Policy briefing: February 2010

The Money Game Project finance and video games development in the UK Executive summary

Seemingly everyone agrees on the importance of the video games sector to the UK economy. Yet the fiscal environment may prevent policymakers giving the sector what it most wants – a tax credit that helps to level the international playing field. Policies to improve the quality of university video games courses are crucial, but they will not stave off the industry’s near-term decline in global development rankings. Fresh thinking is urgently needed on what government can do. This briefing – the first in a series on this topic from NESTA – looks at one such idea, encouraging external project finance.

Video games studios in the UK rely on global publishers for the financing of their development activities. Although this has helped to channel funds into the video games sector, it has also made it difficult for UK studios with high growth potential to scale their businesses – under this model, publishers retain ownership over the Intellectual Property (IP) that is generated, a crucial source of long-term value in the sector. And there is recent evidence showing that publishers are commissioning less original IP. This puts UK studios in a tight spot – they can’t compete on costs, particularly against territories overseas where development is publicly subsidised, and leveraging their creative talent and ingenuity seems to be getting harder, at least with publisher-backing.

Excessive reliance on publisher funding might also be hindering UK studios’ transition to booming online and mobile gaming markets. This is because business models in these new markets are less suited to traditional models of publisher finance. There is evidence that UK studios are already lagging behind in these markets.

New financing instruments are needed if UK studios are to remain innovative in established markets, and take advantage of the opportunities presented by new ones. More mature creative sectors like film and television offer production companies a wider range of financing options, including project – as well as corporate – finance drawing on external investors.

External project finance models can make the video games sector more attractive to investors because they allow them to manage their risks in a more controlled manner than if they had to take an equity stake in a whole business. Studios, in turn, are able to retain more of their original IP, and generate additional revenues that can be invested in growth and innovation. Finally, publishers are also able to share with other investors the risks of financing more innovative and original projects in the UK. It is estimated that over £23 million has been invested in the UK games sector in the last five years using external project finance instruments.

But this is a tiny fraction of overall investment in UK video games development – there are significant barriers to the wider uptake of external project finance. Awareness of project finance NESTA models, particularly among studios, is low. External project finance can be complicated, and the fixed legal and administration costs are currently too high for many studios. The main tax 1 Plough Place schemes to encourage investment in the UK – the Enterprise Investment Scheme and Venture London EC4A 1DE [email protected] Capital Trusts – are not as well suited to project as they are corporate finance. Policy has an important role to play in lowering these barriers. The television and film industries also receive www.nesta.org.uk some public project finance in the form of broadcaster and Lottery money. It is time that some of this was redeployed towards video games development.

