Last we week we responded to a Twitteresponded to a Twitter stream lamenting that traditional investors do not invest in games. This struck a chord with us, and we replied with a mini-Tweetstorm of our own. In a series of notes earlier this year we had discussed this reality and looked at a few alternative financing methods for game devs (and here). But after our Twitter exchange we realized that we had not dug into the assumptions underlying this hard reality. Why don’t traditional investors invest in games?

First, we need to talk about ‘investors’. In this context, we are really looking at venture capital (VC) investors. This would seem to be a natural investor base for high-risk game investing, but these are precisely the people not investing in games. There are other pools of investors, but in practical terms those are even harder for game developers to access. The reality is VCs are not investing in games. The reason usually given for this is that games are a ‘hit-driven’ business, but, as that initial Tweet indicated, that is at best a partial answer. Successful consumer apps are essentially ‘hits’, what is so different about games?

We came up with several reasons for this disconnect.

The first is that games really exist in a different category than other forms of software. We recognize that this is a bit squishy, but there is a Sand Hill Road mindset for VCs that is totally removed from the Hollywood mentality of the entertainment business. We will not get into the San Francisco vs. Los Angeles debate, but it is safe to say that the economic model and participant intuition of the Entertainment industry is very different from that of the Technology industry.

We can be more specific. Games are a very ‘long-tail’ business. There are thousands of new games released every year, but only a very small fraction attains much commercial success. When investors talk about ‘hits’, what they really mean is that the statistics behind game success are denominated in much larger numbers than tech companies. A typical VC investor will make a dozen or so investments each year. Each investment requires a lot of upfront time and then ongoing commitments. Out of ten investments, they expect maybe four of five to deliver meaningful returns, with the rest delivering little or anything. Successful game investing probably requires them to add a zero to all of these figures. Most VC firms cannot scale to doing a few hundred investments a year, but this is what it would probably require to find that handful of hits.

Another argument we hear is that predicting game success is much harder. We view that as half-valid. It is true that traditional software now undergoes a well-understood investment trajectory, and good investors have good intuition early on about what will and will not work. Extending this, VC firms have a network of industry professionals to draw on to amplify that intelligence. VCs would need to develop a stable of experienced developers skilled in game engineering, content licensing, merchandising and Influencer marketing (e.g. Twitch streamers) to replicate this for game investing.  Even common skills, like growth hacking or PR, differ greatly in gaming than traditional software. This talent pool does not exist on Sand Hill Road today, or at least is not recognized as such. We say this is only half-valid because VCs could replicate this market wisdom, but would require some big changes to do so.

Take the example we gave about growth hacking. The software industry has developed a critical mass of expertise for growing a consumer user base. This used to be seen as a form of magic, but has now become a highly professional toolset with a distinct class of experienced professionals. But growth hacking for games is very different. Many non-game apps and software are built to gradually scale up, and the growth hackers are brought in to make that ‘gradual’ into sooner. The point is that these markets have the time to grow the user base. By contrast, games’ lives are much shorter. The nature of app stores and other distribution platforms (which we will come back to in a moment) are crowded. This means that games have a very limited window in which to garner attention. If they cannot achieve some form of ‘exit velocity’ from the gravity well of these platforms they are quickly forgotten. This requires a much more accelerated form of growth hacking than other software. We could debate the degree to which this holds, but it is fairly apparent that the window for games is short.

Another important distinction is that the economic model for games is very different than software.

The biggest challenge is that the barriers to entry in gaming are very low. It is rare now, but not impossible, for a small group of developers or even a solo individual, to develop their own game and turn it into a hit. Thus the thousands of new games coming on the market every year. This is why growth hacking needs to be so much more accelerated for games. It also explains why the portfolio math is so skewed. Good games can be lost to the whims of consumers or a buggy launch and from which there is no easy recovery.

As noted above, distribution is also a thorny problem. Put simply there are only a handful of paths to market for games, and these are all beyond the control of the developers. On mobile we have Google’s Play store and Apple’s App Store. For consoles, there are only two choices – Xbox and Microsoft, and getting plugged into their marketing cycles is not easy. There is a bit more leeway for PC games, but Valve’s Steam store has become a very powerful, perhaps dominant, force. While the PC does allow for direct-to-consumer marketing, this is both an expensive path to take and a relatively small slice of the market. It is possible to succeed on any or all of these channels, but it is a much harder path than that for traditional software. We have spent a lot of time in the telecom market and our sense is that investors view this platform chokepoint as similar to the pain of trying to sell to Telecom operators. The dynamic of a small company trying to negotiate for its survival with an indifferent mammoth bureaucracy is not attractive to investors for some valid reasons.

Another way to look at this is the cost of developing a game. One possible way to stand out from the sea of competition is to build a bigger, better looking game. Of course, doing so requires a big, expensive team. The cost of building a game for the consoles is notoriously high. Again, smaller developer organizations do exist and can succeed, but this requires a combination of lots of marketing dollars, a truly unique game and a fair dose of luck in gaining consumer awareness. Put simply, the most successful games today end up costing a lot of money  to bring to market.

This further adds to the disconnect with investors. In software, the industry is now familiar with the concept of Minimum Viable Product (or MVP), which is the most basic feature set required for a product to test out its market fit. This model allows software developers to build a basic product and then slowly add features to grow the market. By contrast, games have to be largely complete before launching. True, game players are now accustomed to games receiving periodic updates which can sometimes greatly add to gameplay, but our sense is it takes a much more complete product before developers can get a sense of product acceptance, let alone time to first revenue.

The life of a game title can also be much shorter. While there are a number of games that have been around for a decade or longer, the vast majority of games plateau or disappear in their first year. Further, most games have a very finite life. Commercial success for all but a handful of titles is finite. By contrast, software can continue to drive revenue for many years. In financial terms, this means for any net present value calculation the terminal value of a game is effectively zero, which we do not believe is true for most software titles. Furthering this dynamic, a software product that has earned some traction but stalled on growth can be acquired and bundled into the sales organization of another company, extending its life. This is much less common in games, and tends to take place at valuations that are orders of magnitude smaller.

This brings us to the final hurdle which is the exit path for a game.  The market for game IPOs in the US is very limited. The only major name that comes to mind in recent times is Candy Crush creator King Digital, which had a very rocky time as a public company before getting acquired. And this is of course the other problem, there are only a handful of acquirors in the gaming space – Activision/Blizzard, Electronic Arts and Glu in the US. Internationally, there is Tencent which already owns a stake in pretty much every successful private game maker already. There are a handful of exceptions, and an emerging second tier of game studios. But this does little to change the fact that this is a tiny pool of buyers.

All of this makes for some pretty grim reading. The game market is constrained by too many competitors supplying titles underneath a distribution tier that is highly concentrated and thus effectively all-powerful. Couple this with the challenging portfolio math and it should be clear why games attract so little in traditional VC dollars.

That all being said, we think this blind spot is a big mistake. Our key takeaway from this note is that what we need is a new way of approaching game investing. Gaming is a huge and growing market. It is arguably the largest consumer content category. Its weakness is the perception that the field is too technical for Hollywoo investors and too consumer-fickle for VCs. We have argued in past notes (and here and here) that we are starting to see new investors tackle this market. Pollen is helping small companies monetize more effectively and market mobile games. Konvoy is combining a new profit-sharing mechanism and clever financial structures which should be able to greatly bend the curve on portfolio math. And we imagine there are more pioneers out there. We understand and sympathize with traditional investors reluctance to invest in gaming, but if they will not invest, it is time to find others who will.