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METANOMICS:       VIRTUAL GOODS: OPPORTUNITIES, CHALLENGES AND ACQUISITIONS                                    OCTOBER 18,...
MICHAEL BOBROFF: Yeah. I guess a common definition of a virtual good would really bedigital content that enhances a game p...
under the subscription model.And so one of the disadvantages of the subscription model is that you effectively, in manycas...
becoming much more sophisticated in understanding that dynamic, understanding thatfree users are, in fact, a very importan...
you have a company that is generating revenue and only two percent of your users arepaid users, just think about what kind...
spread. So it sounds like thats a prediction that really didnt pan out, that, in fact, much ofthe growth has come from the...
happening in the future?MICHAEL BOBROFF: Privacy is clearly very important to social-gaming companies, interms of maintain...
up acquiring Playfish. And then there are many other smaller acquisitions that are nowbeing made by the traditional video-...
something a lot of our audience members will be familiar with, that a lot of companiescame into Second Life and threw thei...
In the white paper, we introduced three different types of models, and those models arereally based on the level of inform...
revenue over a period of time is really driven by an implied obligation by the social-gamingcompany to continue to deliver...
of purchase [AUDIO GLITCH] that users termination date. And although the first date ofpurchase can be objectively determin...
ROBERT BLOOMFIELD: Yeah. And that was going to be my next question: How helpfuldo you believe these types of models are fo...
users.ROBERT BLOOMFIELD: Weve got a couple people boggling at this notion of a virtualdurable good. Do you mind just givin...
the law on the tax side? Do you see this as a work in process?MICHAEL BOBROFF: Sorry, Rob, on the sales-tax side or what?R...
ROBERT BLOOMFIELD: I was going to say, one of the analogies that occurs to me isthat, well, I guess in the U.S., in more e...
social-gaming and virtual-goods industry?MICHAEL BOBROFF: I see a couple of things on the horizon. As I mentioned earlier,...
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Metanomics: The Virtual Goods Industry Update

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The virtual goods industry has seen rapid growth over the past few years. They have redefined games where subscription-based models have been replaced by free-to-play games that sell virtual goods to a thin sliver of their player base: what are often called the ‘whales’.

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Transcript of "Metanomics: The Virtual Goods Industry Update"

  1. 1. METANOMICS: VIRTUAL GOODS: OPPORTUNITIES, CHALLENGES AND ACQUISITIONS OCTOBER 18, 2010Metanomics is a weekly broadcast on the serious uses of virtual worlds. Visithttp://metanomics.net. Metanomics is owned and operated by Remedy Communications.ROBERT BLOOMFIELD: Hi. Im Robert Bloomfield, professor at Cornell UniversitysJohnson Graduate School of Management. Today we continue exploring Virtual Worlds inthe larger sphere of social media, culture, enterprise and policy. Naturally, our discussionabout Virtual Worlds takes place in a Virtual World. So join us. This is Metanomics.ANNOUNCER: Metanomics is filmed today in front of a live audience at our studios inSecond Life. We are pleased to broadcast weekly to our event partners and to welcomediscussion. We use ChatBridge technology to allow viewers to comment during the show.Metanomics is sponsored by the Johnson Graduate School of Management at CornellUniversity. Welcome. This is Metanomics.ROBERT BLOOMFIELD: Welcome to Metanomics. Our guest today is Mick Bobroff. Mickis an audit partner in Ernst & Youngs northern California technology practice andspecializes in the software, digital media and online games industries. Mick is probablypretty comfortable with changing and uncertain settings. Before working on social gamesand multiplayer online role-playing games, Mick spent six years at the Ernst & Youngoffices in Moscow, in Russia, shortly after the dissolution of the Soviet Union. Its a topicIm actually very interested in hearing about. So, Mick, welcome to Metanomics.MICHAEL BOBROFF: Thanks for having me, Rob. Good to be here.ROBERT BLOOMFIELD: Let me just mention to Treet Im hearing a little bit of an echo.Perhaps thats taken care of now, so well go ahead. I wanted to start really by just askingsome basic questions, to get your sense of the industry, and we can start with this notionof a virtual good. In your mind, what is the definition of a virtual good?
