• 12/19/07 06:15 PM
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    Starbreeze Business Analysis

    Business and Law

    Introduction

    Starbreeze is a Swedish game development company, founded in 2000 through the merger of O3 games and Starbreeze studios. The company is based in Uppsala, where it also has all of its employees. During the summer of 2007 the company has been given much attention, thanks to the release of a new game, The Darkness, which gained rave reviews. The game has an average score of 82% on Gamerankings.com, making it the 29th highest ranked game on Xbox 360 and the 12th highest ranked game on Playstation 3 at the time of writing (out of several hundred games). The company has a strong reputation for making good games, thanks partly to The Darkness, and partly to an earlier game, Chronicles of Riddick, which released in 2004.

    The game engine (the software which is used to build the game) that Starbreeze uses has been developed in-house, and is the company's primary immaterial property. Starbreeze develops games on contract for other companies, and as such the games it develops aren't actually owned by Starbreeze itself. The primary reason for this is that Starbreeze doesn't itself have the capital to make its own games, and the secondary reason is that it doesn't own any valuable Intellectual Property (IP) on which to base those games. The Darkness is based on a comic book and the IP is owned by Top Cow, while Chronicles of Riddick is based on a movie and is owned by Vivendi.

    There is also a certain risk involved in making your own games, since if it flops, then you will take the entire hit yourself. With the current arrangement, the risk for Starbreeze is more limited, since it gets the money it needs to make a game from the contracting company during the actual development process, and if the game doesn't sell well, then it is the contracting company that stands to lose money.

    The main risk factor to Starbreeze is that it is completely dependent on finding partners in order to get continuous cash flow. If the company were to complete a game project and then had to endure several months without finding a partner to provide funding for a new project, then Starbreeze would likely go bankrupt. The profit margins are also low with the current business model. If a game sells well, the returns to Starbreeze are small, since the contracting company takes the lion's share of any profits. And of the sum paid to Starbreeze during the development of a game, most if not all is required to use for actual game development, so very little can be squirreled away.

    Another risk factor for the company is the employees. Starbreeze is at its heart a design company, and the quality of the end product is completely determined by the quality of the employees. Competition for the best and most experienced game developers is fierce, which means that they have a strong bargaining position and can demand a relatively high salary. For a game development company the single highest cost is the employees - compared to them computers and other equipment is cheap. In order to keep good employees, additional incentives such as bonuses must be used, which further decreases the return to investors. A problem for Starbreeze is that it is located in the relatively minor town of Uppsala, which makes it difficult to attract foreign developers, and means that location can't be used as an incentive. Another Swedish entertainment company, Paradox Entertainment, moved its head office from Stockholm to Los Angeles, after it became obvious how expensive and difficult it is to run a business from Sweden when all the potential customers are in the United States.

    Starbreeze thus faces a number of relatively large problems. The most recent game, The Darkness, received very positive reviews, and is reportedly selling quite well, but the profit to Starbreeze is likely to be tiny. It is still uncertain whether the game will sell enough copies for Starbreeze to receive any royalties whatsoever. In some ways the company is stuck in a kind of economic hamster wheel - the company is moving, but not really moving forward. It gets money to make a game, it spends the money making the game, and at the end of the two year development period, it's right back where it was at the beginning.

    This picture is only half true though. For every new game Starbreeze makes that is a success, it strengthens its reputation, which gives it a stronger bargaining position and thereby better contracts. At the present moment, the company has a strong capital base, so it's not going to go bankrupt any time soon, but the risks for game development companies aren't small. Another company which was founded at roughly the same time Starbreeze was, called Troika, went bankrupt in 2005, only a few months after having released a game (Vampire: Bloodlines), despite positive reviews, because it couldn't find a new publisher in time.

    The aim of this report is to analyse the company's present situation and business model, and discuss ways in which the company can move forward and strengthen its position on the market.

    Analysis

    As was mentioned in the introduction, the present business model is problematic. Starbreeze can be compared to a craftsman, who gets paid for his work, but doesn't get anything beyond that. For the company's shareholders this is obviously unacceptable - sooner or later they need to see a return on their investment. But the present business model makes it difficult for the company to turn a profit that is anywhere near that which is acceptable in terms of return on equity. The low profit margins are the result of intense competition. Starbreeze must not only compete with other private studios, but also with the large game- and console companies in-house studios. It's difficult to demand a premium for your work, when others are willing to do the same work for less. In order to be able to motivate a premium, the company must have a strong track record and a clearly demonstrated ability to make better games than the competitors.