2 The Money Game 1. Chatfield, T. (2010) ‘Fun Project finance and video games development in the UK Inc: Why Games are the 21st Century’s Most Serious Business.’ London: Virgin Books. 2. The global market for video games, which was worth £30.9 billion in 2008, is expected to grow at an annual rate of 10.3 per cent over the next four years – almost twice as fast as filmed entertainment (see PwC (2008) ‘Global Media and Entertainment Outlook 2008-2012.’ London: PricewaterhouseCoopers). In the UK, there is a video game console in half of all households. Video games revenues surpassed the revenues for film (including box office and DVD sales) in 2009 (see Wallop, H. (2009) ‘Video games bigger 1. A creative success story for the UK UK development studios have a worldwide than film.’ Daily Telegraph, 26 December). The UK was, faces its greatest challenge reputation for their ingenuity, talent and in 2008, the third largest technical prowess – indeed they have been development territory in the world after the USA and In recent months the UK video games behind some of the sector’s most innovative Japan, with global revenues sector has become the focus of a great deal and commercially successful Intellectual worth £2.03 billion, and 10,000 people directly of attention from policymakers across the Properties (IPs) – Grand Theft Auto, Tomb employed by video games political spectrum. Seemingly a consensus Raider and Fable are but three classic studios (see Games Investor Consulting (2008) ‘Raise the has been reached on its economic (and examples. Their renowned capacity to innovate Game.’ London: NESTA). cultural) significance. Last June an All Party should leave studios well-placed to reap the 3. NESTA (2009) ‘Time to Play.’ Parliamentary Group for the sector was commercial opportunities of new and fast- London: NESTA. 4. Crossley, R. (2010) UK spent established with over 20 MPs and Lords. It growing gaming markets. £280m on casual games in is now widely accepted that, just when video 2009. ‘Casual Gaming Biz.’ 11 February. Available from: games have become a mass entertainment Like other creative industries, video games http://www.casualgaming. medium,1 the UK video games sector faces are undergoing a revolution as more and more biz/news/29813/UK-spent- 280m-on-casual-games- a serious risk of losing its position at the people use online platforms to access content, in-2009 [Accessed 11 forefront of global development.2 and come together on the Internet to enjoy February 2010]. social and multi-player gaming experiences. 5. Graft, K. (2010) Valve: Steam Broke 25 Million Active Yet, the dire straits of the public finances Video games companies have been ahead of Users In 2009. ‘Gamasutra.’ means that no party has yet been able to the curve in reaching and monetising these 29 January. Available from: http://www.gamasutra.com/ commit to what many in the sector have online audiences through innovative business view/news/27011/Valve_ called for: a tax credit to level the playing models such as micro-transactions, virtual Steam_Broke_25_Million_ Active_Users_In_2009.php field with competitors such as Canada, France markets and ‘freemium’ strategies. Britons [Accessed 9 February 2010]. and Singapore, where the industry receives spent £280 million on casual video games 6. Ogden, G. (2010) Xbox Live 3 4 Arcade Revenue Hit $100 significant public subsidies. Policies to further in 2009. Steam, a digital platform for the Million in 2009. ‘Edge Online.’ improve the quality of graduates coming out distribution of PC video games, reached 25 6 February. Available from: 5 http://www.edge-online. from video games courses are crucial, but they million global users, while Xbox Live Arcade, com/news/xbox-live-arcade- will not deliver the immediate benefits which Microsoft’s dedicated online platform for its revenue-hit-100-million-2009 will stave off the industry’s decline in global Xbox360 console, generated $100 million in [Accessed 9 February 2009]. 6 7. The New Statesman (2010) rankings. worldwide revenues that same year. Global smartphone shipments surge 30 per cent in Q4, says Strategy Analytics. ‘The Fresh thinking is urgently needed on how The mass adoption throughout the world of New Statesman.’ 2 February. the government can support the sector. This smartphones with enhanced processing and Available from: http:// www.newstatesman.com/ report, on external project finance for video graphics capabilities, and easy access to online technology/2010/02/market- games development, marks the first in a series marketplaces for the purchase of ‘apps’ has share-smartphone [Accessed of pieces NESTA plans to publish in coming also created enormous audiences for mobile 9 February 2010]. 8. Perez, S. (2009) ‘The months to address this issue. games. 173.8 million smartphones were State of the Smartphone: shipped in 2009,7 and almost a third of their iPhone is Way, Way Ahead.’ Available from: http:// Staying ahead as new markets emerge users report playing video game applications www.readwriteweb.com/ Ultimately, creativity and innovation will daily on these devices. This represents a archives/the_state_of_the_ smartphone_iphone_is_way_ determine the sustainability and growth of market of almost 60 million new users last way_ahea.php [Accessed 9 the UK video games sector – they are what year, larger than the installed base for any of February 2010]. made it a global leader in the first place. the major consoles.8 New business models are