  2. 2. MICHAEL BOBROFF: Yeah. I guess a common definition of a virtual good would really bedigital content that enhances a game players experience within a social gamingenvironment. And a lot of the times, virtual goods are, in fact, provided to game players forfree. And, in other cases, when a digital good is rare or provides enhanced abilities for auser, then a lot of times the virtual good is something that a user has to pay for, andtherein lies a great thing about the business model for virtual goods--a "free to play" virtualgoods-based business model.ROBERT BLOOMFIELD: It seems like one of the big business innovations in the socialgaming industry is this switch from subscription-based model to the sale of virtual goods.Where do you think we are in that evolution?MICHAEL BOBROFF: Its really interesting, if you look back to the gaming industry or thevirtual-goods industry. In Asia, if you go back five, six, seven, eight years, many of thecompanies there were initially on subscription models, and, as those businesses began tomature and develop, many of those companies actually switched to "free to play" and thengenerated their revenue by selling virtual goods. And so weve started to see that here inthe U.S. with the social-gaming industry, which really only began two or three years ago.The social-gaming industry has been dominated by the "free to play" virtual goods-basedbusiness model. And then when you look at the more hardcore multi-player role-playinggames, those have traditionally been subscription models. And what weve been seeinglately is that some of those games are now experimenting with or transitioning to the "freeto play" model, and theyre finding that, in some cases, its actually more profitable.ROBERT BLOOMFIELD: What makes it such an attractive and successful model?MICHAEL BOBROFF: So under the virtual goods-based model, obviously when the gameis available for free to its users, the number of users goes up pretty dramatically when youcompare it to a paid subscription service. Now, in a virtual goods-based business modeland a "free to play" virtual goods-based business model, its really only a small portion ofplayers that actually purchase the virtual goods. And, in fact, that percentage could beanywhere from as low as one percent to as high as ten, eleven, twelve percent, dependingupon the nature of the game. But what a lot of companies have learned is that that one ortwo or three or five percent ends up paying a lot more than what that game could generate
  3. 3. under the subscription model.And so one of the disadvantages of the subscription model is that you effectively, in manycases, cap the revenue that you can earn from an individual user; whereas, under thevirtual goods-based business model, there will be some that dont pay for virtual goods,there are some that are comfortable purchasing virtual goods at five or ten dollars amonths. And then there are the whales that will purchase virtual goods and spend, believeit or not, thousands of dollars a month to play the game. So as a result, the beauty of thismodel has been that you have a small number of users that are purchasing virtual goods,and then a subset of that referred to as the whales that pay a significant amount of moneyand then drive a good portion of the revenue.ROBERT BLOOMFIELD: We often talk about the visible part, I guess, of the revenuemodel is the sale of virtual goods. Certainly, online we see lots of other ways to monetize.In particular, Im thinking theres advertising, and theres also the ability to extract valuefrom the customer data. Especially the customer data, does that sort of go hand in handwith a virtual goods revenue model?MICHAEL BOBROFF: The other aspect of revenue that social gaming companies earn is,in fact, advertising revenue, and most of the advertising revenue that is earned currentlyreally has to do with these in-game offers, whereby, if you dont want to purchase virtualgoods for cash, you can go in and click on an ad for a specific advertiser, perhaps sign upfor something, and then, in turn, you earn some premium virtual currency for that action.And so thats brought in some advertising, a certain level of advertising revenue tosocial-gaming companies. It hasnt been a significant portion, but it is growing, and theadvertising is becoming more sophisticated within social gaming. There are a lot of newentrants into the market.But on the free users, free users do play a very important part in the economics of asocial-gaming company because all of these users, when you play these social games, acritical part of your strategy is to make sure that youre connected to your friends andyoure able to gift certain virtual goods to your friends. And so the way that a lot of thesesocial-gaming companies look at their free users is (a) theyre a source of advertisingrevenue, but (b) equally as important is that theyre likely to invite friends that are, in fact,going to be paid users. And so what Ive found is that social-gaming companies are
