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With Web 2.0 fever finally starting to wane, the investor community has been pumping some serious dollars into virtual worlds and MMOGs — about $345 million in 39 virtual worlds in the first six months of 2008. And the third quarter has started off with a bang, with veteran (it was started in 2003) virtual world/online community Gaia Online announcing that it has raised $11 million in Series C funding from Institutional Venture Partners. Gaia raised $12 million last year from DAG Ventures, Benchmark Capital and Redpoint Ventures; its funding now totals $32 million. Interestingly, none of the older investors participated in the latest round. The new money indicates that the San Jose, Calif.-based company might not be profitable just yet.

Last year, when Disney acquired Club Penguin for about $700 million, the conventional wisdom was that Gaia would be the next one to get snapped up. Since then, we’ve heard rumors that the company was talking to quite a few suitors.

The reason there has been an increased investor interest in virtual worlds is because the sector captures a highly lucrative younger demographic, notably teenagers. eMarketer expects the number of teen Internet users visiting virtual worlds to rise to 20 million by 2011 — from just 8.2 million in 2007. And unlike the demographic of the traditional gaming business, which is facing a crisis of attention, teens tend to be a more engaged audience, and are more likely to participate in virtual economies and newer forms of advertising.

Gaia’s attempts at commercialization have met with some resistance from its community — read the comments in response to one of our previous posts. Nevertheless, it still has a thriving community and continues to grow at a rapid clip.

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.

Fueled by the purchase of Club Penguin and other success stories, the market for virtual worlds designed for children/teens keeps booming. Om just passed me word that Trinity Ventures is investing in Fluid Entertainment, a Mill Valley, Calif.-based developer now working on a “green kids world” with ecological themes. (Alert to Katie!) For Trinity, this adds another game property to a venture funding roster that includes casual/women-oriented game developer Play First.

Here’s the elevator pitch I’ve heard most often this year: “It’s casual gaming meets social network meets X.” The number of startups and new launches that are being framed that way — with “X” being virtual items, or user-created content, among many other features — has been overwhelming, so much so that my fellow gaming editor, Jane Pinckard, and I decided to start compiling them in ongoing, round-up posts. Last month, Jane tackled iWon, Kickplay, Moola, and Wipido. Here are three more:

DinerDash.com

• The Pitch: The blockbuster casual game of heroic waitressing adds a social network (pictured) and a quasi mini-MMO in which players can run restaurants and buy virtual items.

• The Money: From PlayFirst, the casual game publisher backed by venture funding from Mayfield Fund, Trinity Ventures and Rustic Canyon Partners.

• The Take: Over the years, Flo’s adventures have been downloaded over 200 million times, yet 45 percent of the buyers of the most recent spinoff, Diner Dash: Hometown Hero, were new customers of the franchise (a PR rep tells me). This one looks like a sure hit.

Meebo.com

• The Pitch: The popular avatar-powered chat network is now adding a game platform for developers, so online users can invite friends to engage in bouts of quick gaming. (Sort of live chat meets Facebook-style apps.)

• The Money: Launched in September 2005, gained backing from Sequoia Capital in December of that year and Draper Fisher Jurvetson this January.

• The Take: Currently boasting 6.5 million unique monthly users with an average use time of 2.5 hours, this is fertile ground for advertising revenue. Unsurprisingly, Meebo PR reps tell me they’ve already attracted 200-plus developers to create casual game titles.

Coobico.com

• The Pitch: Habbo Hotel meets Sim City: a Flash-driven casual MMO in which players build cities and socialize. (Set to be released in the first quarter of 2008.)

• The Money: Developed by Linking People Ltd., a small company founded in 2006 in Hong Kong by three veteran German web developers.

• The Take: Visually appealing with an inventive concept, this has a good chance of attracting the same creative teen gamers that made Gaia Online such a hit, as well as older gamers with less time for the hardcore strategy games they used to love. Here’s an interesting Gamasutra interview with the developers. It will be launched first in China and Germany, regions heavy with virtual world players.

We’ll keep an eye on all of them in the coming months. Chances are that a few will reach escape velocity — though just as surely, most will go defunct or be consolidated with a bigger player.

First the good news: virtual worlds are experiencing their own dot com boom. Now the bad news: virtual worlds are experiencing their own dot com boom. Tomorrow and Thursday, the second Virtual Worlds Conference and Expo launches in San Jose; the first one went off last March in New York, when just nine worlds/MMOs were showcased. Six months later, thirty of them will be on hand, many you’ve probably never heard of, and if past history is any guide, just as many you’ll probably not hear much about, afterward. Seven slated for the show are kid-oriented, including Zwinktopia, Gaia Online, and Habbo Hotel, all of which have been featured on GigaOM; with the continued growth of MMOs for minors, this isn’t surprising. But then, four of them are virtual worlds designed for enterprise solutions, including Forterra, Unisfair, Project Darkstar from Sun Microsystems, and something called VT&T, a stealth project from a team of developers formerly of AT&T.

Like the original dot com boom, the Expo is an awkward convergence of traditional media corporations like Disney (new owner of Club Penguin), MTV/Nickelodeon (announcing eight virtual worlds), and Turner (which recently bought partnered with Kaneva), scrappy start-ups like Metaplace and Ogoglio, and lumbering into the proceedings like they always have, Microsoft with Virtual Earth and an unknown MMO set to be announced there.

And if the last boom’s trajectory of hubris and greed is followed, most of these are destined for obscurity– or acquisition by their wiser superiors. While kid-oriented MMOs have the most active users and thus seem like the safest bet, for example, as FoundRead editor Carleen Hawn suggests, they’re also fragile ecosystems that can fall apart with too much outside interference and commercialism.

In any case, I’ll be there to appear on a panel, and looking for GigaOM stories to file from the scene. If you see me, be sure to say hi; and if you miss me at this virtual worlds conference, you can still look for me at the one in London, later this month.

Disclosure: My Second Life blog New World Notes is a “media partner” with the Expo.