3 also emerging in this area: for example, it is video games consoles. Instead, they have had estimated that the market for virtual currencies to draw on other sources of finance. and goods in mobile applications – including mobile video games – will reach a staggering Access to corporate finance is difficult £9 billion in 2014.9 In principle, these studios could resort to corporate finance, structured as debt – such The purpose of this report: finance, as a bank loan or corporate bond – or equity, innovation and growth in the UK video with an investor providing them with funds in games sector exchange for a share of their overall profits.10 But in order to remain strong and innovative, particularly as the competitive environment But like other creative industries, the video shifts with the arrival of new gaming markets, games sector presents certain features that UK studios need access to the right kind of make corporate investments an overly risky finance. This briefing sets out to explore the proposition for many financiers.11 They include landscape for the financing of video games high levels of uncertainty about consumer projects in the UK, and identifies structural demand, reliance on creative talent that is 9. Holden, W. (2009) Freemium weaknesses that are hindering the sector’s often not commercially motivated and the Model to Predominate 12 in Mobile Apps with VAS ability to innovate and grow. intangible IP-based nature of their output. revenues Reaching $14bn Although studios can, in principle, help by 2014, says new Juniper report. ‘Juniper Research.’ Part 2 shows how, like other creative industries mitigate the effect of these risks by adopting May 13. Available from: where commercial success is dependent on a portfolio strategy where they run several http://juniperresearch. com/shop/viewpressrelease. highly unpredictable consumer demand, the projects simultaneously, most of them lack the php?id=179&pr=139 video games sector has developed models scale to do this. [Accessed 9 February 2010]. for the financing of their activities where it 10. In practice, there is a wide spectrum of hybrid is projects rather than businesses that are Publishers as the financiers of video games instruments between debt funded. It goes on to explore the dominant development and equity finance, but both share a focus on the model for the financing of video games For the reasons above it is video games business as the recipient of projects, where publishers provide funds to development projects, rather than businesses, the funds. 11. Caves, R. (2000) ‘Creative studios, and identifies its advantages and which tend to get funded. Rather than Industries: Contracts drawbacks for the UK video games sector. Part investing in unpredictable businesses lacking Between Art and Commerce.’ Cambridge, MA: Harvard 3 describes alternative project finance models the scale to spread the risks of unforeseeable University Press. for the funding of video games development consumer demand, financiers undertake 12. Differently from other risky with the participation of external investors. It investments in specific projects, where the risk- and innovative sectors, the creative industries rely identifies ways in which they can strengthen return profile and exit strategy are more clearly mostly on copyright, and the UK video games sector, and highlights defined and performance is easier to monitor. not patents, to protect their intellectual property. some barriers to their wider adoption. Part 4 They then diversify risks through their own Patents are a stronger form concludes by considering policy implications. portfolios. of protection than copyright, as the latter is easier to circumvent by imitators. As has historically been the case for music and 13. NESTA (2006) ‘Creating Growth.’ London: NESTA. books, publishers within the industry, rather 14. Codemasters is the only UK 2. Established models for the finance than external investors, have adopted this publisher of a global scale of video games development in the UK, financing role. As a result, publishers, who have left after the acquisition of Eidos by Square Enix in and their implications well-established relationships with distributors 2009. and retailers, also act as ‘gatekeepers’ who When self-funding is not enough determine which creative products reach the In the early days of the video games sector, market.13 Because they manage portfolios of budgets were small and studios comprising a creative projects, publishers are also a more handful of talented individuals were able to use attractive investment proposition for external their own resources to fund their development financiers seeking to diversify their risks. activities. They retained control of the Indeed, most of the world’s largest video games creative process and the original IP that was publishers are publicly traded companies.14 generated, which they licensed to publishers for distribution. The dominant models for publisher finance Publishers fund video games projects according Development budgets have escalated to two main models. These are ‘work-for-hire’, significantly since then, as hardware has where a publisher commissions a studio to become more powerful and consumers more develop a video game for a fee, and ‘royalty demanding. This has made it hard for studios to advances’. In this second model, a studio self-fund video games development, especially pitches a project to a publisher, with whom it when targeting higher range platforms such as agrees to share the royalties generated by the

