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In the interest of playing devil’s advocate, I thought I’d throw out 10 reasons why free to play might be slower to succeed in the Western world as it has been in Asia.

While I don’t necessarily believe all of these will inhibit F2P’s growth, one of the slides in my GDC presentation this year is to do with the challenges F2P faces – so this should help fulfill that requirement.

1. Virtual Property “Ownership”

The term ‘virtual’ may not have a strict legal interpretation, but if anything it means that the thing being described is NOT whatever comes after the word ‘virtual.

– Ginsu Yoong, Second Life’s legal counsel, Linden v Bragg

Despite virtual property’s ill-defined legal status, developers have had no qualms about starting byzantine in-game economies driven by the exchange of real money for virtual land, clothing, furniture and much more.

Some developers, like GoPets CEO Eric Bethke, have attempted to get out in front of the virtual property legal issue by defining their own “Avatar Bill of Rights.” But most of us have not been as proactive and instead seem content to leave it up to the courts to decide how to define and deal with our users’ virtual property.

As precedents regarding virtual ownership are set, the growth of some F2P products may be curtailed as the legal burden of dispensing virtual property increases.

2. Slow Broadband
On the issue of net speed, there remains a huge disparity between North America’s broadband ISPs and Korea’s military-grade internet provision.

The net effect is that free to play games like Maple Story can take 1-3 hours or more to download in North America, while Korea’s 45mbps network cuts the same download to a paltry 10 minutes or less.

It’s fair to say that we won’t soon be getting such high download speeds – but the North American market might have already found a way around the issue. With the launch of streaming game services like InstantAction and the proliferation of Flash as a full-blown development platform, downloading entire game clients become less and less the norm.

3. Poor Advertising Strategies
Some products in the F2P sector have come to rely heavily on advertiser support in order to keep their offerings free for the majority of players.

A recent OMMA article that claims advertisers are taking the wrong approach when handling virtual worlds. And as the populations of virtual worlds appear to be prematurely plateauing, advertisers may be starting to sweat.

But there is hope if advertisers change their strategies to suit the unique challenges virtual worlds present. As Worlds In Motion put it:

…themed events, branded avatar clothing, and representative personality appearances are finding success and opportunity in worlds like There, Habbo and vSide.

4. MMO Overload
From Maple Story to Silkroad Online, there is no shortage of MMOs in the free to play space. In the same vein, there is an abundance of virtual worlds such as Second Life or Kaneva. It seems as though the vast majority of new free to play game since 2005 have been virtual worlds or MMOs.

Perhaps it’s the very reason that these games have proliferated in the free to play market; MMOs and virtual worlds are inherently more inclusive than an FPS. Still, it would be a shame to see the free to play space flounder due to constant reiteration of the same genres and themes, turning away players seeking a different experience.

Of course, games like Kwari are looking to change that, but it’s too early to tell just how well they will catch on.

5. Rising Development Costs
With more prominent developers announcing plans to take advantage of the free to play model, the days of games fueled by ramen noodles and nights in the basement could, once again, be history. EA’s upcoming Battlefield Heroes is the latest big budget free to play game, signaling that the big publishers aren’t content to sit back and let Far East imports eat their lunch.

If the consumer makes the jump from 2D to more advanced 3D graphics, it could mean the end of the visually rudimentary worlds and Flash-based free to play games as market leaders, making way for the mainstream big budget games.

6. Second Life Slowdown
Second Life is the Apple Newton of virtual worlds. It was here first, but isn’t the best representation of the potential of virtual worlds. However, it still occupies a place in investors’ minds – akin to a coal mine canary, warning of impending danger.

And while investors took note as Second Life soared to the top, they’re noticing its decline as well (active user hours were down 5% in November). There is concern among some that Second Life’s time might be up, and that’s not a good sign for potential investors in the free to play space.

