Overview
Franỗois Dominic Laramộe
<francoislaramee@videotron.ca>
While online distribution and subscriptions have become viable revenue models for specific segments of the game development community, the industry as a whole remains bound to the retail market, and will stay bound to it for the foreseeable future. However, the way the retail market for games is organized doesn't make it easy for developers and publishers to make money—at least not in a reliable and predictable fashion.
This article explains the inner mechanics of the retail game market, how publishers cope with its limitations, and how its dynamics impact the financial well-being of developers.
Monetary Aspects of Development Contracts
Before we look at the retail market itself, let's examine the contracts that developers sign with publishers;
specifically, the clauses that specify how (and when) the developers get paid. For the purposes of this discussion, the enormous variability of development contracts will be reduced to two broad categories: cost- based deals and royalty-based partnerships.
Cost + Margin Deals
This model, commonplace in subcontracting but also becoming more prevalent in the context of full
development deals, minimizes risk for the developer, but at the cost of lower potential profits. In short, cost and margin deals involve four steps:
Call for proposals. The publisher asks the developer for a proposal based on broad parameters; for example, a racing game featuring the publisher's licensed property, for console X, to be delivered in the third quarter of 2004.
1.
Evaluation. The developer evaluates the cost of making the game.
2.
Negotiation. The parties agree on an acceptable profit margin for the developer. Sometimes this is done explicitly: the developer discloses their cost evaluation and the price is set at 20 or 40% above this figure. More often, the publisher asks several teams for competing bids, and the developers include their own (secret) profit margins in their proposals.
3.
Development. If the developer is able to deliver the product for less than the expected cost, they pocket the difference. Conversely, if costs run out of control, their profits diminish. In extreme cases, the developer might end up completing the project at a loss; while publishers will occasionally agree to pay more than expected rather than seeing a high-payoff game be cancelled, they will only do so if they are convinced that it is the only way to save the game—and they won't forget the incident.
4.
For developers, cost-based contracts might be attractive because risk is confined to the developer's own operations: accurate evaluations and smooth projects guarantee profitability, no matter what happens in the marketplace. However, if the game turns out to be a hit, the developer might regret trading away a share of royalties in exchange for safety.
Advance + Royalty Deals
The royalty model, borrowed from book publishing, is the traditional framework in the game business. It involves three major steps:
Advance. The publisher agrees to pay the developer a fixed amount, which might or might not cover development costs, before the game is published.
1.
Earning back the advance (or "recouping"). The advance is tied to the game's initial sales. For example, if an advance of $500,000 is paid based on $10 per copy, the developer will receive no
additional money until the game has sold over 50,000 units. (If the game never reaches this sales target, the developer will never see another dollar, but at least they get to keep the advance. Deals that require reimbursement of un-recouped advances are all but unheard of, and should be avoided at all costs.) 2.
Royalties. Once the game's sales have earned back the advance, the developer receives additional money for each copy of the game sold. This amount might be defined in dollars (e.g., $5 per copy) or as 3.
a percentage of the publisher's gross sale price, which can vary a great deal during the game's life cycle.
For developers, the royalty model might involve greater risk if the advances do not cover the cost of production.
However, if the game becomes a best seller, the developer stands to earn much more money than in a cost- based arrangement.
Retail Statistics
Unfortunately, while the royalty model worked reasonably well in the old days of $100,000 development budgets, the associated risks are far less manageable in today's market.
A Hit-Driven Business
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. On the console side, the average title stands a much better chance of breaking even, but few teams can break into the console market without proving their worth in the PC world first. The bottom line: the vast majority of game projects lose money for the developer, the publisher, or both.
Therefore, the industry must rely on a small number of best-selling titles to earn enough profits to offset the losses suffered on the bulk of the projects.
Hedging Your Bets
Since all but the largest independent development companies release at most one or two 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 toward their publishers by negotiating advances that cover production costs and a reasonable profit margin.
The publishers, on the other hand, have no one else on whom to offload their risks. Thus, their strategy becomes one 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).
Selling to Retailers
As explained by [Schoback02], gaining wide and deep access to the retailers' shelves is the determining factor in a game's commercial success. Securing good shelf space is therefore the game publisher's most important job.
A Concentrated Business
In North America, a small number of major national retail chains accounts for the overwhelming majority of the game industry's total sales. For publishers, this makes relationships with these retailers especially crucial: if Wal-Mart refuses to stock a game, many potential buyers will not see it on the shelves—and if another major retailer notices the refusal, there is a chance it might reconsider its own decision to buy the game.
