In this additional section from the Playing for Keeps report, Games Investor Consulting investigates the leading games business models and distribution channels in use today. The following trends and profiles characterise the current commercial pressure in the development market, driving studios’ decisions about location, growth, creating IP, starting up and ultimately their viability and sustainability.
The report finds that:
- Consolidation, rising development costs and platform proliferation increase pressure on studios but open up opportunities for specialisation.
- Outdated commercial models and constricted routes to market threaten levels of new independent IP development.
- The decades-old advance recoupment commercial model and retail-based publishing model remain standard for most of the games industry and will do so for many years to come.
- Under the most common commercial models, royalty break-even points for independents are higher than average unit sales and so royalty overages are rare.
- Network technology introducing new business models that give games studios the potential to disintermediate traditional publishers, distributors and retailers and sell direct to consumers is maturing more slowly than many have hoped.
- Games publishers will remain the pivotal link in the games value chain, providing almost all finance for games development and marketing.
- Most independent developers have neither the financial strength nor access to sufficient third party finance to fund more than the earliest stages of a new console IP’s development.
KEY TRENDS IN COMMERCIAL MODELS AND DISTRIBUTION CHANNELS
Although the games industry is in a constant state of flux, there have been a number of major drivers of change in the last few years, which are starting to restructure the industry:
- Consolidation: an unprecedented number of acquisitions and liquidations of independent developers occurred between 2000 and 2006, but today the remaining studios cannot supply demand from publishers looking to expand their portfolios in anticipation of the apex of the industry cycle
- Rising development costs: Development costs have risen rapidly, driving up the break-even point for developers and lowering the chance of independents achieving overages until these platforms hit the mass market (2008 onwards).
- Platform proliferation: Publishers need to support more, increasingly differentiated platforms. This drives up total costs for developing multi-format triple-A titles.
- ‘One size fits all’ becomes harder: Platform differentiation and proliferation and audiences’ increasingly personalised content requirements make it harder for a single studio to successfully develop an identical game across multiple platforms, increasing opportunities for independents to specialise.
- Outdated commercial models: the predominant advance-based models date back to when overages were common, but now independents struggle to see post-advance royalties for the majority of their games. Without updating the models, this is expected to continue to restrict new independent IP.
- Fewer experienced console developers: Studio acquisitions and the technological and financial barriers to entry towards working on current generation consoles are reducing the number of independents experienced with, and capable of, working on premium console IP.
- Barriers to entry for new IP: Publisher risk aversion for new IP from independents means that there are structural barriers to entry for new IP, which lacks routes to market. Many new independent IPs have underperformed as publishers focus on licences and internally developed IP. This tendency risks impoverishing the UK market as a whole by restricting the historically rich source of new IP from independents.
- New distribution channels slowly maturing: After years of hype, new routes to market are starting to open up opportunities to independents, with direct-to-consumer digital distribution and downloadable console games disintermediating publishers. However, these channels are crowded, often result in new types of necessary intermediary, and are not expected to win a significant market share for several years.
- Online games requires production changes: As online components of games become more widespread, changes in studio’s production pipelines and skills sets (towards service provision, account management and being responsive to consumers) become increasingly important.
- Games supply chain lengthens: Complexity of development, outsourcing, and post-launch online content delivery and services are lengthening the industry’s supply chain, providing opportunities for service provision specialists.
MAJOR COMMERCIAL MODELS
The following are profiles of the standard games development commercial terms including the benefits, downsides and sustainability for the UK games development sector. The findings and figures were compiled in early 2007.
Independent IP - Advance model (part-funded)
Structure: The developer builds a prototype at its own cost (15 to 25 per cent of full game). Once signed, the publisher funds the remaining development + a modest margin, which is recouped against a negotiated share of net receipts (20 to 30 per cent). Once the advance is paid off, the developer receives royalty overages.
Benefits: The potential (if rare) for post-advance royalties; many independents consider this the best way to retain IP rights by sharing investment; risk is lower because the majority of production and marketing is funded.
Downsides: Royalty break-even points (550,000 units for a typical next generation game) have risen over average unit sales (300,000 to 400,000 units) so royalties are rare; publishers may commit less to independent IP; need for pre-investment in engines and technology; potential weak negotiating position; increasing difficulty for independents to self-fund new IP due to poor access to finance limits amount of new independent IP; risk of project cancellation; launch sales often represent the majority of sales due to lack of secondary markets; .
Sustainability: Medium-low. Few developers can self-fund major titles, but publishers still favour this model.
Updating the model: Rarely, some independents negotiate royalties at the publisher break-even point, but increasingly independents negotiate variable rate royalties which accelerate the rate of recoupment by having a higher pre-recoupment percentage and a lower post-recoupment percentage.
Third party IP - Work for Hire (revenue share)
Structure: The most frequent model for independents, which features an advance plus a low share of net receipts (10 to 15 per cent) on licensed IP. Developers with strong processes and good reputations tend to win this kind of work, and may command slightly higher shares of post-advance receipts but overages still represent on average only a small (around 10 per cent) portion of an average studio’s annual revenues.
Benefits: Lower risk for developer, despite the need for investment in technology; higher quality IP establishes developer’s reputation and trains staff; greater upside potential on higher value IP.
Downsides: Unpredictable margins may not cover overheads; IP poverty, continual investment in technology development is required; growth potential is limited; continual sales effort required.
Sustainability: Medium-high. Its continued popularity with publishers ensures that this will remain the dominant model, despite the risk of competition from lower cost territories such as Eastern Europe.
Updating the model: Royalties at the publisher break-even point (rare), variable rate royalties which accelerate the rate of recoupment (more common)
Independent IP - Advance model (100% self-funded)
Structure: The developer foots the entire development bill (more common on lower cost platforms), which is the least risk for the publisher and the highest risk for the developer. Here developers essentially hire a publisher’s distribution and marketing capacity, releasing a higher proportion of net receipts (50 to 60 per cent) to the developer.
Benefits: Higher percentage of net receipts and faster break-evens; IP retention usually achieved.
Downsides: poor access to funding and rising development costs means few independents can afford this; publishers may commit less to independent IP, including lower marketing budgets, so few self-funded titles succeed; less market seeding; lack of secondary markets (see above).
Sustainability: Sustainable in theory but rare in practice.
Updating the model: Private financing, although available, is rare but hard to obtain
Third party IP - Work for hire (buy-out) model
Structure: Developers work on licensed IP, share no royalties with the developer, but a win a better operating profit margin (15 to 20 per cent). This is found more frequently on lower cost platforms (for example on mobile).
Benefits: Lowest risk for developer, less reliance on unpredictable royalties, consistent deal flow can mean higher company stability, portfolio development on big brands, and lower risk of cancellation on more important IP for the publisher.
Downside: Developers must demonstrate existing technology; stricter production targets; less original IP is developed; lower-cost markets threaten UK studios; a continual sales effort is required
Sustainability: Publishers who use this model show little sign of changing terms, but the result is that UK studios will face competition from cheaper territories.
Updating the model: Some studios negotiate bonuses based on unit sales milestones on top of advances.
The second part of this research, which provides and incisive lookin at the predominant games distribution channels around the world, will be published online tomorrow.