NESTA will soon publish its ground-breaking report on the impact of an anticipated cultural tax break for the games industry.

Develop has obtained a copy of that very report. Below you can read its preliminary findings in full.

Even more detailed findings are set to be made public, and will be found on NESTA’s website.

SEE ALSO:
Industry admits to decline in original IP
Fears over ‘culturally British’ tax test
Employment ‘to fall’ across UK game studios
Hope grows for UK game tax breaks
The NESTA report in numbers
News archive: UK game tax credits

It’s Time To Play

A Survey on the impact of a tax credit for cultural video games in the UK development sector

– NESTA, the National Endowment for Science, Technology and the Arts

Executive Summary

NESTA recently commissioned Games Investor Consulting (GIC) to survey 30 leading British video games developers, publishers and sources of funding with the aim of producing robust evidence to inform future government initiatives to support the UK video games sector.

Following the directions set out in Digital Britain, this survey has focused on the potential impact of a tax credit for culturally British video games along the lines of those measures already available for the UK film sector and the French video games sector.

This report acknowledges that a strong video games ecosystem requires a healthy balance between small start-up independent studios, larger established independents and the publishers who often fund their work, or develop games in their large internal studios.

Identifying the key challenges and potential impacts of the cultural tax credit on businesses in different positions of the industry’s value chain is a crucial task.

To achieve this goal, the survey has targeted senior decision-makers who fulfil different key roles across the sector. They include senior executives in independent and publisher-owned studios, 3rd party development managers (who manage external contracting between publishers and independent studios), and executives at publisher head offices (in charge of the formulation of global investment strategies by publishers).

The report also includes external sources of funding, such as project financiers and venture capitalists who already have or might consider funding individual development projects and video games companies.

These are the key findings of the survey:

A world-class sector under pressure

Survey respondents describe a world-class creative industry under increasing pressure.

Experience, creativity and quality have been the traditional advantages of UK video games developers, while high costs and skill shortages are their main disadvantages.

The availability of government subsidies overseas is making the UK even less competitive as a video games development territory, not only from the point of view of costs, but also of skills- Strong government support in competitor countries (particularly Canada) is attracting key senior staff in a ‘brain drain’ which intensifies existing skill shortages and threatens the quality of the UK’s output.

Original IP development seems to be in decline
Nearly three quarters of respondents claim that original Intellectual Property (IP) development has slowed or stopped in the last 5 years, and more than half think that this the trend will continue in the future, with the potential exception of emerging networked gaming platforms.

Risk aversion by publishers is making it harder for UK developers to be creative and innovative, areas where they have excelled in the past.

A slow-down in the UK video games sector
Most respondents report growth of some kind over the past 2 years. This growth is expected to slow down, or halt altogether in the coming 2 years. The survey sample includes some of the UK’s most successful video games business. This means that the growth prospects for the rest of the industry could be expected to be significantly worse.

A shift in publisher strategy might benefit some UK developers
Although 3rd party development managers report low levels of investment in UK-based original IP production over the last 2 years, they claim that there will be a steady increase in the funds available for original IP in the years to come.

This is a consequence of a shift in some publishers’ development resources from internal studios towards external contractors, who are often seen as more efficient. This increased demand will, however, need to be matched by an increased supply of original IP from the UK.

There is optimism about the potential impact of a tax credit for cultural games
Almost all respondents believe that if introduced, the tax credit for cultural games currently under discussion would have a positive impact on the sector, as long as it is designed to take into account the specific requirements of the industry, and administered effectively. The tax credit for cultural games would help to ‘level the international playing field’, and make it easier for UK studios to retain their talent.

In regards to direct impacts, 89% of studios responding to the survey believe that a tax credit for cultural games would lead to increases in their staff numbers. 70% of publisher and external finance company respondents state that a tax credit could make the difference between investing in and passing on a games development opportunity in the UK.

