With so much venture funding going into web-based, ad-driven casual games (both the companies that create them and those that monetize them), you’d think the gaming industry as a whole was moving in that direction. I certainly did, at least until today. But Yahoo Games just told me that starting this week, they’re going to host free, downloadable casual games embedded with video ads. (Think games that play more like TV shows, with commercials in between breaks.) Fifty of them are available now; by end of the year, according to division head Kyle Laughlin, they plan to have 400 of these ad-wrapped games online.

This is no small play, and has the potential to reshape the game industry. Just look at the numbers:

Yahoo’s game sub-domain averages 18 million unique monthly visitors from the U.S. alone, according to Laughlin, and 49 million worldwide. This audience is already downloading tens of millions of games from their download page, but they’ve largely been poorly monetized, 60-minute trials that require you to pay to play further (something few do).

With this new distribution system, Yahoo and its partners can target ads according to game player demographics: action games for young dudes, puzzle titles for older players, and so on. Each game is an average of 100 megs, which means downloading will take just few a minutes using decent broadband, but you end up with a more robust, engaging game experience than a (much) smaller, Flash-based web game. (Laughlin claims play time for their casual web games is around 15-20 minutes, but 160+ minutes for their downloadables.)

The advertising itself will be delivered by NeoEdge, which we wrote about last November, and Double Fusion, which we wrote about in 2006. Originally intended to deliver ads for hardcore gamers, Double Fusion has been shifting its focus over the last year, concentrating instead on casual games, which have more players and broader demographics than the 18-34 guy cohort that makes up most of the hardcore base. As CEO Jonathan Epstein put it to me in a joint conference call with Yahoo and NeoEdge, “The nature of the game market is changed.” With this move, I’d say it’s about to change even more.

Imaged credit: games.yahoo.com

The casual games market is booming, generating over $2.25 billion in yearly revenue despite virtually no brick-and-mortar representation or advertising and marketing costs. But is this market rewarding for investors? For VCs interested in this space, here’s rundown of how it works.

A casual game is defined as a stand-alone entertainment software title that is digitally distributed by one or many “portals,” or independently owned Internet retail sites. Casual games typically operate under a try-before-you-buy business model –- the downloads allow players to play for a set period of time (usually 60 minutes) before shutting down. If the player wishes to continue playing, they must pay the retail price, which they can do electronically from inside the program, instantly unlocking the game for unlimited play. The average rate of purchase to play is lower than 1 percent, and games that convert higher than 2 percent are considered “hits.” The largest market for these games is women ages 30-60, a significant departure from the standard computer games market.

Development costs

The development cost of a casual game typically hovers somewhere around $100,000. That money goes into paying developers, including artists, programmers, game designers, project managers and audio engineers, as well as the developer’s overhead. This investment usually pays for between eight and 12 months of work. Of course, there are ways to reduce costs. In recent years, many developers have outsourced art and coding to companies overseas, in places like Eastern Europe, India or China. But such a move needs to be carefully managed, as many outsourced games are shipped with little quality control, often sporting poor or confusing English.

The primary profit center for casual games is online retail. Games in the genre retail for $19.99, minus retailer discounts and incentives. Since conversion rates for a casual game usually linger below 1 percent, the only profitable games are hits – mid-level successes rarely recoup their development costs. Causal games are not a high-margin business. Because the market involves so many middlemen, the final slice of the pie that makes it to developers is usually quite small.

Investing

Investment in casual game development can come in two forms: as a publisher or as a development partner. Each carries its own risks and rewards. Typically most VC investment in the casual games industry goes to the publisher, and most of the major publishers (including PlayFirst, Big Fish and iWin) were founded with VC money. Publishers then contract with individual developers to create games, paying them an up-front amount as well as a percentage of sales. Once the game is completed, publishers then distribute the game to portals and handle receivables from those portals. Most of the major publishers also maintain portals of their own, retailing both titles they publish as well as other games.

VC money does not, of course, guarantee a hit game. PlayFirst is the best example of using venture capital to successful ends, commissioning Gamelab (where I currently work) to develop their first set of titles, including the very successful Diner Dash. But another Playfirst-commission title we developed, Subway Scramble, didn’t do nearly as well.

Recently, a few studios have worked with VCs on the development side and then self-published the resultant games. This method eliminates the publisher’s revenue share, meaning more of the total income goes to the developer. Studios that have followed this method are typically more established in the marketplace, with at least one successful title under their belts. However, the lion’s share of the game’s sale price still goes to the portals and distributors, and recoupment can be slow.

Revenue streams

Developers and publishers depend on the revenue from hit games to subsidize their output, and there is still no dependable method to predict which games will be hits. With an average of one new game getting released every weekday, the market is already becoming saturated. Because development time is relatively short, a successful game will see its mechanics and theme copied and cloned within six months to a year of being released. So while the development cost of a casual game is low compared to a standard PC or console title, the chance of a single title turning a profit is also reduced.

Secondary revenue streams from casual games include advertiser-supported, “free-to-play” versions, which are generating a higher revenue-per-download rate than purchased games, as well as boxed
physical retail copies (usually handled through another third-party distributor) and ports of the game to other devices, including mobile phones and portable gaming consoles. Because casual games are
typically small in file size, with simple input mechanics, they make this transition more easily than complex PC games.

Investing in the casual games market is much like investing in any content market – dependent on a large number of unpredictable forces. There are proven marketing and content models that are exploitable, but the saturation of the market with products slavishly following those models steadily reduces their effectiveness. For a VC, the best bet is to work with an established developer with a strong, marketable idea and keep costs low. Anything else is way too risky for a market this crowded and volatile.

Written by K. Thor Jensen, who’s worked in the games industry for nearly 10 years and is currently an associate producer for Gamelab.

Image credits: playfirst.com, bigfishgames.com, and iwin.com.