4 product in exchange for an advance that funds concepts at the expense of developing original, development activities.15 Once the video game more innovative projects. is released, the publisher recoups the advance from the sales receipts of the video game, after There is evidence that this has become which point it begins to share royalties with the increasingly the case as development budgets 15. This advance, usually non- studio. (Table A1 on page 9 summarises the have escalated.19 Related to this, typically refundable, is calculated to cover the costs of various financing models). publishers require studios to relinquish producing the video game, ownership over any original IP they commission and released in instalments against the achievement of A recent survey of UK studios by The in exchange for funding. Even in cases where specific milestones. Independent Games Association (TIGA), the a studio is able to hold onto its IP, publishers 16. TIGA (2009) ‘State of the UK Video Game industry trade body, emphasises the sector’s will usually insist on privileged publishing Development Sector.’ heavy reliance on publishers – both as rights for sequels and derivative products.20 In London: TIGA. customers and sources of finance.16 Seventy- some cases, publishers even insist on ‘cross- 17. In practice, issues often do emerge during the one per cent of independent studios report collateralisation’, where a studio’s royalties for development of a video that publishers are their main customers – on a successful video game may be withheld to game that significantly affect the profitability average, 58 per cent of their sales go to a single recoup losses in earlier projects. of the studio as the publisher client. Fifty-nine per cent of studios specification can rarely be truly exhaustive. Because report that they have performed development Publishers are commissioning less original the developer is reliant under work-for-hire agreements in the 12 IP development on the publisher for its finance, it is at a commercial months prior to the survey and 58 per cent of Nearly three-quarters of studios responding to disadvantage in any dispute. studios report that they have received royalty a NESTA survey carried out in 2009 reported 18. Authors’ guesstimate based on the number of video advances from publishers. that major console-based IP is in decline, and games that achieve sales 78 per cent of developers expect this trend to above the point where the 21 publisher recoups the initial The advantages and downsides of publisher continue in the future. In fact, the situation investment. finance risks becoming even worse for studios, as 19. Sinclair, B. (2010) Analysts These work-for-hire and royalty advance cash-strapped publishers narrow their product blame 2009 slump on music games, lack of models have been used for a long time in portfolios and focus their investments on their innovation. ‘Gamespot.’ the sector, and they are well understood by own in-house studios.22 15 January. Available from: http://uk.gamespot. all participants. Publishers have established com/news/6246485. relationships with distributors and retailers, As NESTA has previously argued, a big strength html [Accessed 15 February 2010]; also which enables them to reduce, to an extent, of the UK’s video games sector is its innovative Tschang, F.T. (2007) uncertainty about consumer demand. and nimble independent studios, who co-exist Balancing the Tensions Between Rationalization Publishers also provide studios with support with larger organisations such as publisher- and Creativity in the services such as quality assurance, testing owned studios which have the scale to produce Video Games Industry. ‘Organization Science.’ 23 and localisation. From the studio perspective, blockbusters targeting higher-end platforms. Volume 18(6), pp.989-1005. signing a development agreement with a 20. The proliferation of gaming platforms also means that publisher (regardless of the model) provides a That publishers are commissioning less original the original IP generated high degree of security that they will have the IP from studios is detrimental insofar as it during development can 17 be exploited more widely required finance to complete the project. reduces the viability of the UK independent – whenever they relinquish sector. Although it may seem that publisher- their IP in exchange for publisher funding, studios However, work-for-hire and royalty-based owned studios – which employ around one- are in effect sacrificing finance models make it difficult for studios with half of the UK’s development workforce potentially higher revenues in the future. For a legal growth potential to scale their businesses. In – are immune from these challenges, they perspective on this issue the case of work-for-hire, they do not receive themselves compete for resources against see http://archives.igda. org/articles/behr-wallace_ any royalties even if the video game developed ‘sister’ studios that are in many cases located contracts.php ends up being a ‘runaway success’. In principle, in territories where the video games sector is 21. NESTA (2009) ‘Time to Play.’ the royalty advance model should allow both publicly subsidised. London: NESTA. 22. Crossley, R. (2010) Devs parties to benefit from commercially successful urge caution as publisher products. But, in practice, the terms of trade at The conclusion is that UK video games studios deals ebb. ‘Develop Magazine.’ 11 February. which these deals are struck are not favourable – independents and publisher-owned alike – Available from: http:// to studios. Perhaps less than 5 per cent of are increasingly caught between a rock and a www.develop-online.net/ news/33881/Devs-urge- studios earn additional royalties beyond the hard place: competing with the likes of Canada, caution-as-publisher-deals- initial advance.18 Singapore and China through lower costs ebb [Accessed 11 February is not an option, and being innovative, the 2010]. 23. Games Investor Consulting It is not clear whether the dominance of alternative, is becoming more difficult without (2008) ‘Raise the Game.’ publisher finance is good for innovation either. new sources of finance. London: NESTA. Since the publisher bears the financial risk of the project, there is an understandable attraction towards tried and tested video game