7. Watered Down AdverWorlds
With their lower barrier to entry and great potential to spin money, an slew of less innovative products are beginning to hit the market. Hardest to ignore are adverworlds like Build-A-Bear, Rush Zone, BeBratz, BarbieGirls and their ilk – marketing spend thinly disguised as entertainment.

The consumer’s willingness to pay money for virtual items in a world where their avatar is little more than a target for advertising will be tested by products like these.

8. Unsanctioned Secondary Markets
Then there’s the issue of gold farming. With websites like IGE operating independently of game developers and establishing secondary markets for game currency and items, it’s not just traditional MMOs that are being subjected to this kind of treatment anymore.

What’s worse, while gold farming might fuddle with World of Warcraft’s player-driven economy, some developers believe a secondary market allows players to skip the middleman altogether – a potentially fatal issue for free to play games who survive on item-based revenue streams.

The recent launch of publisher-sanctioned Live Gamer is a step in the right direction for devs and pubs looking to reclaim lost revenue.

9. Limited Payment Methods

We have hanging on our wall a user who sent a $5 bill in a $15 fedEx package.

– Craig Sherman, Gaia Online

While other territories enjoy a plethora of tailored-to-the-consumer payment methods, North America has embraced relatively few.

SMS would surely be nearly as popular a payment method here as it is in Europe if our carrier surcharges weren’t in the range of 50% a transaction. Landlines – an expensive but very secure payment option in China – might also be popular with some services.

GoPets has 90 different payment systems worldwide, catering excellently to foreign payment preferences. Nonetheless, consumers still have trouble getting money into their favorite North American games.

10. Kids Only Games
The current offering of free to play games caters nearly exclusively to the under-25 set. An NPD study released last year showed that while 91% of online gaming among kids aged 2-17 is free to play, by the time those kids graduated high school, the boys had moved to sixty-dollar console games and the girls dropped out of gaming entirely.

In the core gaming arena, Nintendo has found a way to appeal to young and old alike. Free to play’s appeal among adults relies on the proliferation of products that do a Nintendo-quality job of bridging the age gap or target older demographics only.

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From a Fortune article, EA CEO John Riccitiello had this to say about the free to play business model and how it will affect traditional retail games.

Riccitiello says the $31 billion gaming industry will suffer if it doesn’t start to reevaluate its business model. Game executives at Sony (SNE), Microsoft (MSFT) and Activision (ATVI) must answer some tough questions in the coming years, like how long they can expect consumers to pay $59 for a video game. Riccitiello predicts the model will be obsolete in the next decade. [Ed: emphasis mine]

“In the next five years, we’re all going to have to deal with this. In China, they’re giving games away for free,” he says. “People who benefit from the current model will need to embrace a new revenue model, or wait for others to disrupt.” As more publishers transition to making games for online distribution, Riccitiello says he expects EA will experiment with different pricing models.

As a colleague just said to me in an email, “It’s encouraging to see they (EA and big publishers as a whole) recognize the issue”.

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Motley Fool has a good wrap up of Shanda’s just released Q2 numbers. I’ve included a couple quotes from the article below.

Further to my previous article on the potential acquisition costs of the Asian F2P leaders, Shanda seems already unaffordable for all but the most well-heeled Western suitors.

Revenue soared 39% to hit $74.1 million in the second quarter. Earnings, before a one-time gain related to the company’s sale of its stake in SINA (Nasdaq: SINA), soared 78% to $0.42 per American depositary share (ADS).

Wall Street was expecting the company to earn just $0.36 per ADS on $72.4 million in revenue. The pros have been perpetually humbled by Shanda. This is now the fifth consecutive quarter in which the company lapped the market’s profit targets by at least $0.06 per ADS.

And most interestingly:

Yes, China’s online gaming market is getting crowded, but just three players — NetEase (Nasdaq: NTES), The9 (Nasdaq: NCTY), and Shanda — account for roughly 60% of the market. [Ed: emphasis mine]

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Last month my family traveled to London, a city of less than 500,000 in Southwestern Ontario. While there, I watched my 7 and 13 year old cousins, Brad and Kyle, play games on their family computer.

