300,000) 600,000 (High) £3,900,0000 1,200,000 (Super High) £12,300.000 Source: Game Investor, (2006)

Table 2.5 Profit Model of a Video Game Product

“However, is this really the case? Once again, taking a historical perspective, games based on original IP are the top selling games, and the games that are the most critically acclaimed.” (Secrets of the Game Business, 2nd Ed., 2005:38)

The best selling video game products of all time on various platforms are based on

original Intellectual Property. PC (The Sims: 16 million, Myst: 11 Million, Half-Life: 8

million), PlayStation 2 (Gran Turismo 3: A-Spec: 14.36 million, Grand Theft Auto:

Vice City: 13.63 million, Grand Theft Auto: San Andreas: 13.44 million) and Xbox

(Halo 2: 7.75 million, Halo: Combat Evolved: 6.61 million, Fable: 2.39 million).

(Wikipedia: 2006)12

.

Developers are all ready marginalised in terms of the financial return they receive from

publishing contracts. With the prevalent industry practice of developers signing away

rights to original Intellectual Property, technology, assets, and content for their original

games there is very little real value left to achieve sustainable competitive advantage

and long term operational profitability for the average third party video game developer.

This industry practice of Intellectual Property stripping enforces the marginalisation of

third party developers, increasing the power and control publishers have in industry

wide value chain activities and enforces the work-for-hire status of most third party

developers.

Intellectual Property ownership affect third party developers across primary value chain

activities (marketing, sales, operations and service) and secondary activities (firm

infrastructure, human resource management, technology development and procurement)

as margins are squeezed from non-development activities such as sales, marketing, and

12 Wikipedia, List of Best Selling Computer and Video Games.

29

services. Developers are forced to structure their internal vale chain around activates

that reduce costs and add profit margin through product development (i.e. methods,

processes and activities).

Developer M&A, Consolidation, Buyout and Closure

“The bigger publishers (including the console manufacturers) have sought to buy, or part-buy, development companies and their own smaller rivals (publisher-developers). While horizontal integration is largely concerned with generating economies of scale and building up bigger and more diverse product portfolios, vertical integration is motivated by the desire to control costs and assure a steady flow of products through gaining control over the development process.” (New Media and Regional Development, 2000:96)

Due to consolidation activities on behalf of the large scale agents within the video game

industry and the marginalisation of commercial, revenue and profit opportunities

presented throughout developer activities a significant proportion of the best

independent development companies are purchased completely or in part by platform

holders or publishers. This activity is not a new phenomenon as there is substantial

precedent for M&A and buyout activities in the UK dating back to 1993.

Year Acquired Location Activity Acquirer Location Activity Stake 1993 Psygnosis UK PD Sony Corp. JP HW, PD 100 % 1995 Rare UK PD Nintendo JP HW, PD 25 % 1995 Bullfrog UK PD Electronic

Arts (EA) UK PD 100 %

1995 Domark UK PD Eidos UK PD 100 % 1995 CentreGold

Group (inc. Core Design)

UK PD Eidos UK 100 %

1996 Ocean UK PD Infogrames FR PD 100 % 1996 Probe UK PD Acclaim US PD 100 % 1996 Iguana UK PD Acclaim US PD 100 % 1997 DMA UK D Acclaim UK PD 100 % 1997 Mainstream

Interactive AU PD Gremlin UK PD 100 %

1997 Spidersoft UK D Take 2 Interactive

UK PD 100 %

1997 Millennium UK D Sony Computer Entertainment Europe (SCEE)

UK (JP) PD 100 %

1998 Rare UK PD Nintendo JP HW, PD 25 % 1998 Crystal US D Eidos UK PD 100 %

30

Dynamics 1998 Centresoft UK DR Activision US PD 100 % 198 Reflections UK D GT

Interactive US PD 100 %

1998 Virgin (VIE) UK PD Interplay US PD 44 % 1999 Gremlin UK PD Infogrames FR PD 100 % 2000 LTStudios UK PD Argonaut UK PD 100 % 2000 Just Add

Monsters UK PD Argonaut UK PD 100 %

2002 Particle Systems

UK PD Argonaut UK PD 100 %

2002 Rare UK PD Microsoft USA HW, PD 100 % 2002 Zed Two USA PD Warthog UK PD 100 % 2003 Fever Pitch USA PD Warthog UK PD 100 % 2003 Pivotal Games UK PD SCI UK HW, PD 100 % 2004 Just Add

Monsters UK PD Ninja Theory UK PD 100 %

2005 Warthog UK PD Tiger Telematics

UK HW, PD 100 %

2005 Eidos UK PD SCi Entertainment

UK PD 100 %

2006 Lionhead Studios

UK PD Microsoft USA HW, PD 100 %

Key: HW = Hardware; D = Developer; DR= Distributor; PD=Publisher/Developer. Source: New Media and Regional Development, (2006:96). The End Game How Developers Sold Their

Studios – Part I (2004).

Table 2.6 Selected Mergers and Acquisitions within the UK Computer and Video

Games Industry, 1993-2006.

Publishers have the financial resources necessary to acquire prominent developers.

Publishers purchase, fund, and invest in developers for their development expertise, to

increase in-house or external development resources. Developer acquisitions can

provide substantial growth opportunities and competitive advantage gains for large scale

platform holders and publishers. Proprietary technology and Intellectual Property are

key assets than can be acquired through successful M&A, purchase or investment.

(Rogers, D., L., 2004)13

.

“Publicly owned publishing companies have an insatiable appetite for growth and net profits. Each is on a full-time mission to increase their revenue, trim their operational costs, and take advantage from their competitors for the hearths and wallets of game consumers. If your company can assist them in this endeavour then you could be an acquisition target” (The End Game: How Developers Sold Their Studios – Part One, 2004)

13 The End Game: How Developers Sold Their Studios – Part One.

31

Those developers that do not get acquired by large scale industry agents, either continue

operations as normal, or face closure as industry, market, financial, and/or operational

pressures force independent developers to cover the mounting cost of working in the

risk laden video game industry. A number of significant closures in the UK video game

industry have occurred in recent years demonstrating the inherent risks presented to

independent developers working in the video game industry in the UK;

Date Name Activity Location UK Operations Staff 2001 Pure Entertainment D UK Unknown 2002 Akaei PD UK Unknown 2002 Kaboom Studio Group PD UK 35 + 2003 Asylum Entertainment D UK 70 + 2003 Rage Software PD UK 245 + 2003 Silicon Dreams D UK 230 + 2003 Attention to Detail D UK 70 + 2003 Mucky Foot D UK 25 + 2004 Acclaim PD US 160 + 2004 Argonaut Games PD UK 120 + 2004 Confounding Factor D UK 50 + 2005 Blue 52 D UK 25 + 2005 Elixir Studios D UK 50 + 2005 VIS Entertainment D US 96 + 2006 Andromeda Entertainment DR UK Unknown 2006 DC Studios D US 29 + 2006 Visual Science D UK 92 + Key: HW = Hardware; D = Developer; DR= Distributor; PD=Publisher/Developer. Source: Various Internet sources.

Table 2.7 Selected Closures within the UK Computer and Video Games Industry,

2001-2006.

Developer M&A, consolidation, buyout, and closure affect third party developers across

all primary (inbound logistics, operations, outbound logistics, marketing, sales, and

services) and secondary activities (firm infrastructure, human resource management,

technology development and procurement) value chain activities and dimensions. .

Closed Market, Sales and Distribution Channels

“First Law of the Game Industry: Channel to market is everything. Second Law of the Game Industry: Whoever stands between you and the customer holds you by the balls.” (The Game Industry and the Economics of Failure, 2005)

32

Another key challenge facing third party developers is the fact that platform holders and

publishers control the pathways throughout distribution and retail channels and

subsequently monopolise direct access to the consumer and the marketplace. Since most

developers are employed as work-for-hire contractors enlisted by large powerful

industry value chain agents they have little if no real access to the marketplace either

directly or through indirect means such as retailers and distributors.

This is a significant operational challenge and goes a long way to explaining the lack of

power the developers have in the video game industry. Without dedicated branding and

marketing activities developers stand to lose market awareness in the eyes of the

consumer. Developers have a lack of control in terms of value added activities such as

marketing, advertising, community, and PR.

Closed markets, sales, and distribution channels affect third party developers across all

primary (inbound logistics, operations, outbound logistics, marketing, sales, and

services) and secondary activities (firm infrastructure, human resource management,

technology development and procurement) value chain activities and dimensions.

2.2 Effects of Challenges Facing Third Party UK Video Game Developers

“As the technological sophistication of computer games has increased, raising production values, budgets, and the time to market, developers have increasingly been forced to turn to large publisher-developers for finance, seeking advances against royalties to enable the game to be produced. Alternative sources of finance, such as venture capital, are hard to come by but not impossible. Small developers, though, often fell that venture capitalists want a disproportionate equity stake in the company – 50 percent is quite common – in return for financial backing. So stuck between a rock and a hard place, most developers have fallen back on the publisher for finance.” (New Media and Regional Development, 2000:94-95)

The International Game Developers Association, Developer Business Summit, 2004

concludes that the challenges facing video game developers affect video games

developers across the following ‘functional points of view’; production and operations,

marketing, public relations, finance, sales, distribution, contracts, legal and human

resources.

33

“The amount of time it took to develop a game was doubling. The amount of people it took was doubling. Hence the cost was going up about five times, and yet the cost of the software was unchanged if not descending. So the risk on the product was going up and the potential profit per person per year was going down. We sold the company to mitigate the risk.” (Exploring the Business Side of the Business Side of Making Games, 2004).

This report categorises the challenges and affects facing video game developers using

Michael Porter’s (1985) value chain framework which considers competitive advantage

of firms through an understanding of individual capabilities sub-categorised into

primary and secondary activities. The value chain frame work is a means of analysing

and categorising specific firm activities and relating them to their contribution towards

that firm’s competitive performance.

“Competitive advantage cannot be understood by looking at a firm as a whole. It stems form the many discrete activities a firm performs in designing, producing, marketing, delivering, and supporting its product. Each of these activities can contribute to a firms relative cost position and create a basis for differentiation.” (Competitive Advantage, 2004:33)

Ultimately the list of extensive challenges outlined in this report point to an increasingly

tough operating environment for third party video game developers. The true effect of

all these challenges is to put pressure on the competitive performance capabilities and

profit margins of third party developers.

34

3 INDUSTRY ANALYSIS

Delivering a game into a consumer’s hands has become an increasingly complex, lengthy and costly process. Members of the interactive entertainment industry constantly debate the relative importance of game developers as creative authors versus publishers as soulless business people, or retailers as channel arbiters versus media as opinion mongers. However, financial and logistical market forces have created a system in which each ‘driver’ entity on the highway to the consumer – developer, publishers, platform owner, and retailer – is essential to the transaction, and profits accordingly. “Adjunct” entities that feed into the channel offer a plethora of service alternatives that reduce cost, save time, or improve quality along the channel and, ultimately, for consumers.” (Secrets of the Game Business, 2006:95)

3.1 Industry Analysis

UK video game industry sales accounted for more than £1.1 billion in retail sales

outside of the UK in 2000. UK developed video game sales produced a total positive

trade contribution of more than three-quarters of a billion (£757m) between 1997 and

1999, comparing favourably to film (£462m) and television (-£944m) in the same three

year period. (DTi, 2002:19).