The tax credit for cultural games would kick-start original IP development and encourage experimentation with new business models
Two thirds of studios claim that a tax credit for cultural games would have a definite, positive impact on original IP development, while 75% of independents believe that the measure would help them to keep hold of the original IP that they produce.

All independent studios state that a tax credit would encourage them to adopt new business models based on digital distribution, with the potential to establish direct relationships with their consumers and generate steadier revenue streams.

In order to fund these new ventures, they would be more likely to seek financing from sources outside of the video games industry, such as venture capital or project financing.

The tax credit would boost publisher investment in the UK video games sector
All 3rd party development managers claim that a tax credit would increase their companies’ funding of externally contracted development, and could make the difference between investing in and passing on a UK games development opportunity.

Similarly, 80% of senior publisher executives claim that tax credits would boost their funding of development by both internal and independent studios in the UK.

The investor perspective
The majority of external finance sources consider the UK video games sector to be an unattractive prospect for investment at the moment. The reasons for this are lack of scale, and an excessive emphasis on traditional, high-risk retail business models instead of network gaming and direct-to-consumer propositions.

They are unanimously positive about the impact of a tax credit on the scale and/or number of investments in UK video games projects. Half of respondents would change their attitude towards investing in UK video games companies if the tax credit for cultural games was introduced.

Introduction to the survey

Games Investor Consulting (GIC) has been contracted by NESTA to survey 30 leading British video games developers, publishers and investors.

The aim of this survey, following the call for evidence in Digital Britain1, is to produce robust evidence for policymaking in support of the activities of the UK video games studio sector, particularly in regards to the potential impact of a tax credit for culturally British games.

In this section we introduce our sample and methodology. In section 2 we present the key findings of the survey, and in section 3, their implications. Appendix 1 identifies our respondents, and Appendix 2 contains a detailed breakdown of the responses according to different categories of respondent and topic.

The interview programme
Between July and August 2009, GIC conducted interviews with 30 leading figures in the games development, publishing and financing sectors. We targeted Managing Directors, Commercial Directors, Chief Executive Officers, 3rd Party Development Managers and senior financial executives working in some of the largest and most important video games companies and external finance companies in the UK. Their companies employ nearly 50% of the UK’s entire permanent video games developer headcount. We have classified our respondents into 4 categories depending on their company’s position in the sector’s value chain and their role within the company (see appendix for a list of respondents’ companies):

Development studios (14 respondents): Development studios design and create video games either for publishers to take to market or, in a slowly growing number of instances, for direct–to- consumer distribution and sale. Development studios are either publisher-owned (also referred to as ‘internal’), operating exclusively for their parent company, or independent and mostly reliant on publisher contracts as a source of revenue.

3rd party development managers at publishers (5 respondents):
Publishers perform a range of roles, from funding and project management through to distribution, promotion and commercial exploitation typically via wholesale to retailers. In addition to exploiting games developed by the studios that they own, most publishers make use of independent studios, either funding the development of original video game Intellectual Properties (IPs) or commissioning games based on their own or licensed IP using a ‘work-for-hire’ model. The respondents in this category are responsible for sourcing and managing these third party development projects.

Publisher head offices (5 respondents):
This category of respondents comprises of senior figures within publishers’ global or regional head offices. Their roles typically encompass all development and publishing operations.

These respondents have been primarily questioned about their internal development strategies. Their broader company purview and greater seniority sets them apart from 3rd party development managers and the publisher studio respondents.

External finance companies (6 respondents):
This category of respondents comprises private equity, project finance, financial advisors and venture capital companies.

They were selected according to three main criteria: they had to have a functional understanding of the video games industry (which is uncommon in the finance sector), they had to represent a broad selection of investment methodologies (from project finance to early stage venture capital and buyouts) and had to include both companies that had and had not yet made investments in UK video games.

We hope that the inclusion of these respondents in our survey will provide us with a complementary, possibly more nuanced view of the impact of a tax credit in video games development as compared to the video games industry, which we would expect to be mostly favourable to the measure.

