How Gaming's Upstarts Stay Ahead in a Changing Market Despite the latest Halo hype, an army of entrepreneurs is aiming to take over the video-game industry. Some leading startups share their tips for surviving any high-tech market reinvention.

Shipping this week, Microsoft's Halo: Reach for Xbox 360 and Sony's motion-sensing PlayStation Move are the talk of the $20.2 billion video game industry. Both mark the start of the all-important holiday retail season, but the excitement belies the churn in a business being transformed by scrappy new technologies, platforms and entrepreneurs.

"We're experiencing the most change in the shortest amount of time that the gaming business has ever seen," says Trip Hawkins, founder of publishing juggernaut Electronic Arts. "Things will never be the same again."

Credit a perfect storm of socioeconomic factors from tightened household spending to changing play habits and the growth of mobile devices. The iPhone Store and other alternative distribution channels are allowing thousands of independents to slash costs, experiment with innovative concepts and do an end-run around traditional publishing models. Subsequently, a field weaned on blockbuster products and brick-and-mortar distribution is watching its once-captive audience fragment across devices and platforms.

But a sector awash in opportunity is also suffocating under a tidal wave of competition and oversaturation. The past two years haven't just accelerated the field's typical boom and bust cycle, they've also become a textbook study in market disruption, with average prices plummeting, product visibility shrinking and standard retail lifecycles dwindling across the board. Interestingly, industry employment continues to grow roughly 9 percent annually since 2005, bringing in more than $2.9 billion in wages, while layoffs continue to rock Activision, THQ and other established, large-scale players.

Credit the rise of gaming entrepreneurs. While giving high-flying corporate execs migraines, this environment is also birthing the greatest explosion in entrepreneurialism since gaming's garage days. The lessons to be learned could apply across any number of industries affected by changing technologies, that is, almost every industry.

"Big-budget production models are failing and barriers to entry are lower than ever," says Wanda Meloni of M2 Research, an Encinitas, Calif.-based market research firm specializing in digital entertainment. "The opportunities have never been better for small independents."

Still, the business is hardly fun and games. Here is a look at the top trends, how they're transforming the field and what it takes to survive in an industry whose future is suddenly in play.

Social Games: Marketing a Product as a Service
A staggering 200 million social network users now play casual games like FarmVille and Pet Society monthly, which draw audiences numbering in the tens of millions. It's a sobering wake-up call compared to the previous benchmark for breakout industry success, online fantasy universe World of Warcraft, which boasts 11.5 million subscribers. Thanks to their low system requirements, familiar concepts and overall user-friendliness, these popular titles are single-handedly helping to grow the gaming market. But despite presenting massive opportunities, challenges for small businesses operating in the space are also considerable. Dozens are released daily, brand loyalty is minimal and user turnover is massive. However, it hasn't stopped San Francisco-based Booyah's leading Facebook title, Nightclub City, from reaching 8 million active users.

"With free products, what you're really building are real-time subscription models," says CEO Keith Lee, whose games cost nothing to play, but generate thousands through the sale of virtual goods. "Rather than pricing to set levels, by offering content at tiered pricing structures, you optimize revenue per user by effectively letting people spend what they want." Also imperative with "freemium" goods -- free products that upcharge for optional upgrades on the back-end -- is designing every user action with monetization in mind from the beginning. Don't overspend on marketing and PR in the digital era either, Lee recommends. Investing in product features that provide compelling reasons to share your creations with friends (e.g. to tackle group problems, compete for high scores or simply exchange eye-catching photos) can generate literally 1,000 to 5,000 percent more trials.

Going forward, Lee says, it helps to think of any good you offer as a service, rather than as a product, and recognize the value of establishing long-term relationships with customers. As such, offerings must be supported post-launch with additional content add-ons, community initiatives and aggressive customer acquisition and retention tactics. For Facebook games, this means tapping into the social network's ability to simultaneously and rapidly update the program for every user, unlike traditional games, which rely on an initial launch and subsequent intermittent patches or upgrades. Because software makers can track who's clicking on what and how often, and source real-time fan feedback, it literally pays to listen to your customers, adapting features and pricing as the market dictates. As a result, companies like Booyah regularly support titles such as My Town with new expansions, product enhancements and limited-time sales promotions designed to keep new and existing players alike happy and engaged.