Somewhat surprisingly, Brad and Kyle had just one retail PC game between them (Settlers). Instead, their favorite games were Puzzle Pirates, Habbo Hotel, and Runescape – all free to play, virtual item sales games (with the exception of Runescape, which uses tiered subs rather than virtual items for its revenue).

What does this say about where the North American PC market is headed?

Based on overwhelming anecdotal evidence, it’s clear to me that the younger set (under 20) is embracing free to play and virtual goods games because the budget and engagement model is tailored made for for them. And as the younger set is further weened on the same virtual goods business model that’s already dominating Asia, retail only pay-to-play PC games will be ignored en masse.

In some respects, North American companies have begun adjusting to the F2P/virtual goods wave. With gifting sites like Facebook and HotorNot.com, microtransaction services like Xbox Live and casual MMOGs like Puzzle Pirates, one might argue that we’re at least keeping up with the pack in this emerging space.

But what are traditional North American game publishers (EA, Activision, etc) doing to adjust to this new, non-retail, online-centric business model? Are they seeding their own internal virtual goods projects? Building virtual goods into their existing or upcoming products? Acquiring early movers in the space?

At least right now, the answer appears to be “none of the above”.

North American game companies are taking the same “partner and acquire” approach that they’ve used to achieve growth and purchase innovation for the last two decades. When done correctly, this approach pays off handsomely. Activision partnered with Infinity Ward to produce the first Call of Duty, then opted to purchase the developer for a meager $5M just before Call of Duty 1 shipped. Activision knew that when CoD became a big hit, Infinity Ward’s asking price would grow immensely due to their successful IP.

In another bit of foresight, Take Two bought Irrational in 2005 for just $8.2M. Last week, Irrational delivered Bioshock – the highest rated new IP in years. If Irrational were for sale today, their asking price would likely be 5-10x what they sold for.

But studios with already successful IP (or a track record that indicates their next game will be huge as well), command a larger acquisition premium than the aforementioned deals.

For example:

IP Acquisitions

Track Record Acquisitions

But an even larger premium is paid for companies that couple good IP or a good track record with an online-only distribution model.

Online Acquisitions

Why the higher acquisition premium? Because online-only companies such as Club Penguin, Shanda, Netease, etc routinely see annual profit margins of 50% or more.

Look no further than Club Penguin making $35M profit on $65M annual revenue.

By contrast, retail game sector margins have been in decline ever since the last big reduction in costs: the move from carts to CDs in the mid-90s. Development and distribution costs have risen so dramatically in the last two console generations that EA’s net income has declined 87% since 2004, Take Two has lost $90M total over the last six years (50M units of GTA sold and still a loss?), and Ubisoft and THQ are considered a profitability leaders at nearly 10% annually. *

So it’s no wonder that deals like Disney/Club Penguin and EA/JamDat have much higher valuations than their retail counterparts. They have a far better ROI.

But let’s get back to my point: the “partner & acquire” approach Western companies have traditionally used to internalize innovation will likely prove cost prohibitive as it’s being applied thus far in the virtual goods space.

Some of the recent virtual goods partnerships made by publishers include:

These are all great relationships, but they are bridging strategies primarily suitable for the short to medium term. The acquisition portion of these partnerships would be cost prohibitive. Which North American game publisher would be able to afford the acquisition cost of a Nexon or Shanda based on the latter companies’ very healthy margins and rapid revenue growth?

Let’s use Shanda and THQ’s most recent Q1 2007 results as an example.

THQ (Q1 2007)

  • Gross Revenue: $139M (down 12% from previous year)
  • Profit: -$10M (net loss)

Shanda (Q1 2007)

  • Gross Revenue: $68.8M (up 61% from previous year)
  • Profit: $58M

Western companies have huge revenues, but even huger development costs owing to their terrestrial products – resulting in little or no profits. Eastern companies have smaller (rapidly growing) revenues, huge profit margins from online only distribution and a big head start on virtual goods. This contrast holds more or less true for most of these Western/Eastern partnerships.