The interview data has been anonymised, and permission has been sought for any quoted material. Our respondents were reassured that the interviews were confidential and that individual company opinions would not be published without approval.

Questionnaire content
We designed bespoke questionnaires for each of the 4 respondent types identified above (see appendix 2 for the companies). Each of these questionnaires contains specific questions addressing issues which are unique to the type of respondent and organization being interviewed, as well as some common questions which are relevant across our survey sample.

Most of the questions in the interviews were open.

Analysis
As we have already mentioned, the interviews undertaken in this survey were semi- structured, with open-ended questions addressing the key points included in the questionnaire.

We have identified key emerging themes from the responses, highlighting when relevant, differences in opinion or emphasis between respondents in different
categories.

It is important to stress that our survey sample is too small and heterogeneous to produce statistically significant results. Although in Appendix 2 we present some of the results in terms of percentages and average scores, these values should be interpreted as indicative of broad trends, rather than representative of the industry as a whole, or any one games (or finance) company type.

Section 2: Key Findings

State and trends of the UK video games development sector
The UK video games development sector has advantages in quality, and disadvantages in costs
When asked about the advantages and disadvantages of developing video games in the UK, our respondents indicate two key factors, ‘quality’ and ‘cost’, which have countervailing effects in the attractiveness of the UK as a place to make games.

Other responses to this question are linked to these two factors. First, there are concerns about the potential impact of skills shortages (including the drain of senior personnel to other development territories) on quality. Second, there is a perception that higher levels of government assistance overseas are making the UK less cost-competitive.

As a result, UK studio executives often find it difficult to persuade their sources of finance (usually finance directors at the head offices of their global company or 3rd party development managers at their potential publishers) that their creative excellence outweighs higher costs to deliver potential returns on investment.

As one senior publisher executive points out when discussing his UK studio:

“Production costs are far too high and only make sense if the developer/franchise is extremely high quality. Our (UK) studio… (has) to do a very, very good job, otherwise we will move that IP out to one of our studios around the world. The key is if the company guarantees that the game developed there will be AAA and only that developer has the expertise to do it then fine, but if that quality drops it will be moved. If we had government assistance then that studio would be used for other
games rather than being shut.”
– Anonymous senior publisher executive

The games industry has historically followed a highly cyclical pattern of growth with the industry’s fortunes largely echoing the parabolic sales curve of the major video games platforms such as Sony’s PlayStation and Microsoft’s Xbox consoles.

The industry is currently considered to be mid-cycle. As it advances towards the lowest part of the console cycle around 2010-2011 (when publishers begin to shift resources to development for the next console generation) and government assistance overseas increases, risk aversion and cost consciousness will alter the balance against UK developers.

A brain drain of UK talent
The top two trends identified by our respondents, overseas subsidies and ‘brain drain’, are two sides of the same coin. The brain drain is a relatively recent trend that was not visible when Games Investor Consulting last surveyed the industry for government.

In that survey, executives reported that representatives from Canada were approaching them and offering them incentives to relocate but they were not, at that point, tempted to move.

The exceptions to this since then have been Eidos (until recently the largest indigenous and independent UK publisher), which shed 75% of its UK development resource and relocated in Montreal, and Babel, which grew faster in Montreal than in the UK.

It is clear from our results that government support is now enabling studios in Canada to attract some of the UK’s most talented and experienced developers, who they target with generous relocation packages. One in three respondents to this survey claim that this brain drain will, over time, have a detrimental impact on the quality of UK video games development.

Trends in original IP generation
Nearly three quarters of our respondents believe that original Intellectual Property (IP) generation in the UK has been in decline or stopped altogether in recent years. 60% of 3rd party development managers confirm that they have not published any new original IP from UK studios in recent years.

