Will social games go the same way as the casual downloadable market?

Some of the characteristics of the social game market are very similar to those of casual games. There is little marketing and promotion in either market, because social games rely on the viral nature of social networks to spread the word; cloning is already a problem. The audience demographics are similar. Both are typically played in short sessions.

The major difference (so far?) is that there's no equivalent of the portal in the value chain. Social game operators retain a full 100% of the revenues they generate (less a few percentage points for using Paypal or a credit card gateway) -- by contrast to the mere 20% that casual downloadable game companies get from the portals. Coupled with minimal marketing costs, this is a sweet, sweet deal, and it's no surprise the market has engendered such enthusiasm.

FaceBook Needs Revenue

The 100 pound gorilla in the room that no one talks about, however, is whether (or more likely, when and how) the social networks themselves will demand a piece of the action. Mostly, Facebook, MySpace and the others appear to be happy, so far, to have third parties provide services to their users that increase the value of the service to those users -- social games attract and retain users for the network as a whole.

Yet all of the mass-audience social networks have huge valuations that their current level of revenues do not remotely justify. For example, the valuation of FaceBook is currently just under $10 billion. If you accept a p/e (price/earnings) ratio of 20 as typical for a company in the long turn, this implies that FaceBook is expected eventually to earn annualized profits of around $500m. Last year, FaceBook had total revenues of about $400m, of which $150m was from a probably unrepeatable ad deal with Microsoft. FaceBook claims to have reached profitability in 2009, but presumably just barely -- in other words, profits were unquestionably a small fraction of that $400m.

Meanwhile, the major social game providers are all profitable, apparently at a high level, and themselves supporting valuations in the hundreds of millions.

In other words, if FaceBook is to be sustainable at anything like its current valuation, it needs to ramp up revenues quickly -- and the obvious source to tap is all that game revenue.

Enter "Pay with FaceBook"

As it happens, FaceBook has been clear about where it expects its next big addition to revenues to come from; it's from Pay with FaceBook. Pay with FaceBook is a payments system, whereby users buy FaceBook Credits and can then spend them on any service on FaceBook that integrates with the system. Interestingly, there seems to be some confusion, among analysts at least, as to whether this is expected to ultimately be a PayPal killer, or merely a FaceBook-specific virtual currency -- and in truth, the system could go either way. But it's notable that one of the options for purchasing FaceBook Credits is -- tada, PayPal. If FaceBook were planning on competing head-to-head with PayPal, they presumably wouldn't be doing this.

FaceBook executives have gone so far as to say that they expect Pay with FaceBook to double the company's revenues over the course of the coming year, and this is not, in fact, impossible.

But what does it mean for social game providers? Well, of course it means that they can now offer another payments system to their customers, one that a high proportion of their customers, being FaceBook users by nature, are likely to adopt. And another payments system, especially a widespread and easy to use one, will by nature increase revenues.

BUT: Pay with FaceBook charges 30% of revenues to sellers of virtual goods -- and virtual goods are what social games sell.

Payments System or Retailer's Cut?

Now, you can view this in either of two ways: If you view Pay with FaceBook as a payments system, this is extortionate. PayPal and every credit card gateway charges a single-digit percentage for handling transactions, almost always under 5%, typically with an additional per-transaction charge of 25 cents or less. In other words, viewed as a payments sytem, Pay with FaceBook is the single most expensive system available anywhere on the planet (with the sole exception of mobile payments, which are even more onerous, and which is why mobile payments have not taken off).

Viewed as a cost for accessing a distribution channel, however, 30% is pretty reasonable. It's what XBLA, WiiWare, and the iPhone app store take. It's a far better deal than the casual downloadable market offers, where portals and intermediaries like Oberon/i-Play want 80% of the consumer dollar -- and a far, far better deal than developers get in the conventional digital game market, where they typically receive a skinflint 15% of wholesale revenues, entirely recoupable against development advances.

And it is, at the moment, only one, optional, additional payments system; social games can still take credit cards and use PayPal and so on, and aren't even required to integrate with Pay with FaceBook.

And how long will that last?

The Network Owns You

Social network games live and die by the social network. The virality of those networks, the ability to grow big audiences quickly, is the single vital reason social network games are successful -- it's surely not the excellence and intensity of their gameplay. If you are a social network game provider, of course you will integrate with FaceBook credits; the last thing you want to do is piss off FaceBook. If they want you to adopt Pay with FaceBook, of course you do so. Because game developers are not fools, and they know that if FaceBook wants to, it can utterly cripple them. FaceBook is under no obligation to allow third parties access to their network.

In other words, social network games are ultimately in precisely the same position, vis-a-vis the social networks, as casual downloadables are relative to the portals. The social networks are in the whip hand. They are the main providers of value. The social network game providers are like intestinal bacteria; they may help their host, but their survival is entirely at the host's whim.

The Precedent

An important precedent is being set here. FaceBook is dialing itself in for a piece of the social gaming pie. It's a small piece, at present. As social network game revenues continue to soar -- and, as usual, the analysts are predicting beellions and beellions of dollars any day now -- why should FaceBook (and the others) not take a bigger chunk. Why shouldn't the "Pay with FaceBook" option become mandatory? Why shouldn't that 30% become 40%? 50%? Even 80%?

We've seen this before, in the casual downloadable market; initially, the portals took a mere 50% of the consumer dollar. But they realized who was in the driver's seat, and that 50% grew and grew, and the result is the steaming pile of poo that is the casual downloadable market today.

Now, possibly FaceBook and the others will look at the lessons of the casual downloadable market, and realize that to sustain social games they need to sustain a viable business ecosystem, in which developers can continue to profit and in which incentives for innovation are maintained. Possibly, they will say, "Yes, we could grab 80% of all that tasty revenue, but it's a bad move, long term." Possibly, the social networks are corporately wise, morally upright, good and kind. Possibly they'll say "never mind the valuation we need to support, we must do The Right Thing."

Also possibly, pigs will fly.

Genetic engineers are working on the problem today. Honest.