The UK video game industry is a significant exporter of global video game products.

From a global perspective UK developed products account for 15.3% of the global

market. UK developed products represent the third largest single global contributor by

volume. The UK lags behind both the US (44.1%) and Japan (35.3%). UK developed

products have a significantly higher volume than the next major contributors Germany

(2.1%), France (1.7%) and Canada (1.7%). (DTi, 2002:18-19).

The UK video game industry is a major contributor to worldwide video game product

development and sales. UK developed video games account for 35% of the UK market,

11% of the US market, 23% of the European market but only 1% of the Japanese

market, which is dominated by domestic video game products. (DTi, 2002:17-18).

35

The value captured by the UK video game industry is represented throughout all

industry wide agents activities i.e. retail, distribution and publishing margins,

development advances and royalties. Independent UK developers account for £219m

(18.9%) of total value generated compared to the in-house development of non-UK

£155m (13.4%) and UK £83m (7.2%) developers which accounts for a total of £238

(20.6%). The total value generated by in-house developers is accounted as part of the

value generated by the owners (platform holders, publishers) of these in-house

development teams. (DTi, 2002:19-20)

£m 219

£m 155

£m 83

£m 254

£m 93

£m 356

Independent UK development In-house dev, non-UK publishersIn-house dev, UK publishers PublshingDistribution Retail

Source: DTi Report, (2002:20).

Figure 3.1 UK Value of PC and Console Software Markets, 2001 (£m).

“Some 270 games related companies employ more than 20,000 people in the United Kingdom. With 8,000 people involved in development, the United Kingdom is the largest development community in Europe.” (Digital Broadband Content: The Online Computer and Video Game Industry, 2005:16)

The UK video game industry employs more than 20,000 people, within an estimated

270 game related organisations, across all sub-sectors of the industry, including

development (in-house, external), publishing, distribution, retail, and other associated

functions such as manufacturing, agents and legal. Of these 20,000 employees 6,000 are

employed in the development sub-sector. (Figure 3.2) demonstrates the breakdown of

36

employees in the UK video game industry by sub-sector. The video game industry

represents 0.036% of the national workforce. (DTi, 2002:20-21).

Development

Publishing

DistributionPeripherals

Retail

OtherPackaging/Printing

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

Source: DTi Report, (2002:20).

Figure 3.2 Breakdown of Employment by Sub-sector.

3.2 Industry Structure (Value System)

“Globally the industry is thus increasingly structured around a core of between 10 and 20 major publishers. All of the major publishers have their own in-house development teams, surrounded by a fringe of third party or ‘independent’ developers. Even these ‘independents’ are often closely tied to an individual publisher by equity, retainers, and output deals – what have once been called ‘one-point-five’ or second party’ developers, as opposed to true third party developers.” (New Media and Regional Development: The Case of the UK Computer and Video Game Industry, 2000:97)

37

Publisher




Distributor RetailersLicence Holder



Publisher




Distributor RetailersLicence Holder



Publisher




Distributor Retailers ConsumerLicence Holder



Figure 3.3 Video Game Industry Structure - Value System.

A firm’s value chain is embedded in a larger stream of activities which Micheal Porter

describes as the value system. Suppliers have value chains (upstream), buyers have

value chains (downstream), in addition many products pass through the value chains of

channels (channel value) on their way to the buyer. The value chains of individual firms

in an industry differ, reflecting their histories, strategies and success at implementation

and operations. One important difference is that a firms value chain may differ in

competitive scope from that of it competitor, representing a potential source of

competitive advantage. (Porter, M., 2004:34)14

.

The value system of the video game industry can be demonstrated in (Figure 3.3).

Platform holders and publishers utilise original or licensed Intellectual Property

acquired from licence holders, themselves or a developer. This Intellectual Property is

developed into video game products by a network of first, second, and third party video

games developers working directly or indirectly for platform holder and publishers.

After the video game products are manufactured a network of distributors and retailers

distribute and sell the finished goods to consumers. The platform holder and distributor

may also be vertically integrated and have its own distribution and sales channels and

capabilities. (Figure 3.3) displays the value system of the video game industry. (Figure

3.4) demonstrates the position of each entity in the production path of a console game.

14 Competitive Advantage.

38

Motion-capture Provider

Contract QA Provider

Delivery Media Manufacturer

Developer Publisher Platform Holder Licence Holder

Data Game CodeBug List Game Code (Master Disk)

Finished Goods

Art/Animation Provider

Distributor or Rep. Group

PR Firm & Advertising

Agency

Data Data

Game Samples

& Marketing Materials

Regional or National Retailers

Finished Goods

Media Consumer

Game Info Finished Goods

Game Info

Game Code

Game Code

Game Code

IntellectualProperty

Source: Secrets of the Game Business 2nd Edition, 2005:96. (Modified).

Figure 3.4 Position of each Entity in the Product Path for a Console Game.

3.2.1 Licence Holders

“A license makes the customer more likely to go to the store for your masterpiece, because they don't have to watch G4 or Tech TV or read a game magazine to learn a new game title and decide it sounds interesting. They already believe it's interesting the moment they learn that there's a game based on their favourite TV show, movie etc. The excitement they already feel about that experience is transferred to the game, as is the assumption of quality. A license makes them more likely to pick up your game and look on the back, because they recognize the name and images on the front of the box. A license makes them more likely to take the game to the checkout stand, because you get the assumption of quality the license brings.” (Building Big Licensed Game with Big Teams, 2004)

39

Licence holders are large media organisations (movie, music, book, board game, card

game, comic studios, companies or corporations) that control the Intellectual Property

rights of various brand name franchises. A licence holder typically licences the use of

Intellectual Property for a brand name franchise for use on a particular console,

hardware platform, or game device. In return the licence holder enjoys a significant

return of royalty and licensing fees and associated cross marketing, promotion, and

advertising benefits.

Licence holders derive their revenue from any of the following sources:

• Licensing fees from Intellectual Property rights of brand name franchises.

• Royalty payments from sales of video game software based on Intellectual

Property and brand name franchises.

3.2.2 Platform Holders

“The core business model strategy adopted by platform manufacturers in the console segment is to sell their hardware as a ‘loss leader’ in order to build market share and to rely on sales of software to make their profits.” (The Business and Culture of Digital Games, 2006:58-59)

Platform holders are companies that manufacture the hardware devices on which game

software runs. Such companies own, control, and influence the software that appears on

their hardware platform either by providing application programming tools or by

licensing manufacturing, production, development, market release, and media

manufacturing rights to developers and publishers.

Frequently platform holders are vertically integrated and create their own games

software through single or multiple internal development teams.

Microsoft, Nintendo and Sony have all developed (Microsoft Xbox Live) or announced

the development (Nintendo Wi-Fi Connection and Sony PlayStation Network Platform)

of online distribution systems that allow them to sell, demonstrate, and distribute video

games directly to Internet enabled consoles.

40

Platform holders derive their revenue from any of the following sources:

• Sales of hardware (consoles and peripherals).

• Sales of (or licensing fees from) platform compatible hardware and peripherals.

• Sales of self-produced video game software (first party).

• Sales of externally produced video games software (second and third party).

• Licensing fees from development tools and APIs necessary to develop games

software for hardware platforms.

• Licence fees from development rights to produce games for a hardware

platform.

• Licence fees from manufacture rights to produce proprietary media for video

game software for a hardware platform.

• Licensing fees for media manufacturing rights.

3.2.3 Publishers

“If developers are the artistic brain behind video games, publishers are the muscle and nerves that coordinate all aspects of bring a game to a consumer. The publisher’s role is so extensive and influential that publishers have taken on the aura of medieval fiefdoms, where money flows in mysterious directions and decisions are cloaked in secrecy.”15

(Secrets of the Game Business, 2nd Ed., 2005:99)

Publishers are the business, management, operational, and financial hub of the video

game industry value chain. Typically publishers are large global conglomerates with

multiple regional operations, overseeing internal and external development, marketing,

sales, Q&A, financing, and licensing activities. Smaller specialist publishers do exist

but consolidation activities within the industry, financial opportunities, and cost savings

presented through economies of scale and scope tend towards larger players dominating

the landscape of the video game industry.

15 Secrets of the Game Business 2nd Edition.

41

“During the 1990’s cornford et al. (2000) found that the global publishing industry consolidated around a ‘a core of between 10 and 20 major publishers” (The Business and Culture of Digital Games, 2006:65)

Publishers are the key negotiation, contract, licence, and intermediate agents between

other major agents in the video game industry value system. Publishers have

relationships with all major platform holders, distributors, retailers, and have

considerable marketing, advertising, and promotional infrastructures. Publishers control

substantial resources to produce, launch, market and promote video game software to

the consumer.

“While creating a sustainable economic platform can be extremely difficult for a developer, there are also a host of business challenges facing game publishers. Many smaller publishers have failed to survive and the industry is increasingly dominated by a handful of companies. For example, in 2003 game publishers Electronic Arts, Nintendo and Sony accounted for more than 50 percent of all console video games sales in the U.S.” (Part II – The Economics of the Gaming Industry, 2004)

Publishers retain the largest share of the revenue generated by video game sales at retail

and enjoy significant profit margins. These profits are used to fund the development of

portfolios of video game products. Publishers enlist the services of internal, external,

and independent studios to produce video games software for launch on multiple

hardware platforms. Publishers typically install their own project managers and

producers at external developers directly or oversee production via some other form of

operational oversight and management system and process.

“In most instances, it is the publisher that funds the development of a game it intends to publish. This normally takes the form of a royalty advance and is paid on a milestone basis. Once a game is released, the developer receives no royalty payments until the title has recouped the publisher's advance.” (Game Investor, The Publishing Process, 2006).

Historically financial investment in development companies is difficult to obtain and

financing activities have been untaken by the publishers. In return for financial backing

development companies transfer full ownership of the assets (code, art, audio, engine,

42

technology), and distribution and Intellectual Property usage rights of the finished

games.

“The publishers, however, have no one else on whom to offload their risks. Thus, their strategy becomes on of cost reduction (limiting the losses on any individual title by reducing advances to a minimum) and risk balancing (by publishing as many different games as possible to increase the odds of a hit).” (Secrets of the Game Business, 2nd Ed., 2005:29)

Publishers derive their revenue from any of the following sources:

• Sales of self-produced video game software (first party).

• Sales of externally produced video game software (second and third party).

• Licensing fees for use of brand name franchises and Intellectual Property

(movies, comics, TV).

3.2.4 Developers

“Since all but the largest independent development companies release at most one or two PC or console games a year, the low probability of a hit makes it very difficult for developers to finance their own work. Therefore most developers seek to shift the risk towards their publishers by negotiating advances that cover the production costs ad a reasonable profit margin.” (Secrets of the Game Business, 2nd Ed., 2005:29)

Developers are responsible for manufacturing video game software. Developers posses

all the disciplines, skills, knowledge, and assets necessary to create a video game

software product (art, animation, design, graphics, programming, project management,

and business development).

There are three types of video game development company:

First Party Developer: are internal teams which are owned and fully integrated with a

platform holder or publisher.

43

Second Party Developer: are external development companies that are contracted to

develop video game products based on licences owned by publishers, licence holders, or

platform holders. Second party developers may or may not be are owned and fully

integrated with a platform holder or publisher.