5 The current funding landscape limits the At a global level these trends are already transition to mobile and online markets impacting on the allocation of development It is widely believed that booming mobile and resources by publishers, who are shutting down online markets could be a new outlet for the or restructuring their console and PC studios creative potential of UK video games studios. to refocus on emerging areas.28 There is a real Indeed, NESTA’s 2009 survey of video games risk that independent and publisher-owned UK businesses highlighted online and mobile video games studios with a successful track as the only video games market segments record in traditional ‘offline’ gaming platforms where original IP was expected to thrive in the will be left behind (Table A2 on page 10 future.24 summarises the different business models that are prevalent in video games markets). However, online games, as well as mobile games distributed through Applications 24. NESTA (2009) ‘Time to Play.’ marketplaces such as Apple’s App Store are London: NESTA; also Wi, J.H. (2009) ‘Innovation and far less suited to the finance models described 3. External project finance as an Strategy of Online games.’ above, where publishers fund video games emerging model for the finance of video London: Imperial College Press. development by independent studios. Online games development 25. They can also acquire and mobile video games usually require independent studios with substantial support and a sustained stream of Differently from video games, other creative the right capabilities – the recent acquisition of UK content updates after release. This means that industries such as film and TV have developed social gaming business whenever publishers commission video games project finance models that draw on external PlayFish by Electronic Arts is an example of this. for these markets, they do so through their in- finance as well as publishers operating inside 26. Games Investor Consulting house studios.25 the sector. With a portfolio of financing (2008) ‘Raise the Game.’ London: NESTA; also options, film and TV production companies can Freeman, W. (2009) If the independent studios that are such an tap more diverse sources of external finance Rick Gibson: UK studios are ignoring the online important component of the UK video games with a wide range of appetites for risk. Some opportunity. ‘Develop.’ June sector are to make the leap to these emerging financiers such as banks have, for example, 8. Available from: http:// www.develop-online.net/ markets, they somehow need to develop new traditionally preferred to invest in lower risk news/32118/Rick-Gibson- technologies and capabilities without drawing film productions with completion guarantees UK-studios-are-ignoring- the-online-opportunity on the publisher finance on which they have (bonds) that insure them against risk, while [Accessed 17 February traditionally relied. other investors, often individuals (including 2010]. angels from within the sector), have been 27. TIGA (2009) ‘State of the UK Video Game The UK is lagging behind these markets willing to fund creative projects at earlier and Development Sector.’ There is strong evidence suggesting that the riskier stages. London: TIGA. 28. Alexander, L. and Remo, UK is already lagging behind competitors in C. (2010) THQ Cuts 60 South Korea, China, Finland, Sweden and How does it work? Jobs As Rainbow, Juice Rebrand, Refocus On Germany in its transition to burgeoning online Where external project finance has been Digital. ‘Gamasutra.’ 2 and mobile markets.26 A recent survey shows used to fund video games, a ‘Special Purpose February. Available from: http://www.gamasutra. that only around one-third of UK developers Vehicle’ (‘SPV’) – usually a company or com/view/news/27090/ are targeting those markets, even though they a partnership – is created and owned or THQ_Cuts_60_Jobs_As_ Rainbow_Juice_Rebrand_ are widely expected to be the fastest-growing, controlled by the stakeholders. The IP under Refocus_On_Digital.php while more than two-thirds still focus on PC development is placed inside the SPV where [Accessed 4th February 27 2010]; also Graft, K. (2009) and video games consoles (Table 1). it is protected from the problems that might EA: ‘No Coincidence’ That emerge during the project. Layoffs, PlayFish Buy Emerged Simultaneously. ‘Gamasutra.’ 12 November. Available from: http:// www.gamasutra.com/ view/news/26058/ EA_No_Coincidence_That_ Layoffs_PlayFish_Buy_ Emerged_Simultaneously. Table 1: The future growth of video games markets, and the UK’s position php [Accessed 4th February 2010]. Console PC Web-based Mobile

Projected annual growth rate in the market between 6.9% -1.2% 16.9% 19% 2008 and 2012

Percentage of UK developers targeting the platform 65% 70% 33% 27%

Sources: PwC (2008) ‘Global Media and Entertainment Outlook 2008-2012.’ London: PricewaterhouseCoopers; TIGA (2009) ‘State of the UK Video Game Development Sector.’ London: TIGA.