  4. 4. becoming much more sophisticated in understanding that dynamic, understanding thatfree users are, in fact, a very important part of their economics.ROBERT BLOOMFIELD: Well, they almost serve their role of both marketing and beingcontent themselves for the people who are willing to pay.MICHAEL BOBROFF: Absolutely.ROBERT BLOOMFIELD: So lets talk about the risks. And I guess risk number one is: Doyou think that this type of business model and the product itself, the social game, do youthink its just a fad?MICHAEL BOBROFF: Thats certainly a question a lot of people are asking. I guess theway that I look at it is social gaming has basically introduced online games to a whole newdemographic. Right? And, all of a sudden, you have people, such as myself, andstay-at-home moms and professionals that are, all of a sudden, playing online games forthe first time in the last couple of years. I think the reason for that is because many ofthese social games you can play for basically five or ten minutes at a time and progresswith the game by just playing five or ten minutes at a time once a day. You have a choiceof whether you want to pay money or not. And, as a result, I think that social gaming hasbecome a new form of entertainment to a whole new demographic of gamers.And so, from my perspective, I think that that will continue, that we will continue to playgames through the social networks and, ultimately, I think itll continue to be a verysuccessful business. One of the things that I focus on very closely is that only a smallpercentage of users currently purchase virtual goods, and I throw out the percentage ofanywhere from one percent to as high as twelve percent, depending upon the category ofthe game. But, if you think about it, one of the aspects that all social-gaming companiesare getting better at every day is that theyre getting better at changing the game dynamicssuch that they create an appetite for purchasing virtual goods by the users.And the second thing that I think has happened over time is that it has become moreacceptable to purchase virtual goods from a social standpoint and also people justunderstand the value of having and purchasing virtual goods within an online game. So if
  5. 5. you have a company that is generating revenue and only two percent of your users arepaid users, just think about what kind of revenue growth you would have if you tick that upfrom two percent to three percent, without even growing your user base. So thats one ofthe reasons Im very, very excited about being associated with the industry.ROBERT BLOOMFIELD: Now, another potential risk here is that it seems like manysocial games are dependent on a software platform for their very existence. In particular,Im thinking of games that reside on Facebook. I understand many people say anyway thefirst game that was a big hit was Scrabulus, a scrabble derivative, and it was only availableon Facebook. I guess, first, do you see that as a risk for a social game to be dependent ona particular platform? Well, Ill just leave it there.MICHAEL BOBROFF: Yeah. I think many social-game companies are, in fact, focused onthat very issue. There are certain social-game companies out there that are verydependent on their relationship with Facebook. I would say that almost all are thinkingthrough that issue and determining how best to diversify their risk by including their gameson other platforms or perhaps launching some of the games or giving the users the abilityto play their games directly on their websites. So as some of these social-gamecompanies begin to go international, they are also looking at some of the social networksthat exist in Asia and in Europe, and theyre finding that thats also an effective way ofdiversifying their dependence on a single relationship. But clearly, Facebook is a veryimportant partner to many of the social-game companies today.ROBERT BLOOMFIELD: Ultimately Im going to want to ask you to make somepredictions, but Ill give you time to mull that over while we discuss some predictions fromtwo and three years ago about the future of social gaming. One set from Ravi Mehta, andthen Ive got another one that comes from Jeremy Liew of Lightspeed Ventures. Hes apartner and has published predictions at the end of each year, for the last several years,about social games and virtual goods. So the good thing here is, you can evaluate thesepredictions after seeing what actually happened, and you dont have to criticize yourselfbecause theyre not yours.You had mentioned that youre seeing a lot of people from 25-and-up age group as part ofthese games. This is from Jeremy Liew. He emphasizes in his prediction many users skewyoung, and, if you believe the demographics is destiny, then youll expect this behavior to
  6. 6. spread. So it sounds like thats a prediction that really didnt pan out, that, in fact, much ofthe growth has come from the older crowd. First, is that your assessment? And second,where do you see the growth coming from in the next few years?MICHAEL BOBROFF: I think the demographic, the high school demographic and then theearly twenties demographic will always be important within the online-games industry, thesocial-gaming industry, but I think what has come as a surprise to many has been thepopularity of these games by the 25-to-45 year old demographic. And, as I mentionedearlier, I would venture to say that I think that will continue because playing these socialgames does not require a big investment of your time, and, as a result, its become a newform of entertainment for people that historically havent been playing these games. So Iwould expect that to continue in the future.ROBERT BLOOMFIELD: Another of Jeremys predictions is, social networks willmonetize by providing virtual currencies. You were talking about the small percentage ofpeople currently who are buying virtual goods. Do you see something happening, like theLinkedIn or Facebook or MySpace or whatever, providing their own