Harsh Reality of Virtual Worlds

Coming into a market with 200 competitors during a downturn seems like a death knell. But when the market is virtual worlds—the loosely defined, still-evolving new media sector that has both beguiled venture capitalists and left them mostly unrewarded—the 201st time just might be the charm.

Umair Khan is about to find out. In December, he launched Secret Builders, which he bills as the first virtual world based on classic literary stories, making it one of the youngest of the 200-plus virtual worlds aimed at kids. Khan says tens of thousands of people registered for Secret Builders in its first six weeks, putting it on pace for hundreds of thousands of users by year-end, despite spending nothing on marketing.

Khan predicts he will need only 20,000 regular users to build a sustainable revenue model, built on sponsorships, in-world sales of virtual goods and, eventually, merchandising. In part, that’s because his burn rate is about $85,000 a month. He has raised more than $2 million from angel investors—including $100 from the 9-year-old son of a friend.

“Virtual worlds are here to stay. A lot of them are successful, and a lot more will be,” says Khan, who was a venture partner at The Entrepreneurs Fund in Menlo Park before launching Secret Builders, where he is CEO.

Who’s to say he’s wrong?

Bill Gurley, a general partner at Benchmark Capital, the first VC to invest in Second Life creator Linden Lab, says it’s nearly impossible to tell whether a world will gain traction until it’s actually out there.

Gurley notes that Club Penguin, the only North American-based virtual world to have a substantial exit, was probably unfundable as a seed company. The company, which operates a website where kids create cartoon penguins and play with them in a virtual world, was started by three Canadian fathers in 2005 and never raised formal venture capital. “If they had come in and pitched their idea as a PowerPoint presentation—‘We’re going to build a bunch of flash penguins!’—it would have gotten zero takers,” Gurley says.

VC interest in virtual worlds has grown steadily over the past few years. Twenty-nine U.S. venture firms invested about $117 million in 14 companies that included the phrase “virtual world” in their company descriptions last year, according to Thomson Reuters (publisher of VCJ). That compared to 19 U.S. venture firms that invested about $72 million in 10 such companies in 2007.

Even when [virtual worlds] are small, you can assess the basic business model. … You can really measure the business model in the first few months of operation.”

Shawn Carolan

Some say investment in the sector is even bigger. Tradeshow company Show Initiative issued a report in February that said venture capital and media firms last year invested $408 million in more than 30 companies that “monetize at least in part through sales of virtual goods and currency” (see table). Show Initiative did not have comparable data for the prior year.

Venture capitalists say they continue to look for deals in the sector. Nic Brisbourne, a partner at DJF Esprit in London, says he is looking to make the firm’s first investment. “I still think it’s a wide-open opportunity,” Brisbourne says.

Virtual Promise

Several things attract VCs to virtual worlds. They look like promising new forms of consumer media, with diverse revenue sources. They’re relatively cheap to operate. They’re also typically much less expensive per hour than other forms of entertainment, making them potentially a good bet for being attractive to consumers in a downturn. And you can very quickly see if they’re catching on.

“Even when they’re small, you can assess the basic business model,” says Shawn Carolan, managing director of Menlo Ventures. “Each consumer is a statistically significant data point—either they use it or they churn; and if they use it they either pay or not pay. You can really measure the business model in the first few months of operation.”

Menlo has made two investments in the virtual world space. It has backed IMVU, which offers virtual worlds with instant messaging, and Playspan, which makes commerce software for virtual worlds and other online worlds. Menlo re-upped in IMVU’s $10 million fourth round funding in January, in a deal led by Best Buy Capital, and including Allegis Capital and Bridgescale Partners. At the time, IMVU said it had more than 30 million users.

Eugene Yoo, vice president at Globespan Capital Partners, notes another advantage of virtual worlds as a medium: “It’s not solely reliant on advertising revenues,” he says. “In fact, in-world goods are outpacing in-world ads.”

Yoo also notes that usage data indicate that people are willing to pay premiums for some kinds of services, in effect creating subscription revenues. He is not alone in suggesting World of Warcraft, the highly successful online game/world, is a model for the business.

If you believe the past is prologue, as the young age and become the workforce, the communications they’ve adopted will become mainstream. It could be as mainstream as texting or instant messaging.

Jeremy Liew

Globespan was the second VC firm to put money into Second Life, after Benchmark. Recently, it, along with New Enterprise Associates, Northern Light Venture Capital and Qiming Venture Partners, put a combined $25 million into Nurien over two rounds last year and this year. Nurien, based in South Korea, has developed a 3D social network and gaming platform. Yoo calls it a “leading-edge” technology platform, even in South Korea, where virtual worlds are already a proven market.

Jeremy Liew, managing director of Lightspeed Venture Partners, thinks the medium has potential beyond entertainment. He is trying to figure out whether the popularity of virtual worlds among younger people worldwide foreshadows the next big communications mode. “If you believe the past is prologue, as the young age and become the workforce, the communications they’ve adopted will become mainstream,” Liew says. “It could be as mainstream as texting or instant messaging.”

For now, Lightspeed has focused on entertainment plays, with four investments in virtual worlds or gaming companies with virtual world aspects.

Look East

In South Korea and China, virtual worlds have been smash hits, generating hefty revenue almost exclusively from selling virtual goods and services. Gurley is particularly bullish on the microtransaction-based revenue model that dominates in Asia, saying it’s on its way to happening in the United States.

Something needs to happen, because VCs so far have seen little payoff from their investments in virtual worlds. There have been several deals in the range of tens of millions, but there has been only one substantial exit outside of Asia: Disney bought Club Penguin for $700 million in August of 2007—paying $350 million upfront and promising another $350 million by the end of this year if certain milestones are met.

Popular virtual worlds creators such as Linden Lab and Sulake, the Finnish company that produces the wildly popular virtual world Habbo, remain privately held. The market in the West is enough of a struggle that even Google failed with its virtual world effort, which was called Lively. It shut down at the end of last year, only a few months after it launched.

“Despite my enthusiasm [for virtual worlds], it’s fair to say that the venture community has overinvested,” says Gurley.

Despite my enthusiasm [for virtual worlds], it’s fair to say that the venture community has overinvested.”

Bill Gurley

Few of these worlds have even $10 million in annual revenue, says Menlo Ventures’ Carolan. But he notes that the space is still very young.

No Exit

No one expects a good year for exits in 2009 for VC-backed companies in general. “You don’t want to sell right now,” says Globespan’s Yoo. “The currency will be better in 2010.” He and others think that the companies that survive will be in good shape to either go public or attract interest from large acquirers from both the new and old media worlds.

Deals that happen this year may be from weakness. Joey Seiler, editor of Virtual Worlds News, thinks that there will be old media companies trolling for deals, looking to assemble several virtual worlds with different demographics and offer them as an advertising package.

Despite the slow going, VCs say virtual worlds have a real future. They can see the numbers adding up. One knowledgeable insider says Second Life has revenue “well north” of $50 million and is clearly going to be profitable.

Over in Seoul, Taehoon Kim, co-founder and president of Nurien, hopes to enter the U.S. market by the end of 2009. He sees a huge market opportunity without the vicious competition that exists in Korea and China.

“The U.S. is like a blue ocean for us,” he says. “It’s where we were five years ago. It’s definitely taking off.”