Shanda’s market cap today is $2B. It’s not far-fetched to assume their purchase price might be close to $3B. The only companies with that kind of cash on hand are EA and Microsoft.

While it could be a partial stock deal, why would Shanda would trade their high growth stock for low growth publisher stock? Any partial stock transaction would ultimately result in a higher overall purchase price.

Netease (NTES) has a market cap of $2.06B. The9’s (NCTY) market cap is $1.14B. Nexon is privately held, but with $235M in revenue two years ago, they won’t be cheap either. The point is, there aren’t many deals left among the virtual goods establishment.

The billion dollar question is: Where will these numbers be next year? Or in 2-3 years?

My gut says that in two years, North American companies will be “priced out” of acquiring a leadership position in the global virtual goods market.

To avoid this fate, big American publishers need internally developed/wholly owned virtual goods projects or partnerships with newer, smaller virtual goods companies whose acquisition costs are far below the big Asian players such as Shanda, Netease, Nexon, The9, NHN, etc.

So…

  • When will we see early stage virtual goods startups acquired by game publishers in massively undervalued deals a la ATVI/Infinity Ward? Are the big publishers even capable of spotting these deals as well as venture capitalists? Companies like Conduit, Three Rings and Areae would be prime targets for early acquisition if VCs like Charles River and others weren’t already all over them. Venture capital’s eagerness to fund low risk/high margin virtual goods plays (and not high risk/low margin retail game companies) will drive innovation in the sector, ratcheting up acquisition costs for publishers are late to the party.
  • When will we hear of internally developed virtual goods projects underway at major publishers? Perhaps EA and Ubisoft’s new casual games focus will bring about the next big Flash MMO or virtual world, but I can’t help but think most of their attention is still on on the try-before-you-buy $20 casual games, rather than F2P/virtual goods. Ironically, some of the biggest stateside-initiatives in free-to-play are coming from Asian companies like Sony Online (FreeRealms) and NCsoft (Dungeon Runners).

Until we see big American publishers announcing more than stop gap Asian partnerships, I’m concerned that the next generation of gamers – my cousins Brad and Kyle in London, Ontario – will be playing even fewer games from today’s North American publishing giants.

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Notes:

* For more of these numbers, check out the GAAP financials for big publishers using this link to EDGAR, then enter a stock ticker like ERTS to get to a 10-K form like this one for EA. Search for “statements” or “2004” and keep going until you get a table with last five years or so, then check out the net income row.)

The following 10 revenue models allow some or all of their associated game or virtual world to be played for free. The ordering is quite unscientific and I’m sure I’ve missed something obvious or messed up a detail. I leave it to the internet to correct me.

1. Virtual Item Sales
A well familiar revenue model first established in Korea and now the dominant model in Asia. Nexon – makers of KartRider, MapleStory, Audition and more – are widely seen as the leaders in this area, doing $230M of gross revenue in 2005 (the most recent year for which they’ve released figures), with 85% of that revenue coming from virtual item sales.

Virtual item sales is the practice of allowing users to purchase functional, decorative, or functional & decorative in-game items for use in and out of gameplay. A virtual item system usually uses two currencies – an attention currency (users earn virtual money via in-game activities) and a real money-based currency (users buy virtual money using real money). Typically, 5-15% of users opt for the latter currency and the influx of real world money is what provides the virtual item sales revenue stream.

What’s so compelling about virtual item sales is the unlimited ARPU (average revenue per user). According to Daniel James, CEO of Three Rings, some hardcore Puzzle Pirates users have poured more than $10,000 apiece into the game via virtual item purchases. To reach that contribution level via a World of Warcraft-style $15/month subscription would take a user 55 years.

While extremely shaky sources peg the overall size of the virtual item sales market at $1.5-2B this year, without an NPD-esque measurement organization there’s no way to verify that number.