Rather than go all-out on a single release, Lee further advocates that all high-tech entrepreneurs adopt a minimum viable product strategy when managing their portfolios. Ship products with just enough features to attract a crowd, he says, iterate rapidly, and don't hesitate to abandon offerings that don't garner an immediate response. "You'll know in the first two weeks if a product is successful," he says. "If not, there's no point in keeping it on life support."

Hawkins's own San Mateo, Calif., startup, Digital Chocolate, learned the hard way, by discovering the mobile phone games it initially specialized in -- like 3-D puzzler Tower Bloxx -- didn't translate well to Facebook. "The secret to success today is to make brands that transcend platforms," he says. "But you also have to play to each distribution channel's strengths." To reach the social network's less tech-savvy audience, this meant making original games like Millionaire City and MMA Pro Fighter understandable at a glance, intrinsically designed for multiplayer, and accessible with a single click. In-game events of note also had to be easily shareable via social media, so friends could make others aware that they were seeking aid or competition.

As the company is illustrating with releases like NanoStar Castles and Safari Kingdom, when entering new markets, it's often wiser to spread risk across an assortment of smaller products rather than one flagship offering. "To achieve scalability on any new platform, you have to commit to adopting best practices," Hawkins says. "In the case of new technologies and devices, that means being able and willing to make mistakes… we're still learning every day." Fail quickly and often, he says, until you get the formula down. While a seemingly counterintuitive strategy, it can pay dividends. Digital Chocolate's games have reeled 9 million monthly players on Facebook in just six months, and now bring in more than its entire mobile business.

Mobile Games: Hard Sell, Then Upsell
Traditional PC, PlayStation 3 and Xbox 360 games can take two to three years and $20 million to $30 million to build. By contrast, apps for Apple and Android handsets can be assembled in weeks for less than $20,000, which explains why they've captured an entire generation of bedroom entrepreneurs' imaginations. Given sales of 100 million-plus iOS devices (iPhone, iPad, iPod touch, etc.) though, producing high-quality titles capable of selling in the millions isn't the issue. With more than 40,000 games available through the App Store alone, and bestseller lists the only real way to achieve mass visibility, helping customers discover new software can be a tough task.

"Even Apple doesn't have the power to make something a hit on its own platform," says Chris Ulm, CEO of Carlsbad, Calif.-based Appy Entertainment. As a result, he says, it's essential for small companies to produce multiple products, seize opportunities for exposure and build ways to connect directly with customers. For Appy, it's all about building a running dialogue with fans, which creates a robust direct marketing channel that may someday be capable of self-sustaining any new release. Consumer touchpoints include frequent software price drops designed to attract more registered users, e-mail newsletters that share breaking updates and in-game ads that regularly promote new releases. The strategy appears to be working, with games like FaceFighter! and Zombie Pizza downloaded nearly five million times.

Razor-thin margins are also a concern for app makers, Ulm says, with most successful titles given away for free or priced at 99 cents. "We're training audiences to expect more for less," he says. To offset tightening revenues, rather than invest heavily in large-scale projects and big teams, he instead advocates the use of selective outsourcing and building less ambitious products designed with incremental gains in mind. By employing a core team of seven full-timers, but contracting freelance programming and art tasks out as needed, the company keeps overhead low while steadily building its own technology base and refining its production pipeline with each release. "Every app we do furthers our reach with customers, grows our technology in hops and provides opportunities for what could be profitable joint ventures," he says.

Don Traeger, who built the EA Sports label into interactive entertainment's premier pro athletics brand before launching his latest venture, Santa Clara, Calif., developer Portable Zoo, agrees. "With games like Karuki, we purposefully put out a small product then added levels, changed things and eventually wound up with a big, top-notch title," he says. But experimenting with pricing is also crucial, Traeger says. "When we slash costs on our apps, sales don't just go up while these products are discounted, but also after they return to full price, and the game's retail lifespan lasts longer than expected."