    The company's bargaining position is not only weakened by competition, but even by the fact that it must get contracts in order to avoid bankruptcy. When you're desperate for work, it's pretty difficult to demand a premium for it. This means two things. First of all, the company will get a very small or even non-existent premium up front, instead being offered a share of the income if the game sells well, in the form of royalty. The level of sales at which the Starbreeze starts to collect royalty is however so high that there is a very great risk of not collecting any royalty at all. For Chronicles of Riddick, Starbreeze was only able to collect a million SEK (roughly a hundred thousand USD), despite good sales figures. It is still uncertain whether The Darkness will bring in any royalties whatsoever. Secondly, Starbreeze lives and dies on its reputation - good games means more companies will want to sign contracts with Starbreeze, which strengthens the company's bargaining position. However, getting a better contract generally means getting a better royalty clause, not more money up front. So two years work can potentially mean zero profit.

    Since Starbreeze is a small studio that only develops one or at most two titles at a time, and since each game takes such a long time to make, the company's income generally takes the form of a few large payments a year, whenever a new milestone in the contract has been reached. This makes income quite difficult to predict, which is problematic from the point of view of the company's investors. For this reason, it must be determined if there is some way for company to change its business model so that it gets a more continuous cash flow. There are a few quite small things that the company could do, which could potentially lead to the creation of a few solid cash cows for the company. There are also larger, more fundamental changes that the company could make to its business model. This analysis will begin by discussing the smaller changes, and then move on to the more large scale ones.

    First of all, Starbreeze has one asset that many of its competitors lack, in the form of its own game engine. The game engine is valuable not only because of the function it fills within the company, but also because game engines are much sought after by those developers that lack ones of their own. Building your own game engine is time consuming and expensive, so this isn't an option for many smaller developers. For this reason, most smaller developers license engines from third parties. For example, Valve corporation's Source engine has been licensed out to a large number of developers. The market for game engines is one that Starbreeze could quite easily enter, since it already has an entirely original and state of the art engine of its own. It has the potential to generate nice profit margins, since the engine already exists and will continue to be developed by Starbreeze for its own in-house games, regardless of whether they license it out to other developers or not. These costs should therefore be considered irrelevant. The only relevant costs associated with licensing it out would therefore be the costs for marketing the engine, legal costs associated with writing licensing agreements and costs for providing technical support to licensees, which is to say, they would be probably relatively low. These costs are entirely variable and could easily be increased or decreased depending on demand, so the risk is also low. And since the relevant costs would be small, profitability could potentially be very high.

    Another area which is opening up, thanks to the fact that game consoles are increasingly connected to the internet, is downloadable content, such as mini-games (casual games) and extra material for existing games, such as new levels and "skins". These can often be put together relatively quickly and at low cost and are then sold straight to consumers via the internet. The price is set after what consumers are willing to pay, and has no real connection to the actual (fixed) development and distribution cost. Therefore, downloadable content has the potential to be a pure cash cow, even after the cuts taken by the service provider (for example Xbox Live or Steam) and license holder. This has the potential to increase both the company's income and its sources of income, without markedly increasing costs. Small games are cheap to make so risk is limited. If Starbreeze were to start developing small casual games in addition to its larger projects, it could get more continuous cash flow, from new sources, which would decrease its dependence on the large publishers and thereby strengthen its bargaining position even when it comes to big projects. Downloadable content and casual games could also be used as a method to test new staff members and interns before allowing them to work on larger projects. So the risks associated with employment could also potentially be lower.

    If Starbreeze wishes to strengthen its bargaining position in relation to the publishers then Starbreeze must become a brand that the consumer is conscious of. The Starbreeze logo should in itself be seen by consumers as a mark of quality. The studios that are consistently able to make good games generally get a very loyal core of customers. These help the studio to spread its message and act as un-paid marketers for the company. As an example, one could mention Black Isle, which was able to turn itself in to a strong brand thanks to games such as Baldur's Gate, Fallout and Planescape: Torment. Another example is Bethesda Softworks, thanks to its "Elder Scrolls" series of games. Bethesda has a forum on its site where fans can discuss its games and get access to new information about coming titles, which they then proceed to spread widely. This helps to build hype for coming games. The forum also helps to build loyalty to the company, and gives the company access to a group of people who are very interested in its games, and with whom it can discuss various ideas that it has. The company's existing and coming games are also constantly kept alive in the minds of a group of people who are very active in the gaming community.

