Case Study: Sony

Fragmentation and Consolidation

When Atari introduced its 2600 VCS in 1977, all games were developed in-house by Atari engineers. Despite Atari's rapid success in the late 1970s, the company did not adequately compensate its engineers. In 1979, four of Atari's top engineers left to form a new company called Activision, which became the first independent developer for the Atari 2600. 

The formation of Activision marked the industry's first move towards specialization, whereby independent companies focused solely on software development. The model became increasingly popular during Nintendo's rise in the 1980s. While many of the top titles were developed by Nintendo, independent titles such as Konami's Castlevania and Capcom's Mega Man played a significant role in securing Nintendo's grip on the market. As Nintendo sold more consoles, more independent game companies entered the market while established developers increased staff to handle multiple projects at once. 

In time, independent game companies sought greater control and began to self-publish their titles. They funded projects, developed and tested games, built up marketing departments, and negotiated terms with retailers. Independent publishers, including Capcom and Tecmo, which published games for multiple platforms came to be known as 3rd-party publishers, whereas console manufacturers that published games for their own platform were 1st-party publishers. 

When publishers released a game that struck a chord in the market, they often seized the opportunity to build a franchise around the game. Capcom's Street Fighter, released in 1989, was one such example. While Street Fighter was a moderate success, over the next eight years, Capcom released a series of spinoffs including Street Fighter II, Street Fighter II Champion's Edition, Street Fighter II Turbo, Super Street Fighter II, Street Fighter Alpha, Street Fighter EX, and Street Fighter III. The entire series sold 500,000 coin-operated units and 24 million console games were sold worldwide, generating over $1 billion in revenues for Capcom. 

Lucrative franchises like Street Fighter certainly made publishers very happy, but the engineers and staff that produced the titles tired of incremental improvements to existing titles. Many developers entered the industry because they had game concepts of their own to develop, not to spend years making minor changes to an existing product. Teams of developers began to leave publishers to form their own independent development studios. Starting a new company was risky, but talented teams placed a high value on creative freedom and recognized the financial reward that high-quality innovative titles could bring. 

By the early to mid-1990s, the software video game industry was largely fragmented. While only a few console manufacturers existed at any one time, there were dozens of 3rd-party publishers and three to four times as many independent game developers. New business models were emerging to reflect the movement of creative resources. Third-party publishers were no longer solely funding internal projects, but were also entering into contracts with independent developers. For the developers, publishers typically funded development (which normally took 12-18 months), obtained approvals from manufacturers to release the game on their console, and handled the sales and marketing of the title. In return, publishers received all revenues of the title upon release (less the retail markup) until the cost of development had been recouped. Once the break-even point was reached, developers received a small royalty per unit sold. The royalty would normally increase as agreed-upon sales milestones were met. 

Publishers also insisted on owning the game's brand, or the intellectual property (IP). Owning the IP could be another major source of revenue as a game's brand spread to other markets such as comic books, action figures, and feature films. 

By 2001, sales of video games topped $6 billion in the United States. While the retail cost of games had stayed the same, development budgets were increasing, schedules were lengthening, and production values were at their highest level. On average, 20 to 30 people worked for 18 months to develop a game for the PS2 and each game cost upwards of $5 million to develop. The industry was becoming a blockbuster-driven market. The top three selling games in 2001 (Grand Theft Auto 3, Madden NFL 2002, and Metal Gear Solid 2) totaled over $240 million in sales. 

As more hit titles were created by independent developers, publishers found themselves paying royalty fees that ranged from 10% to 40% of the retail price of software once development costs were recouped. In an effort to avoid paying royalties, publishers began acquiring talented development studios. In 2001, UbiSoft, acquired Red Storm Entertainment, the developer of Tom Clancy's Rainbow Six games, for $43 million and a year later Microsoft purchased Rare Ltd, known for its James Bond titles, for a sizable $375 million. As publishers' pockets got deeper, acquisitions became more commonplace (Figure 3). In time, purchasing talented development studios became a defensive measure for publishers to prevent competitors from acquiring top talent. By 2006, the largest publishers owned several studios including Activision (11 studios) and THQ (14 studios). 

Game Developer Acquisitions 1991-2004

(2003 data reflects Jan-Mar)

Figure 3 Game Developer Acquisitions 1991-2004