Something For Nothing: How The Videogame Industry Is Adapting To A 'Freemium' World

Just five years ago, the video game industry was relatively straightforward.

You designed a game, transferred the data to a compact disc, wrapped the disc with some instructions in a glossy plastic box with compelling artwork, did a little marketing and promotion and perhaps distributed partial versions of the game as demos to draw players in. After that, the full game was sold online or via retail for $40 to $50 a piece. Profit margins for some of the better games could run as high as 50 percent, and the most popular titles, like Activision's first-person shooter "Call of Duty" franchise, could net hundreds of millions of dollars in sales in the first day on the market.

Or you could take advantage of the vast Internet audiences and offer multi-player games for monthly subscriptions of $15 or so, almost all of it free cash flow after designing and development costs are paid out.

But those simpler days for the most established of the video games companies ended with a thud in 2009 when startups like Zynga (NASDAQ: ZNGA) and Rovio Entertainment began making a big splash with games on mobile platforms and social sites like Facebook, offering users at no charge an enticing gaming experience that stacked up well against what they were paying for in packaged products.

This is the "freemium" model, as the business plans of these companies are called because they offer games for free and hope to monetize through advertising or upselling customers to premium content and ancillary products. Now it has overtaken the more traditional approach in market share and cut into sales of packaged games substantially. Indeed, Zynga's array of successful titles, like "Farmville" and "Bubble Safari," generate well over 300 million monthly active users (MAUs) on Facebook, the most of any company on the social media site. And Rovio's mobile marvel Angry Birds reached 1 billion downloads this May. Those are staggering numbers when you consider that Activision Blizzard's "World of Warcraft," at its peak in 2010, boasted only 12 million MAUs.

The threat freemium poses to what the video game industry now refers to as "physical media" has become so worrisome that traditional publishers like Ubisoft Entertainment SA (EPA:UBI) and Electronic Arts Inc. (Nasdaq:EA) have begun to introduce their own lineups of free-to-play titles either to complement their current games or to replace them entirely.

Still, despite its successes, the freemium model has had its own share of problems lately. After an impressive period of growth as a startup, Zynga went public last December and its shares have spent the last three months some 70 percent below the IPO price. And in the wake of a weak quarterly earnings report in July, the company has offered a confused strategic vision, saying that it would move away from its Facebook games, which have accounted for 80 percent of its sales, to focus on mobile games and gambling. Top executive talent, including managers of creative and marketing, have been leaving.

With Zynga's very public problems, some tech bloggers have given up on the freemium model. For example, GigaOM opined that "Freemium has run its course," while Mashable weighed in with "Why the Freemium Model Doesn't Work," and the Wall Street Journal wrote a piece that listed all the ways "freemium fails."

But these arguments for freemium's imminent decline are off-base, particularly when the video gaming industry itself is preoccupied with how to strategically embrace the freemium approach in order to untap a revenue stream -- for many companies, their primary revenue stream -- from the millions of online video gamers who would rather pay nothing or very little for their gaming experiences. In fact, the companies that solve that riddle are likely to be the video game survivors in the coming years. As IGN, one of the largest web-based gaming publications, put it earlier this year: "Freemium is here to stay. In fact, it's probably the future of video games."

The Competition For Engagement

It seems pretty obvious that the first step to success in a freemium gaming model is building strong engagement for individual titles; amassing vast numbers of players is critical.

In some parts of the Web, engagement is created through a program's so-called ecosystem. Take an app like DropBox, which allows people to store files and share information among computers and mobile devices. Because a user would install Dropbox on all of his machines, once a person has signed up and is actively using the program, he's committed to Dropbox. "Now that I'm in the ecosystem, I have to use Dropbox," said Vineet Kumar, a professor at Harvard Business School currently working on a study of the freemium business model. "It's just more convenient than any other option. Whereas with a game, I could just consider the new game that's just been introduced, and there's no cost to switching to that game."

Occasionally, video gaming companies can create a dominant ecosystem as well. "World of Warcraft" did so with its millions of users addicted to the online community; one study from 2007 reported that the average player spent 17 hours a week in the game.

But with so many free games now, these online gaming community successes are not likely to be replicated anymore. A prominent game designer told Europe's Game Developers Conference in August that freemium game developers could expect to lose as much as 70 percent of their initial user base, according to The Verge. "If your free-to-play game cannot deliver on the promise of a great experience in a very short time, it will fail," said Sean Decker, vice president of EA's PlayFree Portfolio.

This small window of opportunity has pushed game developers to adopt design standards that many critics deem manipulative, but they force players to endlessly revisit a game, even if it means less and less enjoyment. For instance, in "Farmville" users are pressured to constantly come back to their virtual property or if left unattended their crops will decay in real time. For those who can't keep constant watch on their "farms," Zynga has sold credit cards and currency in exchange for game points that replenish the game - but some of these offers turned out to be recurring subscriptions, software that users couldn't get rid of or direct marketing schemes to sell names and IP addresses to third parties. For a period of time, Facebook sanctioned Zynga for these activities.