virtual currencies thatwould make it easier for people to buy goods from the games that reside on theseplatforms?MICHAEL BOBROFF: Oh, absolutely. And its already happening. Facebook introducedFacebook credits last year, that provides a common currency for games on Facebook, andthat has become an important revenue stream for them. And, if you look at the socialnetworks around the world, many are now introducing this concept of a virtual currency,that is sold by the social network, that you then use to either redeem the virtual currencyon a social game thats on the network or to apply that virtual currency directly in gamethats on that social networks platform. So I think thats definitely an evolution that isalready happening, and I would expect will continue to take place with all the socialnetworks really.ROBERT BLOOMFIELD: I see theres some commentary going on in our text chat.Cisop Sixpence is expressing concern about privacy on Facebook in particular, but I thinkthis is something that a lot of people worry about just generally with these social games,social networks. So Im wondering, do you have any, I guess, assessments as to whatdegree privacy concerns are restraining growth in social games? And what do you see
  7. 7. happening in the future?MICHAEL BOBROFF: Privacy is clearly very important to social-gaming companies, interms of maintaining trust with its users. If your users lose trust in you, then that wouldcertainly have a detrimental impact on your ability to grow your revenues, to grow youruser base. So I would say that all social-gaming companies are, in fact, focused on that,and there obviously has been a lot of press on this. In fact, I think in the Wall StreetJournal this morning there was a page-one article on this very topic so it is, withoutquestion a challenge and a risk for every one of these companies. And I think itssomething that theyre all working on and clearly is a very important aspect of theirbusiness.ROBERT BLOOMFIELD: Okay. Heres another prediction that comes from Ravi Mehta,and its actually just from not too long ago, July of 2009, so a little over a year ago. Theprediction is traditional game companies will continue to stand on the sidelines. Let me justread a little bit of this. It says, "What was the very first hit social game? Itll probably soundfamiliar: Scrabble. Well, actually Scrabulus launched shortly after the release of theFacebook platform. Scrabulus is a social game based on Scrabble, released by twobrothers who became the first lucky prospectors in the social-game gold rush.Rather than recognizing their good fortune in finding a new rapidly growing medium fortheir games, Hasbro quickly got to the business of shutting Scrabulus down and didnt findtime to release its own version of Scrabble on Facebook, until months later, after majorplayers such as Zynga had staked their claim. None of the traditional game companiesplayed a significant role in social games to date, and this will likely continue until the majorplayers, such as Electronic Arts and Activision, wake up to the opportunity and startacquiring players, like Playdom and Zynga, is what they mentioned. So this is now 14, 15months old or so. Whats your take on what has happened, and where do you see thetraditional game companies coming in over the next few years?MICHAEL BOBROFF: I think all the traditional game companies or most of the traditionalgame companies now have a public strategy of transforming to digital, including gettinginto social games. And some have done it by creating their own games in-house, andothers have done it through acquisition. So Playdom ended up getting acquired by Disney.Disney also had some other acquisitions in the social-gaming space. Electronic Arts ended
  8. 8. up acquiring Playfish. And then there are many other smaller acquisitions that are nowbeing made by the traditional video-game companies and also the traditional mediacompanies. The traditional media companies also see a lot of advantages and a lot ofsynergies to this business, and theyre getting involved as well. So new players are beingadded in this space every day, as more people realize how lucrative the space is.ROBERT BLOOMFIELD: What is the venture-capital appetite for investing in these typesof businesses?MICHAEL BOBROFF: The VCs have been very active in the social-gaming industry, andwhen they look at social-gaming companies or at least the history of social-gamingcompanies to date, which has been short, the period between inception of the company toexit has, thus far, been much shorter than a traditional technology company. And manysocial-gaming companies have been able to scale their business within a relatively shortperiod of time and so, as a result, have been viewed as very attractive by the venturecapitalists. Now, valuations for these social-gaming companies in M&A transactions havebeen very high recently because of all the interest by the new entrants into the market,and so that has also made the space very attractive to venture capitalists.ROBERT BLOOMFIELD: Just to clarify, youre saying thats primarily because of thequick turnaround from development of a game to their realization of revenue?MICHAEL BOBROFF: Thats right. Thats right. I mean one of the interesting things aboutthe model is that the way that many social-gaming companies operate is that they spendanywhere from six weeks to three months developing a game, doing a launch, and thenthey update that game on a weekly, regular basis as they receive feedback from theirusers. So compare that to a traditional console-game publisher [AUDIO GLITCH] game upfront and then basically throw it over the wall for users to purchase. Its actually great to bein a position--the social-gaming companies are in a great position [AUDIO GLITCH]adjustments and tweaks as users provide them feedback.ROBERT BLOOMFIELD: Okay. Very interesting. I see theres a question from anaudience member, Pooky Amsterdam. Hello, Pooky. What limitations traditional mediacompanies encounter by not being part of this landscape? And she mentions, and this is