    A third company which has been able to turn itself in to a strong brand thanks to good games is Bioware, which became widely known thanks to a few role playing games set in the Star Wars universe. Thanks to these, Bioware got a reputation as a good developer of science fiction role playing games. This has allowed Bioware to dump the Star Wars license and instead develop its own IP in the form of Mass Effect, which is similar to Star Wars, but gives Bioware much nicer profit margins, since it doesn't have to pay any licensing fees to a third party. It has been able to dump Star Wars for the simple reason that Bioware has become such a strong brand in itself. Developing a game in an original setting also increases the value of the company, because of how valuable IP's can be. As an example of how much IP's can be worth, it could be mentioned that Paradox Entertainment, with less than ten employees and no physical assets, has a stock market valuation of 20 million dollars (more than 2 million dollars per employee), entirely thanks to the value of Conan the barbarian and the other IP's that it owns.

    What is then the content of all this? Starbreeze needs to work on its brand, and must create a core of loyal customers who can act as ambassadors for the company. A stronger own brand would strengthen the company's bargaining position and increase the possibilities for launching new game brands. In recent years it has become quite common for successful games to be turned in to movies, so just owning an original IP can be a lucrative business in itself. Some examples of games which have become or are in the process of becoming motion pictures are Final Fantasy, Resident Evil, Doom, Far Cry and Halo.

    We will now move on to the more large scale changes to the company's business model which could be worth considering. The most obvious alternative to the present model is to stop developing games on contract for other companies, and instead finance and develop games on its own. This would potentially lead to much larger profits, since the company would get a much larger share of the income from the game, but would also potentially mean much larger losses, since the company would have to finance everything itself (or rather, with the help of the bank and the share holders). Considering that it currently costs around ten million dollars to make a game, a single flop would likely be enough for the company to be forced in to liquidation. What the company must the consider is whether it is worth the risk. One way to minimize risk might be to license a known IP from another company, as Funcom as done with its upcoming MMO, Conan: Hyborian Adventures. But this would lead to lower profit margins and a missed chance to create an own valuable IP. One game was enough for Fallout, Half-Life and Halo to become well known and very valuable IP's (although follow-up games have of course added to the strength of all of these brands). For example, Bethesda recently acquired the Fallout license from Interplay for five million dollars, even though it is years since anything was last done with the Fallout brand.

    The risk is not small, but a successful launch of its own game, especially one in its own setting, would increase the company's ability to create value for its owners, and thereby its value, enormously. With the present business model the profit margins are tiny because so many different actors all have to get their slice of the cake. An unsuccessful launch would however likely lead to the company's destruction. Perhaps this can best be seen as an issue of timing - if the company decides to go its own way too early then it is destroyed, but if it waits too long and goes its own way too late, then it has missed out on a lot of potential value creation.

    Another subject which is fundamental to the company's ability to create value is the employees. The employees are the primary cost factor for the company, and they are also the factor which determines how good the games it makes are. For these reasons it is important to find the right people and also to find the right ways to motivate them to do their very best. One problem for the company is the localization in Uppsala. Although there are plenty of well educated Swedes who would love to work for Starbreeze, most of these lack the experience that the company seeks. And foreigners with the right competence are difficult to attract, since there are also studios in more exciting places like San Francisco and London out to grab them.

    One possible solution to this would be for the company to move its offices somewhere more attractive. But in that case Starbreeze should have moved a few years ago, when it only had twenty employees, instead of now, when it has upwards of seventy. The more employees the company has, the more difficult and painful a move will be. The company would also risk losing key people, who have been with Starbreeze from the start and are central to its success.

    The difficulty in attracting staff means that Starbreeze must offer very competitive wages and other bonuses, such as a share of the income from its games. This decreases short term profitability, while at the same time being absolutely necessary for long term success. Wage costs can therefore not be pressed or rationalised, and since wages are the single major cost for the company, it is practically impossible to cut overall costs and in this way push up profitability. Therefore it is on the income side that change must happen.

    Recommendations

    Based on the above analysis, I have carried out a SWOT analysis of the company. SWOT stands for Strengths, Weaknesses, Opportunities and Threats, and is a way to divide up various aspects of a company's operations, and show them graphically, in order to make it easier to see what's important when developing new strategeies.

    Strengths
    Own game engine
    Proven ability to make good games
    Strong reputation in the industry
    Weaknesses
    No own IP's
    Weak bargaining position as a small studio
    Difficult to cut costs
    Opportunities
    Game engine could be interesting to others
    Downloadable content and casual games
    Increasing number of loyal customers
    Threats
    Difficult to find competent employees
    Tough competition from other studios
    Never certain that a new contract will appear

    Based on this analysis I have developed five recommendations which I think could strengthen Starbreeze's position, guarantee more continuous cash flow, and increase its ability to create value in the future.