Zynga's coercive strategy to generate player engagement hasn't gone unnoticed. In a January 2012 article, The Atlantic famously referred to this type of intentionally addictive app creation as "The Zynga Abyss:" a hollow experience that would inevitably alienate users. And Jesper Juul, author of "A Casual Revolution: Reinventing Video Games And Their Players," said that what's disturbed people historically about Zynga is how flagrantly the developer "only (bases) game design decisions on data."

Indeed, Zynga has been so desperate to sign up more players recently that, although known for its teenage- and soccer mom- targeted games, the company is making a significant push into online gambling. The plan, still a little murky, is to promote Zynga versions of slots, poker and blackjack, among other titles. Sanitized version of these games -- that is, without the use of actual money -- have already debuted. But the next iteration will incorporate the traditional risks of gambling with wins and losses measured in real cash.

While this move could hurt Zynga's reputation among the gaming community -- many do not consider gambling part of the pure gaming experience -- it certainly offers an extraordinary freemium revenue stream. People are willing to spend lots of money when they play games of chance, much more than they feel good about ponying up in "Farmville." "When you talk about gambling, you're not talking about buying a stick for $2," said Robert Jarvis, a law professor at Nova Southeastern University who studies gambling legislation. "People are losing hundreds of dollars in a single day."

Further, with gambling, Jarvis added, "you have a chance to get something for nothing. That's something that humans find irresistible. But not everybody finds killing zombies appealing."

The Question Of Quality

As the poster child for the freemium model, Zynga has led many in the video game industry to despair that if its approach is successful, video-game quality -- a standard encompassing graphics, animation, story line and player progression that each generation of game makers has improved upon -- will be lost. But the user response to Zynga's offerings has allayed some of these fears. In general, Zynga's conversion rate -- that is, the percentage of people who buy something in a free-to-play game -- is a scant 2.5 percent.

By contrast, Kixeye, which makes Facebook-based freemium strategy games such as "Backyard Monsters" and "Battle Pirates," has earned high marks for the relative quality of its offerings, and the company makes a very public point of hiring only people who Kixeye managers claim meet an extremely high standard in their video game knowledge, experience and aspirations.

This quality-first approach has earned Kixeye conversion rates of as high as 10 percent, mostly paid users, a level that the company says opens up a decent revenue stream without sacrificing game design to the lowest common denominator. "If we tried really hard, we could increase conversion by 50 percent," said Will Harbin, Kixeye's CEO. "But we'd probably break a lot in the process."

Instead, Kixeye's freemium monetization strategy is to target hardcore, shoot-em-up gamers with titles that pique their curiosity and love of plot, animation, design and, well, violence -- a male niche that can become obsessed with the games it finds most intriguing. Before long the company plans to launch its own games portal for more user engagement and to build a wider gaming community for the Kixeye brand.

Moreover, rather than relentless upselling in games that decay in real time, Harbin says that there is a welcome revenue stream for offering "the acceleration of time," in which users can pay small amounts of money to incrementally progress past obstacles they'd rather not invest themselves in.

Freemium's Promise

Although the precise strategy to make money on freemium gaming is not clear yet, there is no doubt that there is plenty of money to be had. Until the landscape is less murky, the more established video games makers will keep their feet in both the physical games and free-to-play models. Electronic Arts has placed two of its big-name titles in the freemium world, "Command & Conquer" and "Star Wars: The Old Republic." Monetization plans for these are not yet announced. The company's Facebook offering, "The Sims Social," has a revenue stream in which users buy SimCash to purchase game items.

Other premium titles like "Medal of Honor: Warfighter," "SimCity," and "Crysis 3" will be sold for premium prices either through retail stores or digital download. Similarly, Activision Blizzard is continuing to charge for subscriptions to "World of Warcraft," although the number of paying players is dropping.

"While an increasingly large percentage of our business is shifting to digital, as long as there is a market for physical discs at retail, we will continue to deliver games in those channels," said EA's Decker.

Still, it is well accepted now throughout the gaming industry that if free-to-play is executed well, it can net a degree of user-retention that dwarfs the success of the industry's older business models. Decker likens the distinction between premium and freemium content to movies and television; an individual film brings in more sales up-front, but at the cost of more durable revenue streams than a popular television show. "I need to be convinced to commit my time and money upfront to see a movie," he said, as an analogy to $60 retail games. "Once I have committed, I will rarely walk out of a theater and I will give the movie a chance to develop over the two to three hours I'm watching it." But with a television show, as with a freemium product, Decker says he has to be convinced it's worth watching in the first few moments, "or else I'll change the channel."

But he adds, a blockbuster, high-quality television show can generate a user-base so devoted to the program that they can barely be pried away; they are constantly focused on it, awaiting its next appearance, buying ancillary products, watching reruns, talking about it to friends and even purchasing books about it.

As it is with an excellent freemium game, Decker said, "If a show, like 'Game of Thrones,' can convince me it is great. I will stay with it for years."