Third Party Developer: are independent development companies who develop their

own video game products and sell them to platform holders and publishers in return for

financial support to develop their products.

Developers derive their revenue from any of the following sources:

• Sales of self-produced video game software.

• Advance payments covering development of video game products.

• Royalty payments on predetermined sales figures of video game products.

3.2.5 Distributors

Distributors are organisations that act as intermediately agents between publisher’s

platform and licence holders and retailers. Usually they purchase bulk orders of video

game products and distribute these to large scale retailers making a margin on such

sales. Some distributors handle some of the publisher’s role by undertaking localisation

and marketing of products for particular territories, others undertake inventory risk by

purchasing finished video game products form publishers and selling it on to retailers.

Additionally many publishers and platform holders are vertically integrated and posses

their own full or partial scale distribution capabilities.

Distributors derive their revenue from any of the following sources:

• Sales of video game software.

• Distribution payments on predetermined sales figures of video game products.

44

3.2.6 Retailers

“Gaining wide and deep access to the retailer’s shelves is the determining factor in a game’s commercial success. Securing good shelf space is therefore the publisher’s most important job” (Secrets of the Game Business, 2nd Ed., 2005:29)

Retailers, throughout high street outlets, online or mail order sell finished video game

products direct to the consumer. Typically retailers will buy bulk order products from

distributors or directly from publishers or platform holder at wholesale price. Retails

make a significant margin above the wholesale price. Product saturation and the drive to

create and sell hit games and a saturation of multiple format types in the marketplace

drive consumer price and subsequent profit margins down. Retailers have started

adopting both rental and second hand resale models to increase their overall profit and

obtain additional revenue from existing products.

Retailers derive their revenue from any of the following sources:

• Sales of video game software.

• Sales of video game hardware.

• Sales of video game peripherals.

• Sales of video game support material (walkthrough guides, magazines, etc.).

• Sales of second hand video game software.

• Rentals of video game software.

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4 DEVELOPER ANALYSIS

4.1 Performance Analysis (UK Third party Developers)

“Throughout the 1970s the originators of both video games hardware and software were almost exclusively North American or Japanese companies. The establishment of a UK based computer and video game industry, what became known as ‘BrtiSoft’, originated later from the success of home computers in the early 1980s. Many of the founders of today’s successful UK computer and video game companies started to develop games on these relatively low-cost home computers.” (New Media and Regional Development: The Case of the UK Computer and Video Game Industry, 2000:91)

This report has outlined the significant operational, market, and financial challenges

facing UK third party video game developers. To demonstrate the effect previously

outlined challenges have on UK third party developers this report has gathered the

financial data from twenty two of the leading development organisations producing

video game products in the UK. Data on these organisations has been gathered from

Financial Analysis Made Easy, (F.A.M.E.), a repository of financial data on registered

companies in the U.K and the Republic of Ireland. The list of organisations has been

compiled from T.I.G.A. membership data and the Develop 100: The World’s Most

Successful Game Studios list.

These companies are all independent video game development studios operating in the

UK video game industry as of September, 2006. Selection criteria is based on the

operational duration (2 years minimum), staff size (10 people minimum), operational

status (independently managed organisations registered, based, and operating in the

UK), and industry activity (video game development).

Organisation Name

FAME Account Records

Commence Staff Size Aqua Pacific Limited 1999 Unknown Atomic Planet Entertainment Limited 2001 53 (2004) BigBig Studios Limited 2001 Unknown Bizarre Creations Limited 1999 80 (2005) Blade Interactive Studios Limited 2000 Unknown Blitz Games Limited 1996 122 (2005) Climax Group Limited 2000 251 (2005)

46

Coyote Developments Limited 1999 Unknown Eurocom Developments Limited 1996 17 (2005) Eutechnyx Limited 1997 69 (2005) Exient Limited 2001 Unknown Free Radical Design Limited 1999 73 (2005) Frontier Developments Limited 1996 Unknown Gusto Games Limited 2004 Unknown Kuju Entertainment Limited 1999 142 (2005) Mere Mortals Limited 2001 Unknown Rebellion Development Limited 1996 74 (2005) Relentless Software Limited 2004 Unknown Revolution Software Limited 1996 Unknown Sports Interactive Limited 1996 Unknown Sumo Digital Limited 2004 Unknown Team 17 Software Limited 1996 76 (2005) Source: Various sources.

Table 4.1 Selected UK Third Party Video Game Developers List.

“No matter which way we look at it, one glaring fact remains: not very many people make money in the game industry. Especially not the people who create the product.” (The Game Industry and the Economics of Failure, 2005)

Of the twenty two third party UK video game developers selected only eight posted

complete turnover, profit & loss, and profit margin records in their audited accounts.

The remaining fourteen organisations posted irregular records which did not provide

sufficient recording of revenue, profit & loss, and profit margin necessary for

comparative financial analysis.

(Appendix 1) shows a complete financial record of the selected organisations and the

deficiencies in the gathered accounting records. Organisations selected for comparative

financial analysis are companies with complete turnover, profit & loss, and profit

margin records for the three year period between 2002 and 2005.

Of the eight companies that posted complete revenue, profit & loss, and profit margin

records (Table 4.2) six recorded an operating loss (2005). Of the two organisations that

recoded positive profits (2005), profit margins of 5.67%, and 1.56% were posted. Of the

six organisations that recoded negative profits (2005) profit margins of -64.2%, -

30.81%, -15.25%, -14.92%, -1.5%, and -1.2% were posted.

47

Only one of the selected organisations recorded three consecutive years of positive

profit with 1.56% (2005), 1.07% (2004), and 5.7% (2003) profit margins being posted.

Only one of the selected organisations recorded three years of concurrent negative profit

with -2.78% (2005), -28.81%% (2004), and -9.86% (2003) profit margins posted. Two

of the selected organisations recorded two years of concurrent negative profits. Three of

the selected organisations recorded two years of concurrent positive profits.

The largest average turnover recorded in the three year period between 2002 and 2005

was £11,861,349 and the lowest was £1,263,579. Five of the selected organisation

recorded negative profits with average profit margins over the three year period 2002-

2005 of -15%, -20%, -14%, -10% and -8% posted. Three of the selected organisation

recorded positive profits with average profit margins over the three year period 2002-

2005 of 6%, 4% and 3% posted.

The largest average positive profit recorded in the three year period between 2002 and

2005 was £301,957 (6% profit margin) and the smallest was £107,124 (3% profit

margin). The largest average negative profit recorded in the three year period between

2002 and 2005 was -1,819,167 (-20% profit margin) and the smallest was -£189,495 (-

5% profit margin).

In analysis, the financial performance of the selected development organisations appears

to present a high chance of negative profitability being generated. Of a possible of

twenty four accounting periods (eight companies over 2002, 2004 and 2005), thirteen

negative profit periods were recorded compared to eleven positive profit periods over a

three year period (2002-2005).

Over a three year period between 2002 and 2005 only three selected organisations

recorded positive average profits. The highest average profit margin recorded was 6%

with profit margins of 4%, and 3% also recorded. This level of profitability is low by

most organisational, industry, and sector standards. Considering the inherent risks,

challenge, and operational impediments presented to video game developers very little

chance for sustainable growth opportunities or profitable return on investment seems to

be available to UK third party video game developers.

48

Additionally only eight of the selected companies provide sufficiently complete records

of their operational turnover, profit & loss, and profit margins. These discrepancies

could indicate reluctance by organisations to record the operational challenge of

generating sustainable profitability in this sector. It should be noted that these

accounting discrepancies could arise from particular standardised accounting practices

adopted by organisations operating in this sector.

This report posits that the financial analysis contained in this report presents a case for

arguing that the challenges, industry structure, operational, market, and financial

activities of large scale industry value system agents combine to create demonstrable

impediments towards positive financial, profit, and growth generation for independent

UK third party video game developers.

It would certainly seem that there is cause to assume that the limited profitability

generation presented in the selected organisations recorded financial reports affects the

long term competitive advantage, growth potential, and operational stability of

companies operating in the development sector of the video game industry.

This report argues that the existing publisher business model as well as other already

outlined market, operational, industry, and financial activities endemic within the video

game industry negatively affect the ability of UK video game developers to generate

and retain positive profits, growth opportunities, and sustainable competitive advantage

within the industry and the marketplace.

49

30/06/2005 12 months

(GBP)

30/06/2004 12 months

(GBP)

30/04/2003 12 months

(GBP)

Turnover (2003-2005 Average)

Profit (Loss) before

Taxation (2003-2005 Average)

Profit Margin (%) (2003-2005 Average)

Company 2 Turnover 869,084 2,052,938 868,714 1,263,579 Profit (Loss) before Taxation -267,782 143,866 -444,570 -189,495 Profit Margin (%) -30.81 7.01 -51.18 -25% Company 6 Turnover 4,021,903 4,695,720 4,278,166 4,331,930 Profit (Loss) before Taxation -599,905 303,369 -620,436 -305,657 Profit Margin (%) -14.92 6.46 -14.5 -8% Company 7 Turnover 9,639,555 18,372,000 7,572,491 11,861,349 Profit (Loss) before Taxation -6,188,839 548,000 183,338 -1,819,167 Profit Margin (%) -64.2 2.98 2.42 -20% Company 10 Turnover 3,629,650 2,263,583 2,378,931 2,757,388 Profit (Loss) before Taxation 205,649 -703,194 -84,875 -194,140 Profit Margin (%) 5.67 -31.07 -3.57 -10% Company 12 Turnover 2,972,832 4,814,655 4,286,132 4,024,540 Profit (Loss) before Taxation -44,498 695,774 254,596 301,957 Profit Margin (%) -1.5 14.45 5.94 6% Company 15 Turnover 7,755,225 4,867,081 6,120,829 6,247,712 Profit (Loss) before Taxation -215,975 -1,402,211 -603,399 -740,528 Profit Margin (%) -2.78 -28.81 -9.86 -14% Company 17 Turnover 4,079,333 3,628,515 4,160,116 3,955,988 Profit (Loss) before Taxation 63,589 38,702 219,082 107,124 Profit Margin (%) 1.56 1.07 5.27 3% Company 20 Turnover 2,533,918 3,868,882 1,570,999 2,657,933 Profit (Loss) before Taxation -386,379 1,172,425 -40,924 248,374 Profit Margin (%) -15.25 30.3 -2.6 4% Source: F.A.M.E.

Table 4.2 Selected UK Third Party Video Game Developers Financial Results Comparison, (2003-2005).

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5 PUBLISHER MODEL

5.1 The Publisher Model

“Right now this industry has a business model that does not work. This industry has been flat for the past six years; we've been selling games to the same people. Our revenue model is based on one shot at retail - we have no back-end revenue streams like a movie might in terms of DVD, TV, that type of thing." (The Game Industry Business Model Does Not Work, 2006)

For the purposes of this report the term ‘Publisher Model’ refers to the prevalent and

well documented business model whereby publishers and platform holders control the

majority of power, finances, and chain control (retail, distribution) within the video

game industry and general marketplace.

In terms of third party video game developers the publisher model specifically refers to

the common practice of self operated, fully functional, video game development

organisations, possessing the staff, skills, assets, technology, and support mechanisms

necessary to manufacture video game products, obtaining financial investment (via

milestone, royalty, and advance payments) to manufacture video game products under

contract for platform holder and publishers.