The largest brand-name publishers, like Electronic Arts and Sony, can usually assume that anything they publish will be stocked in every retail store. For smaller companies that can't supply stores with a steady stream of sure-fire novelties every month, the situation is much more difficult: store buyers will decide on a case-by- case basis, and they have very limited shelf space to allocate. Even then, an effective strategy can yield success: Case Study 1.3.1 describes how a small development house with a single product line has achieved success self-publishing in its national market.
Case Study 1.3.1: Self-Publishing
Kutoka Interactive, a small developer of children's edutainment titles starring a mouse named Mia, chose an unusual approach: they publish their games themselves in their home country (Canada) and sell licenses to publishers elsewhere on a country-by-country basis.
"We felt that establishing partnerships with multiple companies was less risky than to rely on a single, big company to market our game every-where," explains Tanya Claessens, Kutoka's vice president. The strategy has paid off: today, the Mia series is distributed in 42 countries and in 14 languages. Moreover, finding the partners was easier than most people would expect: "When we first introduced Mia at MILIA, we received 43 proposals before the show was even over!"
Like many other companies in the field, Kutoka started out as a contract development house and used the income generated by this work to fund development of its own intellectual property. Mia's success on the trade show floor led to great press coverage, which in turn helped Kutoka secure precious shelf space for the games in Canada. "Thanks to the media's enthusiasm, we were able to get our first title into stores in December, which is almost unheard of." Since distributors could not handle the game at this late date, Kutoka's employees had to assemble the boxes in the office at night and ship the games directly to retailers themselves. And despite the positive press, even the retailers who ordered the game remained skeptical: "All we got at first were trial periods of two to four weeks. The game had to sell by then, or it would have been taken off the shelves."
Fortunately, Mia did sell, and today the 25-person company is expanding to a second line of original games and will soon begin publishing third-party software. "We're glad we're not starting out today, though," Tanya
Claessens concludes. "With fewer and fewer major retailers in the market, it is becoming more difficult to win 'mindshare' and to sell original properties."
The Publisher's Headaches
Convincing retailers to put a game on their shelves is unfortunately not nearly enough to ensure a game's financial success. This is because games are sold as consignment items: the retailer will only pay the publisher for copies of the game that consumers actually buy—the rest will be returned, often at the publisher's expense.
Therefore, not only must publishers convince retailers to order the game, they must also entice them to put it on
the best shelf space, at the right time, and for as long as possible. Retailers will therefore study the publisher's marketing plan, sell the right to advertise the game in their store fliers, demand preferential pricing to convince consumers to buy the game in their stores instead of the competitors', and so on.
And sometimes, a relationship with a retailer will be so important that the publisher will be forced to accept the retailer's demand for a temporary exclusivity, or even to change the game's content to satisfy the retailer's standards.
The Channel-to-Market Throttle
Compared to other popular forms of entertainment such as music CDs and movies on DVD, games suffer from three serious disadvantages in the retail market:
Retailers don't stock many titles. The major specialty music stores routinely offer tens of thousands of different recordings. Game shops rarely if ever have more than a few hundred games in stock. And the large surface discounters often propose 10 to 100 times more movies and music CDs than games.
Games are perishable. A weak-selling game will be taken off the shelves in six to eight weeks—there is no second chance. A success story like that of the Austin Powers movie franchise, which was revitalized in home video after the first film drew poorly at the box office, would be impossible in our medium. Even moderate hits rarely last more than a year in the marketplace.
Platforms are perishable. When music lovers were forced to switch from vinyl to cassette tapes and then to CDs—two platform changes in 50 years—the public rose into an uproar. Game players have been through six generations of consoles, from the Pong machines to the Atari VCS to the 8-bit Nintendo to the 16-bit Sega Genesis to the 32-bit PlayStation to the Xbox, in half that time. And unlike the music of the Beatles, the overwhelming majority of the classic games of the DOS and 8-bit era have never been re- released commercially. While players can still enjoy many of these games (despite publishers' best legal efforts to the contrary) thanks to emulators and the so-called salvage community, this sort of non- commercial effort generates no income for the developers who created the games in the first place.
The Developer's Headaches
Suppose that a developer sells a game to a publisher for an advance of $2,000,000 that matches its development cost exactly, plus a royalty of $10 per copy. The developer will earn royalty checks and turn a profit only if the game sells more than 200,000 units.
Now, if the publisher invests $400,000 in the game's manufacturing and marketing and sells it to retailers at a gross price of $30, it will have earned back its own investment as soon as the game sells (2,400,000 / 30) = 80,000 units. Therefore, if the game's sales begin to decline after 100,000 units, the project has already achieved profitability from the publisher's point of view. Consequently, the publisher might not be highly motivated to stimulate sales any more, because such an effort will quickly run into diminishing returns.
Meanwhile, the developer hasn't received one dollar in royalties.