Brian Greenstone, founder of Austin, Texas-based Pangea Software, best known for its Macintosh titles ("It's better to be a big fish in a small pond"), further says that upselling existing customers can be more profitable than attracting new ones. To move units en masse through app stores, he explains, it's imperative that you appear within a sales chart, which leads to heightened visibility and can cause sales to skyrocket. Which one (Top 100 Games, Top 50 Arcade Games, etc.) doesn't matter, Greenstone says. What does is being downloaded more than 1,000 times in the first 12 hours. Standard measures like ads, press releases and YouTube videos aside, Pangea's most effective publicity tactic has simply been text announcements within its current games that let existing players know when new releases are available. "Forget staggered marketing… drop every bomb on your first sortie," he says, laughing.

Rightsizing one's company is also crucial, Greenstone, the firm's sole full-time employee, suggests. "If you're spending more than three months and $500 developing an app, it's too long and too much," he says. "The key is to crank out as much as you can." To keep costs low and participants motivated in any business where success is uncertain and funds limited, he recommends contracting out work wherever possible, and offering collaborators profit-sharing plans. It's a model that's worked out considerably well for Pangaea, now two decades old, whose hit series Nanosaur cost around $200 to make and has since grossed over $1 million.

Digital Games: Slashing Overhead and Selling Direct
So much for GameStop and Wal-Mart. While music, movie and television providers struggle with the digital transition, enterprising game makers are gleefully exploiting low distribution costs, higher margins and on-demand convenience to circumvent traditional publishing channels. According to market analyst The NPD Group, players are responding in record numbers, with sales of digital and retail PC games reaching near-parity in 2009.

Upsides for small businesses are plentiful as well. Online vendors such as Steam, Xbox Live Arcade and PlayStation Network don't just give tiny independents the means to directly connect with consumers and comfortably sell products for $5 to $20. (At odds with standard $50-$60 retail prices for full-sized games or $20-30 for smaller titles and expansion packs). They also eliminate the need for manufacturing, warehousing and shipping, and provide channels through which titles can profitably be released to smaller, more loyal fan bases, letting creators strike gold by tapping previously unsustainable niche markets.

Built from the wreckage of overambitious startup Flagship Studios (creators of the much-hyped Hellgate: London), Seattle-based newcomer Runic Games knows that less is truly more. Abandoning plans to work on a three-year, $10 million-plus massively multiplayer online project, it instead opted to release modest fantasy dungeon hack Torchlight, built in just 11 months for pennies on the dollar. Sold as a $20 digital download through online shops such as Direct2Drive.com and Runic's own website, the single-player title -- capable of holding its own with any retail outing -- has since sold more than 700,000 copies. Plans for a sequel, due in 2011, and grand-scale online version are already underway. "Simpler is better," says co-founder Max Schaefer. "It pays to focus."

Rather than tick off every box on your feature wish-list, for teams with limited resources, empowering users to fill in the blanks can also be a handy solution, Schaefer says. By offering a free level editing toolkit that lets fans remake scenes and scenarios in their own image, Runic has managed to extend the game's reach and longevity at little added cost. Like many other gaming insiders, Schaefer also suggests that traditional methods of marketing and public relations are minimized in the digital era. "Pricing strategies can be hugely effective marketing tools unto themselves," he says. "When we slash costs on Torchlight by half, we literally see 10,000 percent jumps in sales." Free product trials and demos are also vital, he says, citing conversation rates as high as 40 percent for just an hour of two of complimentary play.

Sandlot Games, creators of casual downloadable hits like Tradewinds and Westward, uses similar strategies. But company president Daniel Bernstein also emphasizes the importance of scalability and a diversified business plan. At its peak, the firm maintained 25 employees in Bothell, Wash., and 23 in Russia. But the rapid saturation of casual games downloads for desktop PCs and resulting price drops it prompted led it to cut its domestic staff in half, ramp up overseas production, and dive headfirst into new markets. "Every industry goes through boom and bust cycles," Bernstein says. "Too many businesses fail because they scale themselves to what they think the market should be instead of responding based on actual growth."