“Today, many if not most games, don’t make money, and small publishers often survive on the backs of just a single hit or two a year, if their lucky. Boost the average cost of production up to $10 million and it will be even harder to turn a profit. Analysts say that is almost certainly going to dampen publishers’ appetite for risk.” (Developers Uneasy About New Games Consoles, 2005)

Additionally the model implies that in return for the provision of financial investment

third party video game developers are expected to transfer full ownership of Intellectual

Property, assets, technology, R&D, code, and other rights to the platform holders and

publishers.

5.2 Failures in the Publisher Model

51

“Another challenging and fundamental issue for game developers is the ability to create long-term value in their companies. Typically, a game publisher will attempt to acquire all of the intellectual property rights developed by a developer in connection with a particular game project.” (Part II – The Economics of the Gaming Industry, 2004)

Third party video game developers are the weakest agents in the value system of the

video game industry. This weakness is demonstrated not only in their marginalised

financial share of overall profits but also in terms of the lack of overall strength, scale,

and scope of operations within value system activities of the video game industry. It

could be argued that this weakness is the biggest single failure of the publishing model.

Platform holders and publishers have become large consolidated industry agents

wielding considerable strength, power, and control of all operational activities including

direct (first and second party), indirect (third party) control, and oversight of

development companies, operations, and processes. Their control of finance and more

importantly the instruments by which they provide this finance (advances, royalty and

milestone payments) has marginalised the long term return of investment, profitability,

and growth potential of third party developers.

Additionally the financial and business practices associated with financing video game

development projects is a detrimental model with low royalty percentage rates, royalty

payments received only after milestone and advanced payments have been recouped

through sales, and the full scale signing over of all ownership to Intellectual Property,

project assets, and other rights. This model is thusly damaging to the overall portability,

operational success, and long term sustainable competitive advantage capabilities of

third party video game developers.

“The number of profitable titles per year could fall as low as 80, as developers and publishers are forced to focus on fewer and higher quality titles. The report also predicts continued industry consolidation and the demise of smaller publishers which lack viable growth strategies.” (Survey Analyzes Strategies for Publishing Success, 2005)

The publisher model fails to provide equitable or adequate revenue share from software

sales to allow independent video game developers the opportunity to grow, achieve long

52

term sustainable profitability, and competitive advantage. The publisher model has been

designed to perpetuate reliance on publishers (financial, marketing, advertising,

distribution, and retail chain access services) by independent video games developers

and enforces a very limited set of possible long term operational outcomes for

independent video game developers.

The limited operational pathways available to independent developers are;

Closure: developers can experience operational failure and closure.

M&A, Buyout: developers can be acquired in part or fully by a large scale platform

holder or publisher.

Continuation: developers can continue operating in a marketplace that is increasingly

suffering from the wide array of challenges outlined previously in this report.

It should be noted that there are precedents regarding publisher’s heavy handed use of

power, scale, financial share, and chain access (marketing, retail, distribution) in the

overall value system of the video games industry.

Recently a large number of the largest video game publishers have announced Securities

and Exchange Commission (SEC) reports stating that they are being investigated over

lawsuits relating to alleged backdating of stock options. Electronics Arts (1), Activision

(2), THQ (8), and Take-Two Interactive (10)16, all recently became involved in

investigations and/or lawsuits from shareholders regarding options backdating

allegations. (Gamasutra, 2006).17

Take-Two Interactive faces NASDAQ delisting over failure to file 10-Q quarterly

financial reports citing continuing stock backdating investigations as the main reason

for this failure to comply. (September, 2006). (Gamasutra, 2006).18

16 (#) Top Twenty Publishers Rank, Game Developer Magazine, (October, 2005). 17 EA Embroiled in Backdating Allegations. 18 Take-Two Faces NASDAQ Delisting Over Delayed Filing.

53

Also of note are precedents regarding publisher’s heavy handed use of power, scale,

financial share, and chain access (marketing, retail, distribution) in their direct dealing

with third party developers. Activision (2) was presented with a $10 million lawsuit

(2005) by independent developer Spark Unlimited producers of the Call of Duty: Finest

Hour hit video game. The lawsuit accuses Activision of gross misconduct including

breach of contract, fraud, and misrepresentation.

Spark alleges that over the two years since its foundation Activision induced Spark into

reducing and delaying certain of its rights under the contract so it could realise an even

higher level of profit on the sequels than it had on the original game. Activision refused

to pay Spark the royalties owed on Finest Hour or the bridge financing due under the

contract, stole Spark's idea, and then hired away Spark's own employees to develop that

sequel, hoping that if Spark was sufficiently crippled, Spark would be unable to protect

its rights.

It is also Spark's contention that rather than supply the $750,000 in expenses the

developer claims it incurred while implementing Finest Hour's multiplayer, it actually

charged Spark $1,882,920.97 for the implementation, which it deducted from the first

Finest Hour royalty payment Activision sent it in March 2005.

Spark also claims that "Activision charged Spark millions of dollars in developer

assistance costs that were not approved by Spark and that were never contained on any

amendment" to the developer agreement, including $300,000 in licensing costs "related

to the Activision Game Engine." (Activision Accused of Trying to "Kill Off" Indie

Studio, 2005)

5.3 Value Chain Analysis

A value chain analysis of an average third party video game developer detailing the

activities and organisational core competencies and weaknesses follows. (Table 5.1)

details an approximation of the average value added activities possessed by an imagined

typical UK third party video game developer throughout the value chain.

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Third party video game developers have structured their core competencies and

operational capabilities to allow themselves to operate within the demanding publisher

model and face the significant challenges in the sector.

Third party video game developers operate within a business to business environment

servicing the needs and commercial objectives of publishers and platform holders.

They have thusly focused on value chain activities that can provide value to those

business to business transactions.

So what are these activities and where have UK third party video game developers

structured and focused their value chain activities to benefit in the generation of profits?

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SUPP

OR

T A

CT

IVIT

IES

Firm Infrastructure

Mar

gin

Human Resource Management Recruitment Training Recruiting

Training

Technology Development

Tools Engine

Content Creation System

Content Management System R&D

CRM System

Q&A Systems

Procurement Product Specification

Planning Intellectual Property

Management Media Material Management

Project Management Client Relationship

Management Production Processes

Specialist Skills, Techniques, and

Technology

Milestone Deliveries Beta & Alpha Builds

Gold Master

Pitches Presentations

Demos

Q&A Fixes/Patches

Updates Additional Content M

argi

n

Inbound Logistics Operations Outbound Logistics Marketing & Sales Service PRIMARY ACTIVITIES

Table 5.1 Value Chain of Third Party Video Game Developer (Publisher Model).

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(Figure 5.1) present the value chain of a third party video game developer and the

following breakdown presents a detailed description of the separate activities developed

throughout the value chain that developers have adopted to face the operational

challenges and effects of the publisher business model and the development sub-sector

of the video game industry.

Value activities in the value chain can be divided into two broad types, primary

activities and support activities.

Primary activities are activities involved in the physical creation of the product and its

sale and transfer to the buyer as well as after sae assistance. Support activities support

the primary activities and each other by providing purchased inputs, technology, human

resources, and various firm wide functions. The dotted lines reflect the fact that

procurement, technology development, and human resource management can be

associated with specific primary activities as well as support the entire chain. Firm

infrastructure is not associated with particular primary activities by support the entire

chain. (Competitive Advantage, 2004:39).

Primary Activities

Inbound logistics: Activities associated with receiving, storing, and disseminating

inputs to the product.

Video game Developers need to be able to manage the inputs for a video game project

which are generally the clients complex specifications for complete video game

projects, (Product Specification Planning), explicit usage, specifications, and

instructions for licensed Intellectual Property (Intellectual Property Management), and

the management of media material that is created by platform holders, publishers, or

licence holders relating to their video game products (Media Material Management)

Operations: Activities associated with transforming inputs into the final product.

Most of a video game developers capabilities are structured around the production and

manufacturing of video game products. Core capabilities that developers have focused

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on to add value and create profits through these capabilities revolve around the

planning, management, technology, and processes involved in creating video game

projects for their publisher and platform holder client base (Project Management, Client

Relationship Management, Production Processes, Specialist Skills, Techniques, and

Technology).

Outbound Logistics: Activities associated with collecting, storing, and physically

distributing the product to buyers.

Video game developers have developed procedures than focus on providing value to the

milestone deliveries necessary to track video game project progress and the production

and delivery of the necessary beta, alpha and final gold master stages of product

development (Milestone Deliveries, Beta & Alpha Builds, and Gold Master).

Marketing and Sales: Activities associated with providing a means by which buyers

can purchase the product and inducing them to do so.

As video game developers operate within a business to business environment the core

capabilities that add value to their organisations is their ability to convince and inform

publishers and platform holder about their technical, creative, and production

capabilities. Developer do this by producing prototype products then presenting and

pitching these prototypes to various publishers and platform holders to obtain

development contracts (Pitches, Presentations, Demos).

Services: Activities associated with providing service to enhance or maintain the value

of a product.

Video game developers have developed services that test their products at various stages

of the production process. Developers are expected to support their video game in the

marketplace after launch and thusly produce additional software that fixes or patches

problems noted by publishers, platform holder, or consumers who use the products in

the marketplace (Q&A, Fixes/Patches). Developers will occasionally release additional

content and updates to their video games if market demand justifies additional expense.

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This additional content takes the form of new maps, gameplay features, characters, or

other video game material (Updates, Additional Content).

Support Activities

Technological Development: Technological development consists of a range of

activities that can broadly be grouped into efforts to improve the product and the

development process.

Developers need to invest operational resources into developing custom development

and content creation tools, game engines, and the tools necessary to produce,

manufacture, and track the development of video game products (Tools, Engine,

Content Creation and Management System).

Developers are required to invest heavily in ongoing R&D to maintain technologically

competitive sets of tools, processes, and technologies and keep ahead of technological

developments in PC and console hardware (R&D).

Developers need to invest in customer relationship management systems to maintain

communication links with and allow clients to track progress of large scale video game

project development (CRM System).

Human Resource Management: Human resource management consists of all activities

involved in the recruiting, hiring, training, development, and compensation of all types

of personnel.

Video game developers are required to invest heavily in recruitment and training

activities to support their large investment in operational activities (Recruitment and

Training). Training and recruitment activities are focused on the operations and services

areas of the value chain where most of the staffing requirements are located.

Inbound Logistics, Outbound Logistics, Marketing & Sales

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Video game development organisations do not require significant value support

activities throughout inbound logistic and outbound logistics as the primary

manufactured goods are digital in nature, and not in bulk quantities and thusly do not

require significant support activities in terms of marketing & sales resulting, inbound or

outbound logistics for operations within a business to business environment.

Direct, Indirect and Quality Assurance Activities

Every firm has direct, indirect, and quality assurance value activities. All three types are

present not only among primary but also among support activities. Direct activities are

directly involved in creating value for the firm. Indirect activities make it possible to

perform direct activities on a continuing basis. Quality assurance activities ensure the

quality of other activities. (Competitive Advantage, 2004:44).

(Figure 5.2) details the activity type of the primary and support activities detailed in the

value chain (Figure 5.1).

Of note is that primary activities relating to operations and secondary activities relating

to technological development provide the only direct contributions to organisation

value. This is not unexpected as the primary organisational role and capability

structuring focuses on the manufacturing, production, and development of video game

products. It stands to reason that third party video game developers would focus their

organisational capabilities on these activities.