Executives from publisher head offices acknowledge that this is partly a consequence of increasing risk aversion in parent companies who prefer to focus on well-established franchises over betting on unproven intellectual properties.

This trend is particularly worrying for the UK video games sector which has traditionally relied on its creativity and capacity to innovate as a differentiation factor against cheaper development territories.

More than half of our respondents (and 78% of independent studios) expect this trend to continue during the years to come. There are, however, some exceptions to this view.

For example, 3rd party development managers are more optimistic about the amount of new original IP that their companies will fund in the next two years. This is possibly linked to a change in the strategy followed by some publishers, who anticipate a shift away from development by internal studios towards the contracting of external developers.

However, and as one of our respondents points out, this increased appetite for externally developed IP by publishers will have to be matched by an increase in the supply of original IP from independents which, in his view, has fallen substantially in recent years.

Finally, a quarter of our sample is optimistic about the potential of less expensive networked gaming platforms (such as mobile and online) as new outlets for original IP.

Staff growth halts after some years of boom
84% of our respondents report growth of some kind over the past two years. It is necessary to take into account, however, that our sample includes some of the UK’s most successful video games companies. In this regard, our findings could hardly be expected to be representative of broader trends in the UK video games sector.

GIC’s ongoing monitoring of overall headcount in the UK video games development market, shows, for example, that many UK studios have cut their staff, or gone out of business altogether in the last two years.

Future prospects are modest in the absence of a tax credit, with 76% of respondents anticipating little or no growth. Since the companies in our sample are generally outpacing the rest of the UK video games sector, this result would support the idea that, over the next 2 years, we will witness a decline in the numbers employed by the UK video games sector.

Trends in contracting
3rd party development managers at publishers report a steady growth in outsourced production in recent years. Overall development efficiency is the favourite reason for choosing UK studios over others.

These respondents are also optimistic about continued growth in coming years, in part driven by the aforementioned strategic shifts by some major publishers towards third party development. This might improve growth prospects for some UK developers.

The impacts of a tax credit
It is not surprising that our respondents expect a tax credit for cultural games to have a positive impact. They argue that this measure would, for example, enable UK video games companies to retain their best talent, and increase their cost-competitiveness.

This would result in – according to 95% of respondents from video games companies – in definitive or potential growth in numbers of staff.

Regarding the potential negative impacts of the tax credit, 87% of respondents declare that in principle there should be none, as long as it is administered properly; our respondents are mainly concerned about how strictly applied will the ‘cultural test’ to qualify for the tax credit be, the time-frames for qualification and payment, and the length of the government’s commitment to it.

The impact of the tax credit according to developers
Two thirds of development studios claim that a tax credit will stimulate growth in staff numbers, while the rest declare that there could be a positive impact.

Two thirds of developers are also optimistic about the impact of a tax credit on the generation of original IP. 75% of independent studios believe that a tax credit would help them retain ownership over the IP they generate.

Independents also claim that it would make them significantly more likely to seek external finance (such as venture capital) for their projects.

The positive impact of the tax credit for cultural video games on business model innovation is one of the most striking results of the survey. All independent studios claim that a tax credit would help them to go direct to consumer using new distribution models.

It seems, from our survey, that UK developers would leverage the tax credit for cultural video games in two different ways, depending on their strategic focus.

Some would use it to improve the attractiveness of their ‘pitches’ to publishers for original IP funding or contract development work, or when competing for resources with other internal studios owned by their parent publishers.

Others, primarily independent studios, would use a tax credit to create video games on networked gaming platforms following novel and possibly more sustainable business models than those prevailing in mainstream console development. This approach might well require (and according to the responses from investors, would be more likely to attract) external financing.

The impact of the tax credit according to 3rd party development managers
The optimism of 3rd party development managers is significant given their key role in the ongoing funding of independent developers in the UK.
All respondents in our sample are positive about the potential impact of a tax credit for cultural video games. 80% see potential for an increased number of externally contracted projects, and 75% claim that a tax credit would increase the likelihood of a positive funding decision in favour of UK studios pitching for a project.