  9. 9. something a lot of our audience members will be familiar with, that a lot of companiescame into Second Life and threw their money in, but had no plan at all. Whats yourimpression on whether the traditional game and media companies, do they know whattheyre getting into? Do they know what theyre doing? Or are they primarily relying on theyoung folks who have a vision?MICHAEL BOBROFF: In terms of the development of social games, obviously thetraditional media companies are hiring people within the industry, that have previouslydeveloped social games. But I guess the way that I look at it, with traditional media, is thattheyve found another way, and theyve been doing this for some time, but theyve foundanother way to distribute their branded content. And I think thats another thing that wellstart to see as the traditional media companies get more interested in the social-gamingindustry. Many of these social games will start to become branded social games, andyoull start to see some of the brands that we see in other forms of media.ROBERT BLOOMFIELD: Very interesting. Id like to move on to another topic here, whichis measuring revenue on the sale of virtual goods. And here’s the part of the show where Ihave to remind everyone that were both accountants. Right? Youre an auditor. I work onfinancial reporting and standards setting. Deciding when firms can recognize revenue isalways one of the most challenging parts in financial accounting, and its been a particularchallenge in the software industry. You have written a white paper, and actually Im goingto copy this link and paste it into the chat window so that everyone can see that and clickon it, if they want to. This is a white paper from Ernst & Young, called RevenueRecognition on the Sale of Virtual Goods. Could you start just by setting this up, the bigpicture for us? What is the challenge in revenue recognition for virtual goods?MICHAEL BOBROFF: Right. Revenue recognition on virtual goods: many accountantswhen they first encounter their revenue models within a social-gaming company or justonline games in general their initial reaction is, "Well, I sell virtual currency. That virtualcurrency then needs to be converted into a virtual good. I have no legal obligations after Isell the virtual currency. Why cant I simply recognize the revenue at the point of sale ofvirtual currency?" Although there is certainly a theoretical argument for recognizingrevenue at that point in time, the way that we look at it and the way the industry reallylooks at it is that you really have to look through to see what is the users expectationwhen they purchase a virtual good with virtual currency.
  10. 10. In the white paper, we introduced three different types of models, and those models arereally based on the level of information thats available to the social-gaming company. Butthe theory behind it is that, if I purchase a virtual good with my virtual currency--and Ill usean example of a rare online schoolhouse that remains on my game board within a game,and I purchase it for five dollars--the theory behind it is that, as a user, although the termsof service may, in fact, state that the social-gaming company has no obligation to the userafter that transaction occurs, the fact of the matter, as a user, when I log in tomorrow, intothe game, it is my expectation that that schoolhouse will be there, and its my expectationthat that schoolhouse will continue to be on my game board for as long as I continue toplay the game.By the same token, if I purchase something such as virtual fuel for my virtual vehicle, therevenue really doesnt get earned until you use the virtual fuel for your vehicle, until itsconsumed. So the basic model is that you recognize revenue on the sale of virtual goods,not on the sale of virtual currency. But at the time that the virtual currency is converted intoa virtual good, revenue recognition commences, and you recognize durable items ratablyover its estimated useful life, and consumable items, such as the virtual fuel example, asits consumed.ROBERT BLOOMFIELD: I understand the logic of the basic model, that the company thatis selling the virtual good, theyre getting cash right upfront, and theyre making a long-termcommitment to the person who has purchased it, and so it makes sense to consider that inrecognizing revenue. But I do have a couple problems with this model. And the first one isthat, as I understand your description of the revenue, basically the business model forthese companies, they are selling virtual goods to only a tiny fraction of the people whoare playing the game. And so Im assuming that, if I look at a particular virtual good, thecash that the customer gives me right upfront must be huge relative to the actual cost ofproviding that good to the player for however many months or years are involved. It justseems a little odd to me that users would be delaying the recognition of revenue, if theyhave just a trivial sort of de minimus duty to the customer from then on, do you find thatreasoning persuasive at all?MICHAEL BOBROFF: I absolutely agree with you that the cost of actually providing thevirtual good is generally very small/insignificant. The theory behind recognizing the