It should also be noted that these direct activity types are very high cost and require

large investments in time, finances, staff, and resources.

As technical complexity and shortening market life cycles of console and PC hardware

increase so too do their affects on the cost, scale, and size of the associated direct

capabilities within a video game developer. More staff, more training, higher

recruitment costs, greater project management requirements are all necessary to scale a

organisations ability to develop commercially viable products. Technological

developments, R&D, and the tools and engines necessary to develop products also

increase in complexity, cost, and scale.

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Activity Activity Type Activity Location Product Specification Planning Indirect Inbound Logistics (Primary) Intellectual Property Management

Indirect Inbound Logistics (Primary)

Media Material Management Indirect Inbound Logistics (Primary) Project Management Direct Operations (Primary) Client Relationship Management Direct, Quality Assurance Operations (Primary) Production Processes Direct Operations (Primary) Specialist Skills, Techniques, and Technology

Direct Operations (Primary)

Milestone Deliveries Indirect, Quality Assurance Outbound Logistics (Primary) Beta & Alpha Builds Indirect, Quality Assurance Outbound Logistics (Primary) Gold Master Indirect, Quality Assurance Outbound Logistics (Primary) Pitches Indirect Marketing & Sales (Primary) Presentations Indirect Marketing & Sales (Primary) Demos Indirect Marketing & Sales (Primary) Q&A Quality Assurance Service (Primary) Fixes/Patches Indirect Service (Primary) Updates Indirect Service (Primary) Additional Content Indirect Service (Primary) Recruitment Indirect Human Resource Management

(Support) Training Indirect Human Resource Management

(Support) Tools Direct Technology Development (Support) Engine Direct Technology Development (Support) Content Creation System Direct Technology Development (Support) Content Management System Direct Technology Development (Support) R&D Direct Technology Development (Support) CRM System Direct Technology Development (Support) Q&A Systems Quality Assurance Technology Development (Support)

Table 5.2 Direct, Indirect & Quality Assurance Activities.

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6 CONCLUSIONS AND RECOMMENDATIONS

“It is important to realise that a growing market does not necessarily mean an opportunity to make money. It is easy to say that the game business will grow substantially, but much harder to say if the game business will become a more profitable industry.” (Shake-Up of Game Business Model is Coming, 2005)

6.1 Conclusions

“Our industry is led by highly intelligent and creative people, and more often than not, undisciplined managers, elevated to their roles through their demonstration of exceptional abilities relating to software development, not project management.” (Exploring the Business Side of the Business Side of Making Games, 2001)

Companies exist to generate profits for their owners. Additional operational motivations

range from economic, financial, personal, ethical, and moral factors that owners embed

into their organisational structure and operational activities.

It could be argued, based on observation, that this is the opposite case in most third

party video game developers, who seem non-concerned about long term profits and

possess a strange desire to remain in a non-profitable sub sector of the video game

industry.

Long term competitive advantage, profit generation, and overall profitability of third

party video game developers would seem to be a pipe dream for most organisations

under present industry conditions. Committing your organisation to operating in the

video game development sector would seem to entail a high risk, high work volume,

and high stress factors with little long term growth opportunities and profit generation

potential.

It would therefore seem that if third party video game developers are not in the business

of generating profits they must therefore have other motivations for remaining in such a

risk laden and financially destitute sub-sector of the video game industry.

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This report can only conclude that it is a combination of institutional inertia (i.e.

continuing a business practice because it has always been done that way), occupational

desirability (video game design is seen as a cool occupation), inability or unwillingness

to adapt new organisational behaviour, strategies, tactics, and business models that sees

video game developers continue to suffer at the hands of publishers, platform holders,

and the growing list of operational challenges.

It seems unlikely that video game developers are completely unaware of these

challenges and the detrimental effect of the publisher model on their operational

capabilities and performance.

It may be possible that they are aware of yet unable to respond to these challenges with

new business strategies, tactics, and business models. Possibly developers do not

process the necessary resources to successfully circumvent or penetrate exit barriers or

instigate wide ranging organisational changes.

Perhaps developers lack the necessary tools, strategic, and tactical capabilities, skills,

and knowledge necessary to realise the true effects of the publisher business model and

other challenges.

This report would argue that video game developers are managed primarily by owners,

operators, and mangers whose core skills sets are centred in the disciplines necessary for

the production of video games (programming, project management, art and design etc)

and not in the management of large scale media entertainment production organisations.

Criticism has been labelled against video game developers for their lack of management

skills. Publishers have placed a high value on business skills and profit generating

objectives. Video game developers, it would seem need to place a similarly high value

on their core objective that of making profits and placing a high value on tactical,

strategic, general business and management skills.

“A fresh look is needed by publishers, retailers, and platform holders to position the game industry as a real business with growth potential for the

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quickly changing, broadband media future. Someone’s got to make the first move, who will it be?” (How to Fix the Broken Games Business – The Retail Solution, 2006)

It is the conclusion of this report that UK third party video game development is on the

whole a risk laden, challenging, and unprofitable business activity.

Furthermore the challenges outlined in this report are placing increasing hardships on

profitability for independent developers. Those challenges will only increase in

difficulty and their long term detrimental effects will become more pronounced in the

future.

It is also the belief of this report that the existing publisher business model is

determinately to the long term sustainable profitability, competitive advantage, and long

term operational success of UK third party video game developers. The primary long-

term operational pathways that are open to the remaining independent developers are

seen to be;

Closure: developers can experience operational failure and foreclosure.

M&A, Buyout: developers can be acquired in part or fully by a large scale platform

holder or publisher.

Continuation: developers can continue operating in a marketplace that is increasingly

suffering from the wide array of challenges outlined previously in this report.

6.2 Recommendations

This report has gone into some depth regarding the challenges facing video game

developers, operating independently of publishers and platform holder. Surely there are

some strategies, tactics, and possible fixes for these challenges.

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Recommendations have been suggested that can be explored by third party video game

developers to increase their profitability, increase long term sustainable competitive

advantage, and reduce the risks inherent in working in this sector of the video game

market.

For the most part these recommendations are gathered from various existing sources

gathered through the research of this project. It is the objective of this report to present

solutions that have at least some measure of precedence or level of discussion with the

video game industry and associated media, literature and news sources at large. Thusly

these solutions and recommendations have at least in some part been referred to by and

within the video game industry.

Larger Share of the Royalty

“If funding is required, a publisher will pay the developer a non-refundable advance on anticipated royalties. Thus, once the game is released the developer receives no royalties until sales have exceeded the amount paid out in the advanced funding. However, the majority of titles fail to progress significantly past this level and many entirely fail to do so. The smaller the amount of funding required the higher the royalty that can be commanded and, of course, the sooner post-advance revenue can be attained. Should a title be completely self-financed, the royalty rate will be maximised and royalty revenues will commence with the first unit sold.” (Game Investor, The Publishing Process, 2006)

Development companies can explore opportunities that allow them to receive a larger

share of the royalty such as alternative sources of finances that allow them to cover the

cost necessary to develop of their own projects.

Self Funding

“The extent to which the publisher or distributor take on responsibilities such as the game's promotion, localisation, multiplayer server hosting etc…also affects the royalty rate.” (Game Investor, The Publishing Process 2006)

By way of a comparison of the profits that could be realised by self funding games

compared to the standard advance payments typically provided by publishers refer to

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(Table 6.1). As you can see developers that can afford to self fund or even partially self

fund a game stand to receive a much larger share of the overall return on profits.

Game funding After £2.5m advance Self-funded Ave. net w'sale price £14 £14 Royalty % 25% 40% Royalty £ £3.50/unit £5.60/unit Unit sales Receipts to developer Receipts to developer 150,000 (low) nil £840,000 300,000 (medium) nil £1,680,000 600,000 (high) nil £3,360,000 1,200,000 (super high) £1,700,000 £6,720,000 Source: Game Investor, (2006)

Table 6.1 Profit Comparison of a Video Game Product (Advance vs. Self Funded)

Alternative Funding Equity-funding: For those developers that cannot fund a new title from internal cash

flow and do not want to use publisher funding there is the alternative of seeking to raise

the funds needed to develop the title via external investors. This is usually done by

either issuing and selling new shares in the development company (thus diluting the

existing shareholders) but could also be done by creating a single purpose vehicle

(SPV). The SPV would retain the full intellectual property and royalty rights to the title

and since it would be this company that external investors invested in, there would be

no dilution of the core development company shareholders' holdings.

Debt Funding: A less common method of gaining the money to self-fund development

is by securing a loan. However, it is unlikely that a commercial bank would fund a full

development project (too risky) unless that company was both large and had a

substantial tangible asset base or consistent cash-flow (to use as security). However,

more creative use of debt is possible, especially where the money is secured from a non-

banking and thus more flexible source (e.g. from investors). More often than not, debt

raised from investors is in the form of convertible bonds (debt which can be converted

to new equity after a pre-set period).

“A more recently practised method of development funding is through the use of completion bond or gold-master funding. In essence, a publisher's publishing contract with a developer is used as security by a bank that provides debt finance to fund the development. Thus, it is the bank that pays the development

66

advance which it recoups (plus interest) from the publisher once the title's development is completed to the publisher's satisfaction. The advantage to the publisher is that development can be done off the balance sheet and is much lower risk (the publisher does not pay for titles that fail to meet their pre-agreed specification); the advantage to the developer is that it potentially allows them to command a higher royalty (they are essentially delivering a finished product); the advantage to the bank is that it earns interest on the money loaned. The bank will more often than not bring in a completion guarantor to whom the completion risk is transferred. It is a model that has been employed extensively in the film industry and, increasingly, within the games industry.” (GameInvestor, The Publishing Process, 2006).

Completion Bond/Gold Master Funding: Completion bond funding is a more

complex derivative of debt-funding. In essence, a publishing contract with a developer

is used as security by a bank that provides debt finance to fund the development. Thus,

it is the bank that pays the development advance which it recoups (plus interest) from

the publisher once the title's development is completed to the publisher's satisfaction.

The advantage to the publisher is that development can be done off the balance sheet

and is much lower risk (the publisher does not pay for titles that fail to meet their pre-

agreed specification); the advantage to the developer is that it potentially allows them to

command a higher royalty (they are essentially delivering a finished product); the

advantage to the bank is that it earns interest on the money loaned. The bank will more

often than not bring in a completion guarantor to whom the completion risk is

transferred. It is a model that has been employed extensively in the film industry and,

increasingly, within the games industry. A UK provider of this service for the video

game industry is Wise Monkey.

Co-Publishing: co publishing is a shared publishing agreement with the publisher or

platform holder where the developer takes on some of the financial responsibilities and

cost of the development process whilst gaining a larger share of the overall royalties.

Shared publishing also entails the developer covering some of the costs of publishing,

marketing, distribution, and other typical publishing activities.

Work for Hire: This is usually reserved for conversion work i.e. converting a game

from one platform to another. Because of the number of different games platforms,

there exists a market for companies that specialise in converting (frequently referred to

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as "porting") fully or partially developed games to run on other platforms. For example,

a publisher may want a version of an original PC game made for the Xbox. Because the

developers of the original game might have no experience of (or desire to do) Xbox

programming, the publisher commissions other developers to port the game to these

platforms.