2. Subscription Tiers
Runescape, the Java MMO from Jagex, is one of the leaders in the tiered subscription space. A tiered subscription model allows users to play the core game for free, but those that desire access to elite weapons or other game content, must pay a small ($5/month) subscription fee. Over 1 million of Runescape‘s 6+ million users have opted into the tiered subscription program, grossing $60M annually for Jagex.

Dungeon Runners, an NCsoft free to play MMO, offers a similar $5/month subscription package that affords players access to the elite items, a bank and the ability to stack potions. It also gives subscribers server queue priority.

3. Advertising
Several different forms of game-related advertising revenue streams have popped up in recent years. Firms such as Massive, IGA and Double Fusion do big business in in-game advertising for clients such as EA, Activision, THQ and Microsoft. Game ad agencies typically serve up static ads (ads that ship with a product and never change) or dynamic (ads that are updated in real time via the net) within game products that are contextually appropriate for advertising (i.e. sports, racing, or contemporary shooters).

The size of this conventional in-game advertising market is currently pegged at $100-200M, according to well-placed industry sources. However, the number and quality of games with dynamic advertising enabled is escalating dramatically. So much so that Yankee Group predicts the in-game ad market will reach $732M by 2010.

But other, more emergent forms of in-game advertising have been at the forefront of enabling free to play. Examples include:

4. Real Estate or “Land Use Fees
Second Life is the biggest legitimate player utilizing this revenue model whereby virtual land is sold leased to individuals. Monthly lease fees range from $5 to $195, depending on the size of land in question. Users may also purchase their own island for a one time fee of $1,675 in addition to a monthly fee of $295.

Approximately 70% of Second Life’s revenue comes from land sales and maintenance fees. Of course the virtual land ownership revenue model doesn’t come without headache, as the Bragg vs Linden suit has proven.

Entropia Universe uses land auctions as a revenue stream, but a recent headline-making $100,000 land sale has been called into question as the successful bidder is an employee of Entropia‘s developer, MindArk.

5. Merchandise
In what’s become a phenomenon of Furby proportions, Webkinz plush toys and their associated Webkinz World have taken the pre-teen set by storm. Users purchase a $15 Webkinz plush toy at retail and enter a secret code to activate the associated virtual character in Webkinz World. Beyond the retail plush toy purchase, there are no additional fees for playing in Webkinz World.

Two million Webkinz toys have been sold since April 2005, with more than 1 million of those users registering their pet online. That’s more than US$20M in retail sales in just 24 months. Products such as Bratz/Be-Bratz are quickly jumping on this bandwagon.

Another successful merchandise-based revenue model is collectible card games, or CCGs. Neopets launched a CCG in 2003 and just this week MapleStory became the latest free to play game to go this route, announcing a partnership with Wizards of the Coast. Consumers purchase real-world MapleStory collectible cards that come with codes redeemable for exclusive in-game content in the MapleStory MMORPG.

6. Auctions & Player Trades
In June 2005, Sony set up Station Exchange on select Everquest II servers. Station Exchange facilitates player to player trade of in-game items – including the provision of an escrow service – in return for a 10% closing fee as well as listing fees ranging from $1 (items and coins) to $10 (characters).

While Station Exchange recorded only $274K in net revenue in its first year of limited release, it was enough for Sony Online President John Smedley to declare it the future of RMT. Read the SOE Station Exchange whitepaper for more.

Entropia Universe – a world in which virtual items actually decay with use and require real money to repair or replace – utilizes first party auctions as their primary revenue stream. This means that instead of merely facilitating player to player auctions and taking a cut (a la Station Exchange’s eBay model), Entropia auctions items directly to their players.

Entropia items sell for ludicrous sums, with rare weapons auctions closing at $26,000, land auctions for (allegedly) $100,000. The May 2007 auction of five in-game banking licenses brought in $404,000, total. Ironically, Entropia takes no fees for player-to-player auctions.

In the wake of this success, watch for third party virtual item auction houses such as Dan Kelly’s Sparter.com to offer developers and publishers a cut to ensure the (exclusive?) cooperation of their products.