6 For example, if the studio in charge of of investment that would not otherwise be producing the video game becomes insolvent, feasible. a different one can be contracted to finish it. A set of legal contracts are then set up to • Enabling studios to remain in control establish the responsibilities for the funding, of their original IP: Differently from the development and exploitation of the project, publisher funding models that dominate as well as the allocation of the returns that it in the video games sector, external project generates. Under some variations of the model, finance creates opportunities for studios a completion bond insurance policy can be to keep control of the IP they generate signed in order to insure some of the risks of during a project. This IP can subsequently be the project. A project manager represents the exploited through other channels, creating interests of the investor or the bond-holder, revenues that studios can then reinvest in ensuring that development goes according to innovation and growth. plan. • Supporting innovation by UK video games There are many types of video games project studios: There is a wide range of project finance instrument available, differing in the finance models, some of which are suitable balance of risk exposure relative to potential for projects with capital requirements below returns for investors,29 as well as in the those that are usually attractive for equity amounts of finance that are typically available investors such as venture capitalists. This for the development of the video game. They means that project finance can help to fund are briefly outlined in Table A3 on page 11 with less expensive projects targeting emerging some of the companies that are, or have been, video games markets such as low-budget involved in providing project finance listed in mobile and casual online projects which may Table A4. slip through venture capitalists’ nets. 29. This partly depends on whether the finance is The present use of external project finance • Improving the UK’s publishing provided as working capital in UK video games development capabilities: Project finance can also help which is repaid once the video game is completed, Research by Fund4Games Software suggests publishers to pool their financial resources or as equity investments in that over ten companies have funded over 60 with other investors in order to fund the the project which are repaid out of royalties or other video games projects using external sources development of video games projects by UK income generated by the in the last ten years. Of these projects, 20 are studios. By enabling them to share risks with video game. 30. Games Investor Consulting known to have been substantially developed other financiers, this model can encourage (2008) ‘Raise the Game.’ in the UK. Since 2005 at least £23 million has publishers to invest in those riskier, more NESTA: London. been invested through external project finance original projects in which UK studios have 31. Esty, B. (2004) Why study large projects? An in the UK. Although by no means insignificant, traditionally excelled. introduction to research on this amount is tiny when compared to overall project finance. ‘European Financial Management.’ spending on video games development in the • Encouraging cross-media collaboration: 10:2. UK – £451 million in 2008 alone.30 Film and television companies are increasingly keen to collaborate with External project finance can strengthen the businesses in the video games sector – UK video games sector Warner Brothers, the BBC and Channel 4 are There are several reasons why extending the all already active in this space. The adoption range of financing options to include a wider by the video games sector of project finance adoption of external project finance can help models that are prevalent in these other the UK video games sector grow: creative industries can increase the potential for cross-media funding packages. • Capitalising the UK video games sector: External project finance models can make But there are barriers to the wider adoption the video games sector more attractive to and positive impacts of this financing model external investors because they enable them There are several barriers to the wider to invest in its activities in a more controlled adoption, and realisation of the benefits, manner than is possible with corporate of external project finance models for video investments. Performance outcomes are games development in the UK: more readily observable to investors than when projects are bundled together.31 By • Nearly all of the investments through combining financial resources – including external project finance models in the UK funds from government schemes – attached to date have targeted publishers, rather to different parts of the project, this model than studios. This is because publishers tend can also make it possible to reach scales to be financially stronger, and also better

7 at ensuring the effective exploitation of • There can be significant fixed costs the completed video game through their associated with the establishment of management of sales and distribution an external project finance facility: by channels. In addition to this, publishers have comparison with traditional funding models large finance and legal teams which means in the industry, there are more parties they can establish and manage project involved, and with different motivations. This finance partnerships more effectively. makes contracts more complex and costly to craft – in the range of £25,000 to £75,000 • Unlike in other media sectors, such as on the basis of the authors’ experience. film, the participation of project finance This can make projects of a smaller scale, companies in video games development is particularly in some of the online and mobile rarely acknowledged.32 This means that many markets where UK video games studios are video games businesses, particularly studios, lagging behind, currently uneconomical to are unaware of the existence and potential fund using this finance model. benefits of this finance model.