Conversion work frequently involves heavily reduced royalty rates, capped post-

advance royalty quantities or no royalties at all (so the developer receives up-front

payments only). The challenge for the developer is far more technical than creative and

those companies that can keep to budget and schedule can secure a profitable existence

from such work.

Management Skills

"At 30 years of age, the games industry still suffers from an endemic lack of professional management compared to less mature industries such as the mobile telephony and the internet industries. The high number of bankruptcies - despite favourable market conditions - is testament to this fact. Games companies must complement their formidable creative and technological achievements with strong business planning and analysis in order to reap the benefits of the next phase of console market growth". (Survey Analyzes Strategies for Publishing Success, 2005)

Video game developers need to invest in top level management skills, employees, and

training. Hiring MBA and top level managers from other more profitable media

industries may go a long way towards shifting operational goals and bring fresh new

strategies, tactics, and business methods, models, and processes to the video game

development sub-sector of the video game industry.

Business Models

“Competition is only going to increase and if the established players do not pioneer new business models, someone else will.” (Shake-Up of Game Business Model is Coming. 2005)

68

It is apparent that the existing business model is favourable to the large scale platform

holders and publishers and significantly less favourable to third party video game

developers. As part of a larger scale organisational change strategy to move away from

the oppressive challenges directly resulting from the publisher business model it could

be conceivable to adopt a new business model entirely.

“The game industry is undergoing a radical shift that few game companies understood, and that game companies as we know them today would likely become extinct if they do not alter their business models to adapt, just as the dinosaurs died off when they could not adapt to whatever change it was that decimated them.” (AGC: Koster Says Game Industry Dinosaur Doomed, 2006)

During research for this project two possible alternative business models have been

discovered that could be explored as alternatives to the existing publisher business

models. These are commonly referred to as the Hollywood and Outsourcing business

model.

Hollywood Business Model

The Hollywood business model is the common name used to describe the process that

occurs when various participants (organisations, specialists, experts, and professionals)

band together to manufacture a movie or TV show. This model is widely adopted in the

TV and movie industries and has long been seen a panacea for the video game industry.

At its core the Hollywood model describes the process whereby a group of individuals,

organisations, financial backers, specialists, and agents come together around some

form of creative project usually a film script. The film script is typically owned by an

individual, organisation, or studio.

Once the script has received funding then a project development plan and budget is

agreed upon and any number of specialist contractors, specialists, actors, film crews,

post production/special effects companies etc. become attached to the project at various

stages each performing a core task and then disbanding again after the project is

finished.

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The Hollywood model’s main benefit is it allows for a small core team who owns the

core intellectual Property and posses the necessary skills to bring the other agents,

specialist, organisations to the project and manage that task. This model allows for

much smaller overheads for the small core team, and the retention of valuable

Intellectual Property.

In the context of a video game studio it would enable small teams to create a video

game based on unique Intellectual Property and then build a funding structure around

that Intellectual Property and then manage the recruitment and production of that project

by various specialist organisations, individuals, and contract agents.

This model is being experimented with in the video game industry. Most notably UK

independent video game developer Revolution has adopted this mode of operation

allowing for a small core team of experts to develop the Broken Sword 4 video game

through management of a UK third party video game development company, Sumo

Digital Media.

Outsourcing Business Model

The outsourcing business model describes the practice of outsourcing elements of

production normal tasked to internal production capabilities to an external producer or

production organisation. Typically outsourcing is applicable to production activities that

are labour intensive, high volume, and can benefit from the cost savings presented

through cheap labour forces.

In terms of the video game industry this can be understood to relate to labour intensive

tasks such as 3D modelling, animation, artwork, graphics, and certain programming

tasks. These tasks can be outsourced to low cost labour regions such as China and India.

The outsourcing business model provides the ability to create costs savings and reduce

local staff numbers and associated overheads by getting high volume labour intensive

production completed in lower wage economies.

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There is a significant attached management overhead along with the need for

technology and communication systems necessary to transfer and track the progress and

quality of the produced work. Language, communication, and Q&A issues are also

factors to consider in operational activities centred on the outsourcing business model.

The outsourcing model’s main benefit is it allows for a reduced core team who posses

the necessary skills to manage and oversee the outsourcing operation. Thusly the core

outsourcing management team would be high level specialist managers such as creative

directors and programming managers that would plan, oversee, and mange the

production, and quality control of the outsourced production process and the resulting

outputs.

This model is being experimented with in the video game industry. Most notably UK

independent video game developer Eutechnyx has adopted this mode of operation

allowing for a small core team of experts to manage the production of sizable amounts

of video game artwork using Chinese content creation companies.

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Game Investor contributors, (2006)

The Development Process

http://www.gamesinvestor.com/Business_models/Development/development.htm


Gurwin, D., A., (2004)

Part II – The Economics of the Gaming Industry.

http://news.pghtech.org/teq/teqstory.cfm?id=1276


International Game Developers Association, (2004)


http://biz.gamedaily.com/industry/feature/?id=13314&page=2�


http://www.gamesinvestor.com/Business_models/Publishing/publishing.htm�

http://www.gamesinvestor.com/Business_models/Development/development.htm�

http://news.pghtech.org/teq/teqstory.cfm?id=1276�

74

Developers Business Summit: An IGDA Think-Tank.

Jenkins, D., (2006)

EA Embroiled in Backdating Allegations



Kerr, A., (2003), Irish Communication Review, Volume 9.

Live Life to the Power of PS2: Locating the Digital Games Industry in the New Media

Environment.

Kerr, A., (2006)

The Business and Culture of Digital Games: Gamework/Gameplay.

Sage Publications, London.

Laramée, F., D., (2005)

The Game Industry and the Economics of Failure.

http://www.gamedev.net/reference/articles/article867.asp


Laramée, F., D., (2005)

Secrets of the Game Business, 2nd Edition.

Charles River Media, Inc., Hingham.

Minker, J., (2006)

Game Industry Business Model Does Not Work

http://www.gamesindustry.biz/content_page.php?aid=18929


Ofek, E., (2005), Harvard Business Review.

Home Video Games: Generation Seven.

Porter, M., E., (2004)

Competitive Advantage

http://www.gamedev.net/reference/articles/article867.asp�

http://www.gamesindustry.biz/content_page.php?aid=18929�

75

Free Press, New York.

Rogers, D., L., (2004)

The End Games: How Developers Sold Their Studios – Part One.

http://www.gamasutra.com/features/20040303/rogers_01.shtml

(Accessed August 20, 2006).

Screen Digest, (2005)

Game Software Publishing: Strategies for Market Success.

Schoback, K., (2005)

The Economies of a Next Gen-Game.

https://www.cmpevents.com/Sessions/GD/TheEconomics.ppt


Spector, W., (2006)

SXSW: Spector Talks Alternative Funding.



Thorson, T, (2005)

Activision Accused of Trying to “kill Off” Indie Studio

http://uk.gamespot.com/news/2005/08/30/news_6132290.html?sid=6132290


Vaughan, L., (2004), Stanford Graduate School of Business.

The Reality of Video Games

http://www.gsb.stanford.edu/news/headlines/2004futurentertainconf_videogames.shtml


Wallace, M., (2006)

AGC: Koster Says Game Industry Dinosaur ‘Doomed’



http://www.gamasutra.com/features/20040303/rogers_01.shtml�

https://www.cmpevents.com/Sessions/GD/TheEconomics.ppt�

http://www.gamasutra.com/php-bin/news_index.php?story=8519�

http://www.gsb.stanford.edu/news/headlines/2004futurentertainconf_videogames.shtml�

76

Wedbush Morgan Securities, (2006)

Entertainment Industry Report: Flirting with Disaster, Will Sony’s Battle with Toshiba

Determine the Outcome of the Console Transition?

William, J., F., (2002)

William’s Almanac: Everything You Ever Wanted to Know about Video Games.

Gazelle Books Services, Lancaster.

Wikipedia contributors, (2005)

Comparison of seventh-generation game consoles.

http://en.wikipedia.org/w/index.php?title=Comparison_of_seventh-

generation_game_consoles&oldid=67586138


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Video game console.

http://en.wikipedia.org/w/index.php?title=Video_game_console&oldid=68035311


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http://en.wikipedia.org/w/index.php?title=Video_game_publisher&oldid=66455722

(accessed August 23, 2006)

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(accessed August 24, 2006).

http://en.wikipedia.org/w/index.php?title=Video_game_console&oldid=68035311�

77

TERMINOLOGY

Computer Games

A computer game refers to a game that runs on general purpose computers, which are

capable of operating other applications besides computer games. The most popular

personal computers in the market today (2006) are the IBM compatible PC and

Macintosh manufactured by Apple.

Video Games

A video game refers to a game played on dedicated video game hardware called a

console. The game itself is usually controlled and manipulated using a handheld device

connected to the console called a controller. Each video game is usually contained on a

proprietary disc or cartridge, which are generally sold separately from the console and

each other. In order to play a specific game, you need the specific console for which it

was designed.

The most popular consoles in the market today (2006) are the ‘Sony PlayStation 2’,

‘Nintendo GameCube’, and the ‘Microsoft Xbox’. All major Console manufactures

have launched or are planning to launch a new generation of video game consoles (7th

generation). ‘Sony PlayStation 3’, ‘Microsoft Xbox 360’ and ‘Nintendo Wii’.

Seventh Generation Console (7th)

The seventh generation is an era in the history of computer and video game industry that

began towards the end of 2005 with the release of the Microsoft's Xbox 360. The

transition into the seventh generation will be fully underway in 2006 with the release of

new video game consoles from Nintendo Wii, and Sony PlayStation 3. Microsoft has

labelled this generation as the "HD Era”. Consoles in this generation are typified by

advanced technology (multiple CPUs, CPU, APU), graphic, audio, physics media and

content delivery enhanced with high-speed Internet access and dedicated game, media

and content delivery infrastructures.