One reason for this is that 80% of 3rd party development managers at publishers assess the availability of government assistance when deciding which studio to work with.

The impact of the tax credit according to senior publisher managers
80% of senior publisher managers foresee increased investment if the tax credit is introduced.

Our survey shows that, on average, senior publisher executives are more sensitive to the costs of video games development in the UK (as well as to the government’s inactivity) than respondents in other positions.

Executives claim that a tax credit will improve the global competitiveness of the UK video games sector, and help to retain senior staff in the face of increasingly attractive incentives from subsidised territories.

Although publishers are more cautious than other respondents in regards to the impact of the tax credit on growth prospects, 80% still expect potential or definite growth in their UK resources if it was to be introduced.

The external investor perspective
External investors report a diverse range of barriers to investment in UK video games studios. The two most commonly mentioned issues are, first, the scarcity of investment opportunities suitable for their particular investment mandates, and, second, the unattractiveness of the traditional retail-based and hit-driven video games development and publishing model (which is perceived as too risky and unpredictable).

By contrast, some respondents highlight the attractiveness of network gaming businesses, which according to them offer faster and more predictable growth with greater profitability and exit potential.

However, they also point out that the UK has very few companies operating in these higher value markets relative to other countries. In addition, very few UK video games companies operate at a scale which is attractive for the larger private equity investment firms.

The impact of a tax credit on investment in UK games
All of the external finance respondents agree that the introduction of a tax credit would result in greater investment in UK games companies and projects by external financiers.

However, some of them declare that their own stance towards investing in the video games industry would not be altered by the tax credit. Our sample deliberately includes finance firms that have not invested in UK video games companies, and one of them indicates that the tax credit would not reduce their scepticism about the sector (although, interestingly, that same investor does have investments in video games outside of the UK).

The majority of respondents do nevertheless state that a tax credit for cultural games would either improve their attitude, or help retain an already positive attitude towards investing in games.

Several declare that the tax credit would increase the volume of companies seeking funding (which they welcome), including companies with propositions which would be more attractive to them (particularly in network gaming platforms). It would also lead to the development of a range of new investment vehicles to address this increased demand.

Implications

A healthy video games development ecosystem needs a balance between independent developers and publisher-owned studios. It simultaneously requires a regular flow of innovative start-ups, and the massive investments in cutting edge technology and content that only confident publishers have the resources to undertake.

Some of these publisher investments will focus on internal studios while others will be destined to fund the creation of new blockbuster IPs by highly creative, often more efficient independent studios.

The survey provides important insights into the current state, and future evolution of, the UK video games development sector ecosystem by incorporating views from multiple stakeholders, both within and without the video games sector. It highlights some of the significant challenges faced by the industry, as well as the potential impacts of government support in the shape of a tax credit for cultural video games.

The inclusion of sources of finance in our survey sample is unique and particularly important, as it potentially provides a more restrained assessment of the potential impacts of the tax credit, as compared to those video games companies who stand to benefit more directly from its introduction.

As mentioned previously, our survey sample includes large, renowned and successful companies, that is, those most able to weather the storms of global competition and the console cycle.

In this sense, some of the results they report, particularly regarding growth trends and original IP generation and ownership could be expected to be unrepresentative, and significantly outperform those of the broader UK video games sector, which is mostly formed of smaller companies.

A world-class sector under pressure
Our survey shows that the UK video games development industry faces serious and mounting problems, often linked to the availability of government subsidies for video games companies overseas.

These subsidies are perceived to have several negative impacts: they have made independent studios less attractive as external development partners, and diverted investment away from publisher owned studios in the UK (in some cases, such as Eidos, leading to studio closures and major job losses).

They also seem to be behind an exodus of senior and talented staff away from the UK, and towards studios in subsidised territories. This ‘brain drain’ has intensified industry-wide skill shortages caused by the limited flow of suitably educated graduates from games degree courses at British universities.