  11. 11. revenue over a period of time is really driven by an implied obligation by the social-gamingcompany to continue to deliver the virtual good for as long as that user wants to accessthe game. And I guess another way of looking at it, Rob, is another industry that I spentsome time in is the softwares and service sector, whereby, in many ways, social gamesare a form of service to the end users, and youre effectively paying a fee upfront for aservice over an undefined period of time.So as a result, I see a lot of parallels between the social-gaming industry and in thesoftwares and service industry. And then the softwares and service industry, you obviouslyrecognize the revenue over a defined period of time, over the period of time that youvecommitted to providing the service to the customer. The only difference here is that theperiod of time is not defined.ROBERT BLOOMFIELD: Mm-hmm. You mentioned that there are three models. This isthe game-based revenue model, the user-based revenue model and the item-basedrevenue model. And so first, I guess I have a question. Youre an auditor. Youve writtenthis white paper for, well, its available to anyone, but presumably reflects how you guideyour own clients. Im hoping you can not just walk us through these models, but also tell usa little bit about what is--are these things actually being done? Or is it more of just a theoryon how one might recognize revenue for virtual goods?MICHAEL BOBROFF: Sure, absolutely. And that is correct. This is a white paper that ispublicly available and is consistent with how we guide our clients on these issues.Obviously, every company has its own set of facts and circumstances so it is a generalwhite paper. But what the white paper does cover is, it covers three models of revenuerecognition: the games-based model, the user-based revenue model and the items-basedrevenue model. At the highest level and the easiest one to apply is the game-basedrevenue model, and the theory there is, you recognize all revenue ratably over theestimated remaining period of the life of the game. And you would apply that model if yousimply dont have the data to apply the user-based revenue model which requires a lotmore user-behavior data.The next model is the user-based revenue model, and here what youre required to dounder the user-based revenue model is determine the estimated life of the user. And soyou recognize revenue on the sale of virtual goods ratably over the user life. And this doesrequire some work for many social-gaming companies because coming up with acalculation to support an average user life is not easy. Its typically defined as the first date
  12. 12. of purchase [AUDIO GLITCH] that users termination date. And although the first date ofpurchase can be objectively determined, the termination date is more difficult to determinebecause--and Im a good example of this--many people come in, play the games, leave,try other games, return, and so coming up with a definition as to when a user is consideredterminated is an important aspect of that.And then, finally, the most detailed of the three revenue-recognition models is theitem-based revenue model, and here, in this situation, you actually look to thecharacteristics of the virtual goods that are being purchased. So what that means is that, ifyou buy a durable good, a virtual good that you continue to expect to see within your gameboard, within your game environment, as long as you continue to play the game, thatrevenue gets recognized ratably typically over the estimated user life. Then you have theconsumable items that get recognized upon consumption.And then I guess the third category really is the rental items so to the extent the gamingcompany sells virtual goods that have a rental period associated with them, you wouldrecognize that revenue ratably over the rental period.In terms of who is applying these models, its interesting as if you look at the Chinesecompanies that are SEC registrants that report in US Gap, and there are about six orseven of them, all of those companies, in fact, apply the item-based revenue model. Andwe work with some of them, and they actually have very sophisticated IT andbusiness-intelligent systems that enable them to do that. And that has largely becomeindustry practice within that group of companies.What I would say that I see the most among all the companies that I talk to, especially outhere in California, is that many companies find the item-based revenue model veryburdensome because it does, in fact, require a significant amount of data. It does requiresome technology infrastructure, and that data may not necessarily exist. So mostcompanies that I come across initially apply the user-based revenue model. When youthink about it, the user life is a not only an important data point for revenue-recognitionpurposes, its also an important data point for operating the business. User retention isobviously very important for all of these gaming companies, and so to the extent you cancome up with a user-life calculation that makes sense from both a revenue-recognitionstandpoint and helps you operate the business, it obviously helps everyone concerned.