    1. Offer the game engine to other developers. This may be simpler said than done, but it wouldn't cost much to check around and see if there exists any interest in licensing the engine from Starbreeze. This isn't a new market. Other game developers that are already licensing their engines include Valve corporation with its source engine (used in Half-Life 2), Epic with its Unreal engine (used in Gear of War) and Crytek with its Cryengine (used in Far Cry and the coming Crysis). These companies all use their engines primarily for their own games, but have realised that there is money to be made in licensing the engines to others. Licensing the engine would be a complement to Starbreeze's primary vocation as a game developer, which could be tried out at low cost and low risk. Since Starbreeze will continue to develop its game engine regardless, the relevant costs for doing this would likely be quite low, and Starbreeze would be able to spread its fixed costs for engine development over more customers, pushing up profit margins.
    2. Focus more on downloadable content and casual games. This is another area which has potential to become a cash cow for the company The market for casual games is growing enormously. More people play casual games on-line than visit video-sharing or social-networking sites. Since consoles are also increasingly linked up to the net, it is possible to sell casual games straight to the living room via services such as Xbox Live Marketplace, allowing developers to bypass publishers and retailers. Casual games can also be converted in to mobile games, another market which is growing strongly. Xbox Live Marketplace and similar services have also opened up a market for downloadable content for larger games. Downloadable content and casual games are made on a small scale, and no outside funding would therefore be required, allowing Starbreeze to capture the lion's share of any income itself. The low cost would also mean low risk, and the speed with which downloadable content and casual games can be developed and distributed would allow Starbreeze to gain more continuous cash flow. Focusing more in this area would make Starbreeze less dependent on publishers, strengthening its bargaining position when negotiating with them. It could also give Starbreeze some much needed cash cows, which would increase the possibilities of making own larger scale projects in future.
    3. Create a community around the company. Game developers, just like other creators of entertainment, often get fans. These are very useful, since they preach the company's excellence to their friends (and nothing beats word of mouth). They often have a large amount of knowledge about games, and can therefore be used as a form of unpaid consultants, which the company can use when deciding on all the various aspects of game design. For these reasons, fans are worth putting time and effort in to. Companies which actively interact with and listen to their cusomers have a strong competitive advantage, and thanks to the internet, interacting with customers is both cheap and easy. For example, though Starbreeze has a forum on its website, it is hidden away where visitors are unlikely to find it. If Starbreeze wishes to be serious about having a strong relationship with its customers, it should make the forum easy to find, and its employees should spend time using it to interact with the fans. This is something which Bethesda Softworks has been very successful at, helping it to develop a cult following. Loyal fans are a very useful asset for a game company, and go a long way toward strengthening the brand. During the second half of the nineties, Black Isle became synonymous with good computer role playing games. It was practically impossible to talk about role playing games without the company name Black Isle coming up (though Black Isle was actually a division of Interplay rather than an independent company). It is possible to turn a game developer in to a brand, just as it is possible to turn an author or a rock band in to a brand, as long as you work at it. A very important part of that is nurturing the fans.
    4. Create an internship program to find good employees. The computer games industry suffers from a very strange problem. Lots of people want to work in games, and far too many are educated to work in games, and yet the game companies are having a tough time finding employees! This is because of the very high requirements demanded by the companies. Starbreeze has plenty of in-house competence, so taking in more newly educated people and training them internally probably wouldn't be a problem. Their formal educations have already given them the technical skills they need, so its hardly like Starbreeze would have to train them up from scratch. Since so many are desperate to get in to the industry, many would likely be willing to work as unpaid interns for a couple of months, giving Starbreeze a chance to test them and then choose the very best, at low cost and low risk. Interns could for example be put to work on downloadable content, casual games or Quality Assurance. These could likely be taught the skills they need quite quickly by the experienced personnel already working at the company. And employees coming in to the company in this way would likely be both more loyal (since Starbreeze gave them their "break"), and cheaper, than people who have to be convinced to come to Sweden from the United States or England.
    5. Create an own original IP (or buy one). This is the largest and most risky of the recommendations, but absolutely necessary if Starbreeze is ever going to grow out of its present predicament, with profit margins that are practically non-existent, and a heavy dependence on publishers. Successful examples can be found in the Nordic region. For example, Norwegian Funcom, which owns Anarchy On-line, an IP developed completely in-house. Another alternative, which is more expensive in the short term, but perhaps less risky in the long term, is to buy an existing IP. For example, Icelandic Crowd Control Productions, creators of the MMO Eve On-line, has bought White Wolf, a pencil-and-paper role playing games company which owns the rights to World of Darkness, including the well known Vampire: The Masquerade. Developing an own IP is a big step, and nothing Starbreeze is in acute need of doing immediately, but work should begin in this area, with the long term goal of creating own games in own settings. If Starbreeze is ever to move beyond first base as a small design company, and start generating decent profits for its owners, this step is completely necessary.


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