This trend might have harmful implications for the ability of UK video games companies to create the kind of high quality video games for which the UK is globally known, and which attract global companies in spite of higher costs. Whilst some respondents see network gaming as a potential new outlet for original IP developed by UK studios, very few companies have, to date, moved to seize the opportunities in these radically new, thriving markets.

A tax credit could trigger new original British IP from independents
Most respondents to the survey believe that a tax credit for cultural games would benefit the UK video games industry in a number of ways, principally by improving growth, widening investment prospects, and supporting creativity and innovation.

Independent developers are most positive, although some acknowledge that they may well end up passing on the benefits of the credit to their publisher partners. All independents believe that the credit will help them grow their staff, and explore novel direct-to-consumer business models in networked gaming platforms. They also argue that the tax credit will make it easier for them to retain ownership over the original IP they generate.

These impacts might be significant for the future competitiveness of the UK studio sector.

As NESTA’s Raise The Game report in 2008 described in detail, UK video games developers are finding it increasingly difficult to fund and retain ownership over original games IP.

This has made them reliant on publishers for day-to-day funding via ‘work-for- hire’ contracts. Whilst this kind of externally contracted work from publishers provides substantial cash flow value to independents, it is the creation of successful original IP that generates long-term asset value and profitability for video games companies.

Retaining ownership over successful original IP, and the adoption of new direct-to- consumer distribution models, would enable UK video games developers to hold on to the asset and cash flow value generated by their creations. If, as our respondents report, the tax credit encourages innovation in this area, it could play a critical role in reversing the fortunes of some independent developers in the UK, helping them to adopt more sustainable business models, and reducing their reliance on overseas publisher funding sources.

It would also contribute to speeding up the UK video games sector’s transition towards exploiting booming networked gaming markets in which the UK is currently lagging behind its competitors in the USA, the Nordic countries, South Korea and
Germany.

The impact of a tax credit on publishers’ investment decisions
The future health of the UK video games sector equally depends on the activities of large scale, publisher-owned studios which comprise nearly half the sector’s headcount, and are behind some of the UK’s most important and globally successful IP.

The survey sheds light on the factors behind global publishers’ investment decisions, and on the pressures faced by strong but costly studios located in the UK. The survey finds that the benefits of a tax credit will also significantly benefit publisher-owned studios and the 3rd party development operations of global publishers.

Publisher investment would not only benefit their internal studios but also, as 3rd party development managers highlight, those independent studios which they would be more likely to contract.

A tax credit could attract otherwise sceptical external investors
Investors believe that the tax credit could trigger increased investment for the industry overall and, in most instances, would improve their own attitudes towards investing in video games opportunities.

This result is aligned with most independent developers’ stated goal of seeking external finance if the tax credit is introduced. As we previously highlighted, the tax credit will definitely encourage developers to explore network gaming business models, which are precisely those that external investors are more interested in funding.

The tax credit is no panacea to the problems faced by the UK video games sector
Despite their optimism, most of our respondents do not believe that the tax credit will be the cure to all of the UK video games sector’s ills; for example, it will do little to improve the quality of graduates coming from UK universities, a crucial challenge identified by our respondents.

In addition to this, there are concerns about the implementation of the tax credit, particularly in regards to the application of cultural criteria, and the administration of the scheme.

For example, most respondents believe that the benefits from the tax credit will be limited if it is managed in an excessively bureaucratic fashion, if the credit is not approved at the concept stage of development, or if it is not paid in a timely manner.

Many fear that the scheme will operate over a few years before being withdrawn or substantially modified.

These are potentially disastrous scenarios for an industry where a typical project might take between 18 and 30 months to complete. One respondent claims that a poorly implemented scheme that does not take into account the unique funding and production processes for video games could do more harm than good, and possibly even result in company closures.