Having nearly succumbed to its mistakes forced the company to be more inventive and to turn to emerging platforms like the iPhone, iPad and Facebook. It also led Sandlot to recognize the value of licensing its brands and establishing processes for better product lifecycle management. "We've not only successfully leveraged the help of outsourced partners to sell an unexpected 650,000 copies of Cake Mania on Nintendo DS, an area we had little experience in," Bernstein says. "We also learned the importance of bundling, discount programs and marketing to current customers." Investing in your own website and direct sales channels are also vital for any startup, he says, as is creating a core team and putting fixed procedures and processes in place that let you build a lasting knowledge base. But when neither works, he says, "you've always got to have a Plan B ready to cut to."

Episodic and Downloadable: Finding New Ways to Reach Customers
From 3-D online worlds fueled by the purchase of small virtual goods ("microtransactions") to ad-supported, location-based amusements that exploit cell phones' built-in GPS systems, pioneering new ways to play are emerging every day.

Consider episodic games, value-priced titles serialized into bite-sized regular installments like primetime TV shows. These games initially struggled to take off, but San Francisco-based developer Telltale Games used the cheaper, nimbler production model to resurrect supposedly "dead" classic gaming franchises like Sam & Max and Monkey Island. It's also gone from selling roughly 4,000 copies of its titles in the first month to nearly 50,000, launched its own publishing program and nabbed the Back to the Future and Jurassic Park licenses.

The secret to the seed-funded startup's success is simple, says CEO Dan Connors. "Get products to market as fast as possible, make mistakes as fast as possible and be generating revenue from the moment you ship, then use the income to fund your next production," he says. "Always be bringing in cash, and make certain you own access to your own customers too… it'll give you leverage in any deal. That way, you can sublicense rights to partners with greater reach to take advantage of their superior distribution and marketing, without giving up control of actual products themselves."

Do your homework, too, he says. Knowing the size of your audience, the best channels to reach them and what it takes to sell product into these channels is imperative. No matter how good your company's offerings, it won't matter if you can't ever effectively connect with shoppers, or overspend based on false assumptions.

Fredrik Wester, CEO of Stockholm-based publisher Paradox Interactive, agrees wholeheartedly. Initially a small, struggling developer of strategy and wargame titles, the company hit a turning point when it began to look for ways to creatively co-finance the publishing of other game makers' offerings. With no money in the bank, it was forced to sublicense titles by individual territory throughout North America and Europe, using partnering distributors' cash advances (signed on the strength of software prototypes) to fund continued development.

But while these efforts sustained company growth for a time, steadily declining retail interest in games for armchair generals threatened to derail it in the middle of the last decade. With shelf space dwindling, the company decided in 2006 to launch and digitally sell its titles exclusively through its own retail website, prompted by an e-mail from an Argentine fan who couldn't find its games in local shops. Initially a disaster, Wester admits ("all we could do the first weekend we launched is charge customers, not let them actually download games"), it eventually proved a sound investment.

While it took eight months of seeding retail boxes with complementary codes for digital downloads (billed as free game backups in case shoppers lost their CDs), users eventually came around. So did development partners, who increasingly asked to sell their games through the vendor, leading to the site's eventual transformation into the full-scale online retailer GamersGate.com. Today, more than 2,200 titles are available for download, of which the Top 10 sellers only generate 10 to 15 percent of revenue, underscoring the power of long tail distribution. But more important, Wester says, it also teaches a fundamental lesson in market dynamics.

"You always have to find new ways to reach your customer, and when these channels don't exist, you have to create them," he says. "Dialogue also has to work two ways… in addition to charting your own course, it's also important to let your customers tell you what they want." Hence the firm's later move, despite owning its own online distribution service, to get its games listed on the sites of rival vendors such as Steam and Impulse, with the goal of making its titles more accessible to shoppers. Mission accomplished: Today, the company enjoys premier status in a genre other publishers have all-but abandoned, with new entries in leading franchises like Hearts of Iron and Europa Universalis capable of selling 200,000 copies alone.

However, as with all experts surveyed for this story, Wester says it simply serves to underscore the new reality of doing business in any high-tech industry in 2010. "The old rules of operating teach valuable lessons, but it's obvious that many are quickly becoming outdated," he says. "To survive on today's playing field when progress comes calling, you need to rapidly -- and cost-effectively -- figure out how they're best rewritten."