• Video games have different risk profiles from other creative industries such as film. In 4. Conclusions and policy implications particular, the production timescales involved are longer (lasting from 12-24 months), and Investing in the creativity and innovation of the projects invariably present technological the UK video games sector – as well as creative – risks.33 In the case of The stretched public purse over the coming the film industry, there are specialists with years will make it very hard for the UK to follow the skills required to manage production the path of other development territories risks, and if necessary to intervene and where video games businesses receive generous 32. Very often, the only finish a project.34 These skills are less well government tax breaks. UK studios will have to indication that external finance has been used to developed in the video games industry. This rely on private finance to remain creative and fund a project is a mention also means that support services to manage innovative. In this dynamic and ever-changing in the game’s credits. 33. NESTA (2008) ‘Hidden the risks of video games projects, such as sector, these are the ultimate drivers of growth Innovation in the Creative completion bonds, are more difficult and and sustainability. Industries.’ London: NESTA. costly to access. 34. Bates, J. and Rivers, O. (2007) ‘Knowledgeable This policy briefing has argued that an Capital: Barriers to investing • As currently configured, Venture Capital excessive reliance on publisher finance through in the Creative Industries.’ London: Centre for Creative Trusts (VCTs) and the Enterprise Investment work-for-hire and royalty advance models is Business. Scheme (EIS) are intended as vehicles for making it increasingly difficult for UK video 35. See http://www.hmrc.gov. uk/guidance/vct.htm investments in businesses, not projects. games studios to compete on the basis of their 36. See http://www.hmrc.gov. VCTs can only invest up to 50 per cent of ingenuity and creativity, and to tap into new uk/eis/ the value of the project and any project is growth markets such as online and mobile. limited to a total of £8 million. VCTs can only Alternative finance models, including external invest in ordinary shares, which forces the project finance, can fuel innovation and the SPV to be constituted as a limited company retention of original IP needed for video games involving more overhead and management developers to grow their businesses. than is required for a partnership structure – the preferred form for SPVs. High fixed But there are barriers for the wider adoption of costs as a consequence of regulatory external project finance in the UK video games requirements mean that VCTs cannot be set sector. Arguably, as has been the case for film, up economically to fund a small number of video games will in time develop the skills and projects.35 legal and other support services that make project finance more viable for UK studios. • EIS investments are also constrained by However, studios do not have the time to wait. restrictions on the size of the vehicles (£8 Policy can help to remove some of the barriers million in total, fewer than 50 employees).36 to finance, enabling studios to innovate and Any investment through a combination of compete in new markets. It can do so in the VCT and EIS schemes can be no more than following ways: £2 million in any 12-month period. Although a number of video games companies have • By raising awareness of external project successfully made use of these schemes to finance instruments in the UK video games fund projects, it is clear that this requires sector, particularly amongst studios. The careful (and costly) planning to make sure government should finance networking the rules are satisfied. events bringing together video games

8 businesses and potential investors. One project finance in video games development model worth considering is that of the Film that lower these costs. Production Finance Market organised by Film London. • There has been some talk of the potential creation of a public body with strategic • The established application criteria – both in oversight of the video games sector. terms of scale and timeframe of investment – Co-ordinating the development of legal make it difficult for project finance investors to standards for project finance, and creating a benefit from EIS, while VCTs, for their part, do centralised repository of information about not easily allow investment in projects. There is government schemes to support video a real risk that video games might ‘fall through games development across the UK, and their the cracks’ of existing models to encourage relevance to project finance, should be two investment in high-growth sectors in the UK, or of its functions. receive investments in a way which is less suited to their needs. The criteria for applicability for • This briefing has explored ways that policy EIS and VCTs should be reviewed in order to can remove barriers to private finance in the determine how they might better encourage video games sector. Experience suggests investments in the innovative activities of UK however that public project finance – in the video games studios. form of lottery and broadcaster money – also plays an important role in supporting UK • The current legal costs of external film and television production. The economic project finance facilities make this model importance of the UK video games sector, uneconomic for projects targeting some of alongside film and television, is now widely the cheaper online and mobile markets where acknowledged by everyone. It is time to UK studios are lagging behind. It is important redeploy some of this public project funding to develop standardised legal templates for towards games development too.

Table A1: Established video games financing models

Financing Model Summary Benefits Drawbacks

Self-funded Studios with large cash reserves, The studio is in control of the Mostly suitable for smaller development or which produce games for development process. budgets. smaller platforms, can self-finance The studio can auction the There is a risk the studio will not be able to development without the need to publishing rights in order to reach a find a publisher for the video game once it access other sources of funding. When more favorable revenue agreement. is produced. the game is complete, they ‘sell’ the The studio is more likely to retain The publisher has less incentive to invest in publishing rights to third parties. ownership over the IP it generates. marketing the game.

Work-for-hire A publisher commissions a video Simple arrangement without the No additional reward if the video game game from a studio for a fee that is need to negotiate royalties. performs well. not related to the revenue generated The publisher assumes the risk of The publisher retains ownership over the by the game. project failure. Intellectual Property which is generated. ‘Work-for-hire’ titles tend not to be original

or innovative.