Of course, if the advance paid to the developer didn't even cover the cost of developing the game, this phenomenon can lead to profits for the publisher and disaster for the developer. For this reason, smart developers will negotiate the largest possible advance, even at the expense of a modest royalty rate.
On the Shelves
Different outlets might sell the same game at different prices for reasons of strategy: for example, some retailers will choose to sell a high-profile game at a discount for a short time to draw customers. However, publishers will also change their suggested retail prices with time, lowering them when demand decreases ([Laramée03]). What happens to developer royalties at that time?
If the royalty rate has been set as a fixed percentage of the publisher's sale price, for example 20%, the royalty amount decreases proportionally with the price. One consequence of this fact is that, if the game has not yet earned back its advance at the time of a price drop, the developer might have to wait until unit sales reach much higher levels than expected before he receives a check.
The other royalty model, in which the developer receives a fixed dollar amount per copy of the game sold no matter what the publisher's sale price might be, would therefore seem more attractive. Unfortunately, this model has a serious flaw of its own: as the publisher's price drops, the fixed royalty accounts for an ever-increasing share of the publisher's revenue, until it becomes economically preferable for the publisher to stop marketing the game even if there is still a demand for it.
From the developer's point of view, the optimal agreement ought to generate royalty income as soon as possible and keep the game on the shelves as long as possible. One way to build this strategy into a contractual clause would be to:
Set a ceiling to the unit sales that can be used to recoup the advance. For example, an advance of
$1,800,000 at a royalty rate of $9 per unit corresponds to 200,000 units sold at full price. The contract might therefore specify that the developer is entitled to receive royalties as soon as unit sales reach 250,000 copies, even if the advance has not yet been recouped due to price cuts.
Set an escalating royalty percentage once the advance has been earned back. For example, the royalty on the first 100,000 units might be 20% of the publisher's price, the rate on the next 100,000 might be 25%, and so on. This way, the developer shares in the success of a hit, but since the royalty remains bound to the publisher's price as a reasonable percentage, there will never be any incentive for the publisher to drop the game as long as demand stays strong, since both parties earn money on each unit sold. After all, by the time the higher royalty rate comes into effect, the game is already profitable for both parties.
When Do Royalty Checks Arrive?
Finally, most publishers pay royalties on a quarterly basis, and only on copies that retailers have paid them for (because they have been sold to consumers). This means that it takes some time for money to flow back into developers' pockets: if a game reaches the target sales numbers required to generate royalties on October 21, the fact will be reflected on the publisher's fourth-quarter report, which might only be completed in
February—and accounting might not print the developer's check until March.
Case Study 1.3.2: Royalties versus Guarantees
Sarbakan, a developer of online games based in Quebec City, is most notorious for its mystery serial Arcane and its action series SteppenWolf, both published by Warner Bros. Online. Sarbakan's business model relies on a balance between original intellectual property (whether sold outright, work-for-hire style, or licensed to distributors according to non-exclusive agreements) and service deals.
"We want to maintain a 50–50 split between creating our own projects and providing our services to other intellectual property owners," says Richard Vallerand, Sarbakan's vice president for creative affairs and production. "These are very different businesses, but they complement each other very well."
In SteppenWolf 's case, Sarbakan sold all rights to the property to Warner Bros. The publisher provided a budget sufficient to insure profitability, and Sarbakan retained a share of future earnings tied to the property.
"This way, we gained access to Warner's tremendous marketing machine. This allowed us to gain more players faster than we could have on our own. And since they own the rights, our partners will be more interested in migrating the property toward other media; television, for example. Obviously, they are in a much better position to do so than we are."
By selling the rights to SteppenWolf to Warner Bros., Sarbakan accepted a smaller share of the property's revenue. However, with the power of the conglomerate behind SteppenWolf, this small share might actually amount to more, in the long run, than what Sarbakan might have been able to generate on its own.
"Plus, Warner has allowed us to retain a great deal of creative control over the characters and storylines. This is not the case when we work on someone else's intellectual property: when we do so, the decision process always involves a lot of back and forth."
Conclusion
Not very many games ever earn anything beyond the initial advance for their developers. Even in the best case, it will take months for the game to start earning royalties, and a few more months for the money to reach the developer. As a result, smart companies now base their budgets on the advances alone—and they try to build a healthy profit margin into them. Thus, the "cost and margin" pricing model becomes more prevalent, in fact if not in intention.
The retail market for games is difficult 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 the shelves for very long, and reap much of the income the games generate. Yet, alternative distribution schemes (e.g., online sales) have not risen above marginality, because of download sizes and fears over channel conflicts. Learning how the retail market for games works will help developers thrive in this competitive environment.