7. Expansion Packs

The best known example of expansion packs as a primary revenue model is the Arenanet product, Guild Wars. Likened by Richard Garriott to a series of fantasy novels, Guild Wars relies not on monthly subscription fees for its revenue, but on the sale of successive expansion packs for $29.99.

The game’s creators argue that the thin-pipe origins of their technology allow their game to be run far more economically than competing titles, enabling this no-subscription free model.

Over 3 million people have purchased the previous three Guild Wars products (Guild Wars, Guild Wars: Factions and Guild Wars: Nightfall) with those numbers set to surge again with the release of Guild Wars: Eye of the North on August 31, 2007.

8. Event or Tournament Fees
Netamin’s free to play, ad-supported Ulimate Baseball Online uses event fees as an additional revenue stream. UBO‘s Pay to Play tournaments cost $5 per player to enter and offer cash prizes up to $4,500.

Shot Online, a free to play/virtual item sales golf MMO, also charges users to enter tournaments.

Third parties such as Valve’s Tournament.com and Groove Game’s Skillground.com are getting into the pay to play tournament scene as well. These sites charge charging entry fees for game tournaments for games such as Half-Life 2 and Counter-Strike.

9. TrialPay
At the recent Virtual Goods Summit and again at the Seattle Casual Games Conference, I bumped into representatives from TrialPay. TrialPay is a third party facility that allows customers to pay for products (i.e. games) by trying or buying from advertisers.

What this means is that when you go to pay for a casual game or purchase virtual currency, you can instead select from a demographically targeted list of special offers. Trying or buying one of these offers – from merchants such as Avis, Geico, Vonage, etc – allows you to get your game purchase for free, as the offer merchant has paid the game provider for acquiring a new customer on their behalf.

TrialPay claims that this allows game developers to earn more per user, as some offers pay game developers upwards of $50 per user (as opposed to the $20 a casual game might normally charge).

Someone from TrialPay can jump in and give me a more relevant example of their system’s use in the game space, but all I could find was a casual games company called Dreamquest Games.

10. Donations
Clocking in at last on the list is of alternate revenue streams is player donations. Raph Koster recently blogged about meeting up with the Kingdom of Loathing guys at ComicCon in San Diego. Raph reported that while KoL‘s revenue is “definitely indie,” their primary revenue stream of player donations is a sustainable one.

According to Wired, the donation revenue has allowed creator Zack Johnson to quit his day job and hire six employees to help improve and maintain the product.

That’s what Maid Marian founder Gene Endrody would call a “lifestyle business,” but I suspect most of us wouldn’t scoff at it or any of the above revenue models.

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Play No Evil offers up a good article breaking down why Free To Play is a superior engagement model to subscription or retail. Matt Mihaly from Iron Realms jumps in to offer a counterpoint on MapleStory’s user base (i.e. 57M is a gross number, not representative of active users) and offer up Habbo Hotel as another North American virtual item sales success story.

In regard to Maple Story’s user base, all 57M of them may not be active, but most of them are probably unique due to the fact that in China and South Korea, Maple Story requires users to enter their Social Security Number to sign up. So there likely aren’t very many duplicates, world-wide.

Regarding Habbo’s numbers, Paul Thind (Habbo’s GM) reported their active uniques at 7.5M world-wide (1.7M uniques/month) at last month’s Virtual Goods Summit. Habbo’s annual revenues sit north of $65M.

From the article on Play No Evil, I especially like this passage:

The choice of prices are important. Buying blocks of currency or subscriptions for less than $10 means that it is an impulse buy. $50, or even $20, to buy a game is above the “whine factor” for parents. Nexon’s ability to get payment cards into Target (see previous article) was critical – online game play becomes an impulse purchase at the checkout line. I think this is an area where many casual game companies “don’t get it”. Their prices are above the impulse purchase level.

In a related story, Fox News – that bastion of sound journalism – just did a piece on MapleStory and game addiction.

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