Royalty Advances Studio and publisher agree to share Reduces studio uncertainty about If there are disagreements about whether the royalties earned from a video the minimal revenue that will be a deliverable fulfils the milestone game and the publisher provides an received. requirements, the studio can suffer cash advance (usually non-refundable) Both participants benefit if the flow shortages. against these future royalties. video game performs well. There is potential for discrepancies between This advance is paid with the The publisher has strong incentives the royalties established initially and those fulfillment of pre-established to promote the game. that are passed on to studios. milestones. It is difficult to access publisher funding for When a game is released, the truly original and thus risky video games. publisher shares the royalties with the Publishers usually insist on keeping control developer, having first recouped the over the Intellectual Property that is advance which has been paid. developed. Publishers often insist on a first option to publish sequel and derivative games. The model is less suitable for games not sold at retail.

9 Table A2: Video games development markets

Video games market Average development costs Average development time Business Model Risks for the studio

Off-the-shelf £2m – £15m (console) 15-30 months (console) Sale at retail. Rigorous approval and console (Wii, £250,000 – £600,000 6-12 Months (handheld) certification process to Xbox360, (handheld) access the platform. PlayStation 3) and Potential restrictions to the handheld (PSP/DS) distribution of the video game in other platforms. Substantial second-hand market.

Digitally distributed £60,000 – £250,000 4-8 months Digital download-to-own. Rigorous approval and console (Xbox Live certification process to Arcade, PlayStation access the platform. Network) In some cases, restrictions on pricing.

Smartphone £50,000 – £200,000 3-8 months Digital download-to-own. Approval and certification Micro-transactions and sale process to access the of virtual items. platform. Crowded market.

Mobile phone £25,000 – £120,000 3-6 months Digital download-to-own. Crowded market. Technical fragmentation in the mobile market.

Off-the-shelf PC £500,000 – £10m 9-24 months Sale at retail. Technical fragmentation in Digital download-to-own. the PC market. High levels of piracy. Large second-hand market.

Massively Online PC £2m – £50m 12-24 months Subscription. Large operational costs Free with paid premium after launch (support services. services, server hosting and bandwidth). Online advertising. Dominant subscription Micro-transactions. model limits the target Virtual objects. market.

Casual PC £25,000 – £100,000 3-9 months Subscription. Crowded market. Free with paid premium services. Online advertising. Micro-transactions. Virtual objects.

10 Table A3: Project finance models for funding video games development

Type Key features Benefits Applicability Drawbacks

Development Provides finance for Funder is repaid regardless Larger projects with budgets Few providers of such loans. Working Capital development, but finance of commercial success of > £1m due to cost of setting Concerns over the quality and repayable on completion of game. up legal structures. scope of completion bonds. development. Complex legal framework. Risks may be mitigated by a Relatively low returns. completion bond.

Equity share Provide finance for Can produce extraordinary Projects of almost any size. No guarantee of any return. development in return for returns for the informed share in royalty income. investor.

Prototype funding Provide funding to get Most level of investment Projects of almost any size, Inherently risky. products to the stage required. as only the first part (usually Capital is quite expensive whether other financiers will Applicable to a portfolio less than 10 per cent) of a as funders need to recover step in or where a publisher approach. project is funded. losses on other prototypes. will commission further Approximately £20,000 development. – £200,000 is usually funded.

Partial Models A variant of either Risk to funder significantly Larger projects due to costs Need to find remainder of Development Capital or reduced. of establishing structures. budget. Equity share models where Can be used on a portfolio Complex legal framework. only a portion of the overall basis. budget is funded.

Table A4: Companies servicing project finance

Role Companies

Bond provider Film Finances Limited, IFG

Banks Barclays, Bank Leumi, HBoS

Project managers/monitors Wise Monkey, Fund4Games, Attaction

Acknowledgements

This policy briefing was written by Hasan Bakhshi and Juan Mateos-Garcia, NESTA and Tim Gatland, CEO of F4G Software.

NESTA is the National Endowment for Science, Technology and the Arts. Our aim is to transform the UK’s capacity for innovation. We invest in early-stage companies, inform innovation policy and encourage a culture that helps innovation to flourish.

11 NESTA 1 Plough Place London EC4A 1DE [email protected] www.nesta.org.uk

Published: February 2010