  13. 13. ROBERT BLOOMFIELD: Yeah. And that was going to be my next question: How helpfuldo you believe these types of models are for operating the business? Can you envisionfirms pulling these types of models together, even if they werent worried about adhering tofinancial reporting standards?MICHAEL BOBROFF: Lets take the durable goods/consumable goods as a data point.So for applying the item-based revenue model, you would need to be able to distinguishthe difference between durable goods and consumable goods [AUDIO GLITCH] so thatyou could separately recognize those as revenue. But another way of looking at it fromoperating the business, is consumable items are, in fact, important in operating thebusiness because presumably, if youve got users that are purchasing consumable items,theres a continuous appetite for those consumable items. So what Ive started to see isthat some of the social-gaming companies are, in fact, looking at the activity of theirconsumable items, and that does result in earlier revenue recognition, as compared todurable goods, but to the extent you can get a nice stream of consumable items, thatobviously drives some pretty good revenue growth.ROBERT BLOOMFIELD: We have a couple more audience questions. Linda Sautereau,from the Kelly School of Business at the University of Indiana, says, "Weve got twoaccountants talking about this. Would marketers have a totally different take on it?"Unfortunately, you cant turn yourself into a marketer right away, but no doubt you have alot more interaction with people on the marketing side than people who arent accountantsmight suppose. Do you care to hazard a guess on how marketers view this data, and Isuppose the virtual-goods issue more generally?MICHAEL BOBROFF: If you look at it from what is the best way to market virtual goods toyour users, I think the durable-consumable distinction is, in fact, an important distinctionand that this concept that I mentioned earlier about consumable virtual goods resulting inaccelerated revenue recognition, I believe, from a marketing standpoint, also drivesrevenue growth if youve got the game mechanics nailed down such that you can createan appetite for your users to continuously purchase these consumable goods. So I do lookat it as being an issue that is broader than an accounting issue. It really is an issue on howbest to monetize your virtual goods and how you continue to drive revenue. And then howyou drive more paid users, how do you increase the percentage of paid users to total
  14. 14. users.ROBERT BLOOMFIELD: Weve got a couple people boggling at this notion of a virtualdurable good. Do you mind just giving another stab at describing what you mean bysomething that sounds a bit like an oxymoron?MICHAEL BOBROFF: Sure. There are some that refer to them as perpetual goods, ordurable good is probably the more common term that Ive heard used within the industry,but the basic concept behind it is that its a virtual good that the user continues to haveaccess to, as long as that user continues to play the game, and theres no deterioration inthat virtual good. It just continues to be displayed. So an example: In a farming gamewould be a virtual pink tractor and perhaps the pink tractor is rare as compared to thetypical tractor that you sell. And that tractor will continue to be in the game, and anyactions that you do will not, in fact, have any impact on that pink tractor. Other examples ofdurable goods would be sometimes you see virtual clothing or a virtual barn, a virtualschoolhouse, etcetera. Those are the type of virtual goods that you would typically see,and that would be defined as a durable virtual good.ROBERT BLOOMFIELD: Okay, yeah. Looking at the chat, it looks like that helped so Iappreciate that. Lets see. We dont have a whole lot of time left. There are a couple moretopics Id like to hit. One is that when we spoke earlier, you mentioned that there weresome interesting tax challenges associated with virtual goods and that virtual goods mighteven be, for example, subject to sales tax. What are the tax issues people should beaware of, with virtual goods?MICHAEL BOBROFF: Virtual goods are, in fact, subject to sales tax in certain states, andso what many social-gaming companies have to face is to determine which states theyhave a taxable presence in, and, if then if they have a taxable presence, then in a statethat requires companies to charge sales tax on virtual goods, then you theoretically needto charge the users sales tax on virtual goods. That, unfortunately, is hitting a lot ofcompanies by surprise.ROBERT BLOOMFIELD: Well, let me ask. You talked about revenue recognition in themodels on the financial-reporting side. How exploratory is income reporting at this point,
  15. 15. the law on the tax side? Do you see this as a work in process?MICHAEL BOBROFF: Sorry, Rob, on the sales-tax side or what?ROBERT BLOOMFIELD: Im thinking more just on net income. In corporate income taxesor however these organizations are set up.MICHAEL BOBROFF: Right. No, I think just the same as it is on the financial-reportingside, theres a whole slough of complexities on the tax side. Yeah, its really beyond mycore of expertise to really go into that.ROBERT BLOOMFIELD: Okay. Thats perfectly understandable. Id like to really changegears significantly here. You lived and worked in Russia shortly after the dissolution of theSoviet Union, and I know that sometimes when I hear people talk about the state ofbusiness in those transitional years, it sounds a lot like Silicon Valley. Im wondering if youcould tell us a little bit about what it was like when you were there and whether there arelessons you learned, in those freewheeling days, that you continue to find useful in thegaming industry.MICHAEL BOBROFF: Sure. It was a fun period of my life for sure. I lived and worked inRussia from 1992 to 1996, and arrived there shortly after the fall of the Soviet Union, so itwas a very interesting time in the countrys history. Back then I did serve clients in avariety of industries while I was there, but, without question, the highlight was spending alot of time in Siberia with clients in the oil and gas industry. Some of the friends that I madeas a result of spending many, many long days and long weeks in Siberia, serving the oiland gas industry and trying to figure out, okay, how do you take these sets of books thatare prepared under Russian accounting standards, and how do you account for all ofthese transactions under US Gap or--international accounting standards at the time was ahuge challenge and was also a lot of fun.Its interesting that you draw parallels between what I did back then and what I do now, asI certainly enjoy looking at complex situations, complex transactions and then steppingback and trying to understand what that all means within the context of financial reportingunder US Gap or under international standards.