78

APPENDIX I FINANCIAL RECORDS

30/06/2005 30/06/2004 30/06/2003 30/06/2002 30/06/2001 30/06/2000 30/06/2000 30/06/2000 12 months 12 months 12 months 12 months 12 months 12 months 12 months 12 months GBP GBP GBP GBP GBP GBP GBP GBP Company 1 Turnover Profit (Loss) before Taxation Net Tangible Assets (Liab.) 62,799 58,894 57,049 59,136 128,546 -7,664 Shareholders Funds 62,799 58,894 57,049 59,136 128,546 -7,664 Profit Margin (%) Return on Shareholders Funds (%) Return on Capital Employed (%) Liquidity Ratio 1.35 1.31 1.32 1.2 1.44 0.77 Gearing Ratio (%) Number of Employees Company 2 Turnover 869,084 2,052,938 868,714 Profit (Loss) before Taxation -267,782 143,866 -444,570 Net Tangible Assets (Liab.) 40,573 179,535 57,749 215,876 64,427 Shareholders Funds -285,929 -148,667 -306,557 81,763 29,694 Profit Margin (%) -30.81 7.01 -51.18 Return on Shareholders Funds (%) 93.65 -96.77 145.02 Return on Capital Employed (%) -660 80.13 -769.83 Liquidity Ratio 0.55 0.82 0.45 0.75 1.16 Gearing Ratio (%) n.s. n.s. n.s. 164.03 116.97 Number of Employees 43 53 30 Company 3 Turnover

79

Profit (Loss) before Taxation Net Tangible Assets (Liab.) 10 10 10 10 1 Shareholders Funds 10 10 10 10 1 Profit Margin (%) Return on Shareholders Funds (%) Return on Capital Employed (%) Liquidity Ratio Gearing Ratio (%) Number of Employees Company 4 Turnover Profit (Loss) before Taxation 681,986 1,072,829 1,651,681 Net Tangible Assets (Liab.) 3,299,799 2,707,551 1,692,019 427,338 170,286 -1,432 Shareholders Funds 3,283,904 2,691,922 1,657,852 411,462 156,069 -1,432 Profit Margin (%) Return on Shareholders Funds (%) 20.77 39.85 99.63 Return on Capital Employed (%) 20.67 39.62 97.62 Liquidity Ratio 2.95 2.09 1.38 0.93 0.35 0.46 Gearing Ratio (%) 23.23 30.65 58.45 3.86 9.11 Number of Employees 80 67 62 Company 5 Turnover Profit (Loss) before Taxation Net Tangible Assets (Liab.) -336,603 -407,505 -420,945 -531,827 -440,529 98,728 Shareholders Funds 704,655 601,462 470,458 336,015 114,483 266,039 Profit Margin (%) Return on Shareholders Funds (%) Return on Capital Employed (%) Liquidity Ratio 0.29 0.34 0.47 0.03 0.02 1.21 Gearing Ratio (%) 23.8 43.69 96.49 0.34 33.47 Number of Employees

80

Company 6 Turnover 4,021,903 4,695,720 4,278,166 6,784,233 5,546,863 3,757,849 Profit (Loss) before Taxation -599,905 303,369 -620,436 1,295,643 1,235,120 749,966 Net Tangible Assets (Liab.) 1,940,957 2,585,412 2,183,888 2,584,805 1,787,233 344,893 Shareholders Funds 1,940,957 2,540,292 2,183,888 2,568,689 1,679,045 988,768 Profit Margin (%) -14.92 6.46 -14.5 19.1 22.27 19.96 Return on Shareholders Funds (%) -30.91 11.94 -28.41 50.44 73.56 75.85 Return on Capital Employed (%) -30.91 11.73 -28.41 50.13 69.11 75.85 Liquidity Ratio 2.96 6.07 4.36 3.2 2.08 0.97 Gearing Ratio (%) 1.78 0.63 14.78 Number of Employees 122 109 114 111 92 Company 7 Turnover 9,639,555 18,372,000 7,572,491 Profit (Loss) before Taxation -6,188,839 548,000 183,338 Net Tangible Assets (Liab.) 2,486,338 4,475,000 3,555,411 69,851 51,415 100 Shareholders Funds 1,473,573 7,862,000 7,348,580 69,851 50,690 100 Profit Margin (%) -64.2 2.98 2.42 Return on Shareholders Funds (%) -419.99 6.97 2.49 Return on Capital Employed (%) -137.54 6.72 2.39 Liquidity Ratio 1.59 2.19 1.69 0.66 1.05 Gearing Ratio (%) 233.99 6.97 6.57 1.43 Number of Employees 251 354 115 Company 8 Turnover 656,757 341,292 384,364 Profit (Loss) before Taxation 27,132 -71,228 41,563 Net Tangible Assets (Liab.) -137,620 37,081 -172,391 -34,491 40,576 Shareholders Funds 432 59,377 -16,144 -43,276 28,210 Profit Margin (%) 4.13 -20.87 10.81 Return on Shareholders Funds (%) -168.06 164.59 147.33 Return on Capital Employed (%) -259.76 206.51 102.43

81

Liquidity Ratio 0.32 1.04 0.21 0.51 0.74 Gearing Ratio (%) n.s. 383.95 n.s. n.s. 154.2 Number of Employees Company 9 Turnover Profit (Loss) before Taxation 1,180,783 379,904 850,372 400,892 460,040 341,038 Net Tangible Assets (Liab.) 3,021,700 1,659,446 1,332,428 493,078 1,665,832 1,430,834 Shareholders Funds 3,021,700 1,659,446 1,332,428 493,078 1,665,832 1,430,834 Profit Margin (%) Return on Shareholders Funds (%) 39.08 22.89 63.82 81.3 27.62 23.83 Return on Capital Employed (%) 39.08 22.89 63.82 81.3 27.62 23.83 Liquidity Ratio 1.91 1.44 1.24 0.96 1.04 1.16 Gearing Ratio (%) 39.54 84.05 119.11 175.23 21.61 Number of Employees 217 185 175 132 93 80 Company 10 Turnover 3,629,650 2,263,583 2,378,931 1,734,972 2,079,205 1,612,996 Profit (Loss) before Taxation 205,649 -703,194 -84,875 105,687 138,498 156,226 Net Tangible Assets (Liab.) 51,068 -194,118 247,178 99,474 221,716 315,483 Shareholders Funds -31,543 -300,928 201,740 75,678 8,104 15,601 Profit Margin (%) 5.67 -31.07 -3.57 6.09 6.66 9.69 Return on Shareholders Funds (%) -651.96 233.68 -42.07 139.65 n.s. n.s. Return on Capital Employed (%) 402.7 362.25 -34.34 106.25 62.47 49.52 Liquidity Ratio 0.85 0.72 0.86 0.28 0.87 1.18 Gearing Ratio (%) n.s. n.s. 230.33 160.18 3,078.13 2,011.45 Number of Employees 69 69 55 55 49 37 Company 11 Turnover 159,738 Profit (Loss) before Taxation 62,777 Net Tangible Assets (Liab.) 144,118 95,031 29,083 39,915 3,220 Shareholders Funds 144,118 95,031 29,083 39,915 3,220

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Profit Margin (%) 39.3 Return on Shareholders Funds (%) n.s. Return on Capital Employed (%) n.s. Liquidity Ratio 1.15 1.16 1.05 1.13 0.78 Gearing Ratio (%) Number of Employees Company 12 Turnover 2,972,832 4,814,655 4,286,132 2,536,034 2,620,449 Profit (Loss) before Taxation -44,498 695,774 254,596 964,387 232,222 Net Tangible Assets (Liab.) 743,508 764,559 903,822 548,810 -315,195 -399,260 Shareholders Funds 728,119 715,184 863,538 458,428 -315,195 -399,260 Profit Margin (%) -1.5 14.45 5.94 38.03 8.86 Return on Shareholders Funds (%) -6.11 97.29 29.48 210.37 -73.68 Return on Capital Employed (%) -5.98 91 28.17 175.72 -73.68 Liquidity Ratio 1.33 1.16 0.77 1.25 0.63 0.56 Gearing Ratio (%) 2.11 6.9 4.66 19.72 Number of Employees 73 68 55 39 19 Company 13 Turnover Profit (Loss) before Taxation Net Tangible Assets (Liab.) 2,430,501 1,636,462 1,004,758 577,392 322,774 423,549 Shareholders Funds 2,414,801 1,636,462 1,004,758 577,392 322,774 423,549 Profit Margin (%) Return on Shareholders Funds (%) Return on Capital Employed (%) Liquidity Ratio 4.59 3.34 2.3 4.58 2.86 1.71 Gearing Ratio (%) 0.65 Number of Employees Company 14 Profit (Loss) before Taxation 95,870

83

Net Tangible Assets (Liab.) 17,605 Shareholders Funds 16,467 Profit Margin (%) 28.02 Return on Shareholders Funds (%) 582.19 Return on Capital Employed (%) 544.56 Liquidity Ratio 1.14 Gearing Ratio (%) 6.91 Number of Employees Company 15 Turnover 7,755,225 4,867,081 6,120,829 4,723,049 3,276,902 2,344,403 Profit (Loss) before Taxation -215,975 -1,402,211 -603,399 345,337 515,232 215,698 Net Tangible Assets (Liab.) -1,192,548 -976,573 400,322 889,050 612,740 191,256 Shareholders Funds -1,192,548 -976,573 391,322 888,721 616,611 237,300 Profit Margin (%) -2.78 -28.81 -9.86 7.31 15.72 9.2 Return on Shareholders Funds (%) 18.11 143.58 -154.2 38.86 83.56 90.9 Return on Capital Employed (%) 18.11 143.58 -150.73 38.47 80.43 90.9 Liquidity Ratio 0.52 0.62 0.98 1.93 1.98 1.24 Gearing Ratio (%) n.s. n.s. 353.31 12.97 14.45 23.79 Number of Employees 142 120 133 95 Company 16 Turnover Profit (Loss) before Taxation Net Tangible Assets (Liab.) 79,629 -108,712 -124,157 2 1 Shareholders Funds 19,966 40,709 35,843 2 1 Profit Margin (%) Return on Shareholders Funds (%) Return on Capital Employed (%) Liquidity Ratio 1.17 0.29 0.29 Gearing Ratio (%) 1,020.05 25.99 Number of Employees

84

Company 17 Turnover 4,079,333 3,628,515 4,160,116 2,598,597 2,967,126 Profit (Loss) before Taxation 63,589 38,702 219,082 108,778 140,855 Net Tangible Assets (Liab.) 1,133,159 1,030,131 927,732 724,857 209,684 161,052 Shareholders Funds 1,015,984 944,502 891,862 705,973 209,684 71,329 Profit Margin (%) 1.56 1.07 5.27 4.19 4.75 Return on Shareholders Funds (%) 6.26 4.1 24.56 15.41 67.17 Return on Capital Employed (%) 5.61 3.76 23.61 15.01 67.17 Liquidity Ratio 0.85 0.85 1.2 1.05 1.34 1.2 Gearing Ratio (%) 60.79 53.53 60.6 40.5 0.98 125.79 Number of Employees 74 76 79 COMPANY 18 Turnover 1,474,783 644,346 Profit (Loss) before Taxation 429,890 257,423 Net Tangible Assets (Liab.) 334,724 115,505 Shareholders Funds 331,669 112,318 Profit Margin (%) 29.15 39.95 Return on Shareholders Funds (%) 129.61 229.19 Return on Capital Employed (%) 128.43 222.87 Liquidity Ratio 1.25 1.49 Gearing Ratio (%) 0.92 2.84 Number of Employees Company 19 Profit (Loss) before Taxation Net Tangible Assets (Liab.) 250,485 266,731 334,857 554,717 650,149 462,243 Shareholders Funds 89,915 65,018 133,144 554,717 650,149 462,243 Profit Margin (%) Return on Shareholders Funds (%) Return on Capital Employed (%) Liquidity Ratio 3.33 6.63 2.47 6.49 6.73 1.96 Gearing Ratio (%) 178.58 310.24 151.5

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Number of Employees Company 20 Turnover 2,533,918 3,868,882 1,570,999 3,021,404 2,221,157 1,474,602 Profit (Loss) before Taxation -386,379 1,172,425 -40,924 834,403 262,060 112,093 Net Tangible Assets (Liab.) 941,047 1,205,951 886,252 915,420 305,130 103,070 Shareholders Funds 941,047 1,202,814 886,252 915,420 305,130 103,070 Profit Margin (%) -15.25 30.3 -2.6 27.62 11.8 7.6 Return on Shareholders Funds (%) -41.06 97.47 -4.62 91.15 85.88 108.75 Return on Capital Employed (%) -41.06 97.22 -4.62 91.15 85.88 108.75 Liquidity Ratio 3.35 1.99 1.76 2.02 1.56 1.12 Gearing Ratio (%) 0.45 2.41 5.39 Number of Employees Company 21 Turnover Profit (Loss) before Taxation Net Tangible Assets (Liab.) 176,738 35,915 Shareholders Funds 175,238 35,915 Profit Margin (%) Return on Shareholders Funds (%) Return on Capital Employed (%) Liquidity Ratio 1.26 1.24 Gearing Ratio (%) 0.86 Number of Employees Company 22 Turnover 3,053,203 2,670,933 1,674,477 6,071,759 Profit (Loss) before Taxation -675,990 224,234 185,808 -822,239 1,415,341 Net Tangible Assets (Liab.) 1,078,137 1,119,159 889,215 931,244 625,821 1,561,254 Shareholders Funds 856,640 781,792 432,482 431,244 125,821 814,275 Profit Margin (%) -22.14 6.96 -49.1 23.31 Return on Shareholders Funds (%) -78.91 28.68 43.09 -653.5 173.82

86

Return on Capital Employed (%) -62.7 20.04 19.95 -131.39 90.65 Liquidity Ratio 0.85 1.16 0.94 0.9 0.55 1.4 Gearing Ratio (%) 59.62 122.88 105.61 174.03 432.81 124.73 Number of Employees 76 70 56 56

Source: F.A.M.E. (2006).

Table 2.5 Profit Comparison of a Video Game Product (Advance vs. Self Funded)

87

APPENDIX 2 MANAGEMENT PROJECT PROPOSAL

U.K. 3RD PARTY VIDEO GAME DEVELOPMENT: BUSINESS MODELS,

OPPORTUNITIES, STRATEGIES AND TACTICS.

ALAN O’DEA

FULL TIME MBA

UB: 02009385

MBA Management Project Proposal

Bradford School of Management, 2005-2006.

88

Name: Alan O’Dea

Title: U.K. 3rd Party Video Game Development: Business Models, Opportunities,

Strategies and Tactics.

Supervisor: Dr Rana Tassabehji

Company: The Independent Video Games Association (www.tiga.org)

Submission: September 2006

Scope/Rational of Project

The U.K. video game industry is facing significant challenges. Development costs for

video games (PC and consoles) have risen dramatically in recent years. 3rd party U.K.

development studios cannot finance these development costs themselves, instead

relying on financial investment provided by video game publishers. In return for

financing, publishers expect development studios to sign over Intellectual Property

ownership rights of their game products.

The traditional “Publisher Business Model” (Game Investor, 2006) by which

publishers’ finance 3rd party developers in return for total Intellectual Property

ownership, control of distribution, marketing and supply channels and the majority of

profits is a detrimental business model.

Edit: Consequently 3rd party U.K. video games development may present itself as an

unprofitable business activity with most 3rd party U.K. development studios running at

an operational loss.

The project will review the current “Publisher Business Model” and evaluate its

strengths, weakness and effects on 3rd party U.K. development studios. The project

will investigate alternative business models “Hollywood Business Model” (C.

Grantham & J. Carr, 2002) and “Outsourcing Business Model” (A. Kerr, 2006,

89

Game Investor, 2006), opportunities, strategies and tactics as potential sources of cost

reduction, Intellectual Property retention and sustainable competitive advantage to

U.K. development studios.

The report will present a comparison of the advantages, disadvantages, strengths,

weaknesses and effects of the traditional “Publisher Business Model” and alternative

“Hollywood Business Model” and “Outsourcing Business Model” through a cross

sectional study of elements of the value chain (Porter, M., 1985).

The report will focus on the top ten 3rd party U.K. video game developers. These top

ten developers will be graded according to financial performance, staff levels, and

number of video game products in the marketplace and in development.

Research Questions

• Are 3RD party U.K. development studios financially profitable? • Is the existing “Publisher Business Model” advantageous/disadvantageous to

the sustainable competitive advantage and financial profitability of 3RD party UK developers?

• Is there a need/desire for alternative business models by 3rd party UK developers to drive sustainable competitive advantage and financial profitability?

• What are the financial and non-financial benefits, advantages, disadvantages, strengths, weaknesses, opportunities, cost savings, competitive features represented by the “Publisher Business Model” throughout the value chain of a 3rd party U.K. video game developer?

• What are the financial and non-financial benefits, opportunities, cost savings, competitive features represented by alternative models “Hollywood Business Model” and “Outsourcing Business Model” throughout the value chain of a 3rd party U.K. video game developer.

90

Methodology

The report will be an applied piece of business research. Exploring and analysing the

relevance, advantages, disadvantages, strengths and weaknesses of extent and

alternative business models to a group of 3rd party U.K. video game developers. The

research will be descriptive in nature, focusing on identifying, classifying and

characterising various business models and features therein. The reports will focus on

gathering quantitative and qualitative data in various forms. The report will follow an

inductive approach to gathering data and a positivistic methodology utilising such

tools as surveys, one-to-one interviews and cross-sectional studies.

The primary objective of the report is to explore the existing “Publisher Business

Model” and determine its effects on sustainable competitive advantage, financial and

organisational performance of 3rd party U.K. video game developers.

Primary quantitative and qualitative data will be gathered from the top ten 3rd party

U.K. video game developers through a combination of one-to one interviews, surveys

and cross-sectional studies. Secondary quantitative and qualitative data will be

gathered from various sources; financial reports, industry reports, extent academic and

industry literature.

This data will present an exploration of financial and non-financial advantages,

disadvantages, strengths, weaknesses and effects of the existing “Publisher Business

Model” using the value chain as a frame work to present the findings.

The value chain categorises the generic value-adding activities of an

organisation. The "primary activities" include: inbound logistics, operations

(production), outbound logistics, sales and marketing, and service

(maintenance). The "support activities" include: administrative infrastructure

management, human resources management, R&D, and procurement. These

categories will form the structure by which comparisons of analysis,

performance, advantage and disadvantage are presented in the report.

(Wikipedia, 2006).

91

The secondary objective of the report is to explore a number of alternative models

“Hollywood and Outsourcing Business Model” in comparison to the traditional

“Publisher Business model”.

The benefits, advantages, disadvantages and operational differences portrayed

throughout the various business models (Publisher, Hollywood, Outsourcing) will be

explored and presented through a comparison of component elements of the value

chain. Primary quantitative and qualitative data will be gathered from the top ten 3rd

party U.K. video game developers through a combination of one-to one interviews

and surveys. Secondary quantitative and qualitative data will be gathered from various

sources; financial reports, industry reports, extent academic and industry literature.

A tertiary objective of the report is to present a toolkit of alternative opportunities,

strategies and tactics for 3rd party U.K. development studios to assist in strategic

business decision making, Intellectual Property retention, sustainable competitive

advantage and cost reduction. These opportunities, strategies and tactics will be

gathered from primary sources such as one-to-one interviews and surveys and

secondary sources such as financial reports, industry reports, extent academic and

industry literature.

Methods (Positivistic)

• Cross Sectional Studies - Financial performance of top ten UK 3rd Party developers, Value chain analysis. (Quantitative).

• Surveys - Survey assessing advantages, disadvantages, strengths and weaknesses and affects of “Publisher Business Model” on sample companies and level of interest of alternative models within sample companies. (Quantitative and Qualitative).

• One-to-one interviews - A number of one-to-one with members of the sample organisation and video game industry in general to gather. (Quantitative and Qualitative).

Sample

To obtain a viable sample size for comparative, relevant and thorough analysis a

larger number of independent U.K. video game developers will be included in the

92

research gathering process than are present throughout the top ten UK companies.

Surveys and one-to-one interviews will be presented to as many 3rd party U.K. video

game developers as possible to increase the initial sample size and response rate of

surveys.

Literature Review

The literature review will cover academic material presented as required reading (text

books) through key modules of the MBA course and secondary material such as that

found on Metalib, Athens, lecture notes, library, internet and other knowledge and

learning repositories.

The literature review will cover a range of industry reading including the authors own

extensive library of texts, books, trade magazines, industry reports and other reference

material. The internet and industry trade websites will also provide material to the

literature materials under review for this report.

Data Sources

Primary Information

• Cross Sectional Studies • Surveys • One-to-one interviews

Secondary Information

• Publications - Video Game Industry literature material. • Publications - MBA Module Reading Material. • Publications - Trade press, magazines, reports. • Publications - Industry, market, sector reports. • Websites - Industry, trade, market, reference. • Resources - Metalib, Athens, FAME.

93

Aspects of MBA Syllabus Used

The project will involve aspects of the core courses in Strategic Management,

Advanced Strategic Management and the electives Strategic Technology and

Innovations Management and Intellectual Property in International Business.

Access to Industrial Primary Research Sources

TIGA’s membership and representation spans the entirety of the video game industry

in the U.K. As the premier trade association representing independent video game

developers in the U.K. they can provide access to the necessary sample of 3rd party

U.K. video game developers. This will have benefits to obtaining access to relevant

industry professionals and also help increase the repose rate to surveys during the

research gathering and capture part of the project.

94

Proposed Chapter Headings

Introduction

• Introduction • TIGA • Project Background • Terms of Reference • Project Methodology

Addressing the Issues

• The Need for Solutions, Not More Problems • The Next Generation of Video Games Hardware • Problems Facing UK Developers • Failures in the Traditional Publishing Model • Why seek Alternative Business Models

Industry Analysis

• Industry Analysis • Global Market Analysis • UK Industry Contribution • Major UK Developers & Products • Performance Analysis (UK Developers” Top Ten”)

Market Analysis

• Market Analysis • Industry Structure • Publisher Model • Strengths and Weaknesses • Effects on UK Developers • Publisher Model Value Chain

Developer Analysis

• Operational Structure • Operational Costs • Strengths and Weaknesses • Financial Dependence

95

• Intellectual Property Ownership • Skills, Capabilities, Services Deficiencies • Marketplace Servicing Strategy

Alternative Models

• Why use Alternative Models • Hollywood Model • Strengths and Weaknesses • Outsourcing Model • Strengths and Weaknesses • Advantages and Disadvantages • Value Chain

Supporting Activities

• Cost Reduction • Distribution Methods • Alternative Revenue Streams • Alternative Financing Streams • Financial Investment • Tax & R&D Credits • Advertising • Operational Activities • Strategic Change • Value Chain • Marketplace Service • Strategic Management • Intellectual Property Retention

Conclusions and Recommendation

• Conclusions • Recommendations

Appendices

Bibliography

96

Work Program

97

Bibliography

Games Investor, “Publishing: The Publishing Business Model - Higher risk/reward”

http://www.gamesinvestor.com/Business_models/Publishing/publishing.htm

(accessed May 1, 2006).

Games Investor, “Outsourcing’s Time Has Come”

http://www.gamesinvestor.com/Thinkpieces/Outsourcing/outsourcing.html (accessed

May 1, 2006).

C. Grantham and J. Carr, (2002), “Consumer Evolution” Hoboken, John Wiley &

Sons.

A, Kerr, (2006), “The Business and Culture of Digital Games” London, Sage.

Hyman, Paul, “Game developers mull 'Hollywood model'

http://www.thehollywoodreporter.com/thr/columns/video_games_display.jsp?vnu_co

ntent_id=1000799264 (accessed May 1, 2006).

the publisher business model and uk third party video game development: challenges, effects,...

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