  16. 16. ROBERT BLOOMFIELD: I was going to say, one of the analogies that occurs to me isthat, well, I guess in the U.S., in more established industries, the rule of law is quite clear,you know, notions of ownership of real property or steel or something like that are fairlystraightforward. And so, if we look up and down the supply chain at the agreementsbetween buyers and sellers, its been fairly straightforward and static relative to either.Russia, as things were being opened up and completely new channels and completelynew legal environments were being created.And then maybe Im just stretching this too far, but I feel like I also see this in SiliconValley, where we have such complex forms of partnerships, complex strategicrelationships. I talked, for example, before we discussed the issue that, if youre asocial-gaming company, you may have your platform on Facebook, and it seems to me, asnot a lawyer, that its still not entirely clear the legal rights and responsibilities thateveryone has because they havent yet been sorted out in the court. Do you see any--am Ijust pushing this too far?MICHAEL BOBROFF: No. No, absolutely. That is something that we have to deal withfairly frequently here in Silicon Valley is seeing brand new revenue models that haventbeen tried before or revenue models that have unique aspects to them, partnershipagreements between companies that no one has seen before. And, again, as were put ina situation where both we and our clients have to step back and truly understand what thesubstance of these arrangements are, the substance of the revenue arrangements, thesubstance of the partnership agreements, and then put the best minds together anddetermine how best to account for that.Because a lot of the times we have a lot of clients that do things for the first time and, as isthe case in many industries, you always have three or four companies that soon follow,doing the same thing if the first one is successful. And so it is important, from afinancial-reporting standpoint, that any accounting conclusions that are reached on a newrevenue model or on a partnership agreement is well thought out and can be replicatedonce a new entrant does the same thing.ROBERT BLOOMFIELD: Thank you. So were just approaching the top of the hour. Idlike to ask you to stick your neck out a little bit and make some predictions. What do yousee as being the most important trends we should keep our eyes open for in the
  17. 17. social-gaming and virtual-goods industry?MICHAEL BOBROFF: I see a couple of things on the horizon. As I mentioned earlier, Ithink one trend that we will start to see is that the purchase of virtual goods will becomeincreasingly accepted and increasingly more mainstream by users. And so, if only a smallpercentage of the publishers users are purchasing virtual goods, I expect that percentageto continue to increase as acceptability of purchasing virtual goods increases and as gamedesigners get better at designing game mechanics that increase the monetization. Right? Ithink well also continue to see the console-game publishers having a digitaltransformation strategy and start investing more and more into the social-game market.And I would expect that there will be many more new entrants with deep pockets, includingthe traditional-media companies. So as a result, I do expect to see continued growth in thisindustry, in the foreseeable future, and I think itll be really exciting to watch.ROBERT BLOOMFIELD: Great! Well, I will let you have the last word on that. I reallyappreciate your taking the time to speak with us today.MICHAEL BOBROFF: Well, thanks for having me, Rob.ROBERT BLOOMFIELD: So today our guest has been Mick Bobroff of Ernst & Young, anexpert in the virtual-goods and social-gaming industry. Well actually be on a short hiatusfor a couple weeks and probably coming back in November, when we will be bringing youmore Metanomics, looking at business and policy issues in the Virtual Worlds andonline-media industries.So thanks a lot. This is Rob Bloomfield, Beyers Sellers, signing off. Bye bye.Document: cor1090.docTranscribed by: http://www.hiredhand.com

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