In Search of the Next Farmville

It may sound strange to say social gaming investing is dead when investors are still gaga over social gaming.

But it is true.

Most venture capitalists say that investing in social games has hit its peak and the time is right to look elsewhere for ways to make money.

That’s not to say there won’t be more deals of games makers, particularly later stage companies. The evidence is Kabam Inc.’s series C round of financing in January, which brought the maker of Kingdoms of Camelot $30 million from Redpoint Ventures, Canaan Partners and Intel Capital.

“We had to turn multiple investors away,” says CEO Kevin Chou, underscoring the excitement that remains for social gaming.

But it is likely 2011 will see cash go in new directions and away from content creators. This shift in thinking shouldn’t come as a surprise. Social gaming is becoming a big business dominated by a small handful of companies—largely Zynga Game Network Inc. Funding the next ambitious developer in a garage is a much greater gamble than it was a year or two ago. New investment targets are necessary.

Some of the new directions aren’t hard to imagine. Investors say they are looking at the infrastructure used to build, distribute and monetize games.

Some hope to rollup smaller companies into larger ones with the ability to cross promote games and reach out to mobile platforms. Others hope to scout out lucrative niches that Zynga hasn’t yet discovered, staying one step ahead of the goliath.

Here are several themes VCJ identified as promising in the year ahead.

Social Gaming 2.0

The trouble with social gaming investing is that Zynga has five times the audience of its nearest competitor, and “they will continue to dominate the market,” says Hany Nada, a partner at GGV Capital.

Social games can spring to popularity over night and make good money. But sustaining and scaling their success is difficult in a market where users switch games with the shift of the wind and one competitor has such a lead, Nada says.

Two years ago, social gaming was sizzling hot, but now “most good VCs have taken their foot off the gas,” he adds.

In this changed environment, Nada says he is most attracted to companies providing infrastructure to game makers. This might include game discovery methods, monetization techniques, technologies to link users, recommendation engines or software to analyze the massive amounts of data games generate.

“I’m actively looking” and have come close to pulling the trigger on some deals, he says. “I hope to invest this year.”

There are good reasons to think Nada is on to something. Analytics in many implementations are poor and payment platforms are evolving. VC-backed Gaia Interactive Inc. is one company wrestling with the challenges.

The San Jose, Calif.-based company, which makes social games and operates a social networking site for teens, said at a recent Silicon Valley forum that, despite new Facebook tools, it still doesn’t always know where its users come from.

Social Rollups

Another clever way to play social gaming is the brainchild of Maha Ibrahim, general partner at Canaan Partners and a board member of Kabam. Ibrahim believes social gaming has “evolved into a platform of haves and have-nots.”

To assure their hegemony, the larger players, such as Zynga, are working to break their dependence on Facebook, where most social gaming takes place, and expand to mobile devices and tablets. The goal is to become larger, more diversified, more dominant companies. Witness Zynga’s deal in May to feature games on Yahoo’s network of 600 million users.

Ibrahim says she is interested in capitalizing on the diversification trend by investing in gaming rollups. The idea is to use $20 million to $50 million of capital to build a gaming platform with a single billing system and then acquire games makers and cross promote them, she says. VCs will participate in rollups, she predicts, adding that she is actively looking for deals.

She says that key is to find the right team, the right strategy to break the Facebook dependence and games that have some commonality.

Ibrahim clearly has wind at her back. The appetite for gaming M&A is on the rise and expected to continue. Last year, 20 transactions took place across the $15.6 billion gaming market, double the pace of 2009, according to Bart Spiegel, an entertainment and media M&A director at PricewaterhouseCoopers. Consolidation will continue due to shifts away from retailing to downloading and to the use of micro transactions and in game advertising, he says.

There also is the possibility premiums paid in social gaming deals could shrink. Many in the industry believe Disney overpaid when it bought Playdom in July for as much as $763 million. More modest mark ups could be in the cards.

Zapping Zynga

While it is hard to out gun Zynga, it also is hard to ignore the social gaming phenomenon. About one-fourth of the U.S. Internet audience plays social games, such as Zynga’s CityVille, or roughly 55 million people each month.

We’re entering a new inning in social gaming.

Chris SheehanManaging DirectorCommonAngels

With advertisers beginning to chase these consumers and the sale of virtual goods on the rise, the social gaming market could break $1 billion in sales this year, eMarketer projects. It is clearly an attractive place to play, if someone can find a way to side step the Zynga juggernaut.

That is exactly what Chris Sheehan, managing director at CommonAngels, hopes to do. Sheehan says he is looking for areas of the market not exploited by the social dynamo. “You’ve got to do something different.”

He thinks he found that in Ayeah Games Inc., which last fall launched FanSwarm, a Facebook game that integrates real-time celebrity news and player interaction. He is part of a funding syndicate of angels and microcap funds that includes Boston-based super angel John Landry, founder of Lead Dog Ventures.

“We’re entering a new inning in social gaming,” says Sheehan, who wants to put more money to work in startups able to keep Zynga at bay.

Kabam’s Chou agrees that VCs are looking for different ways to play social gaming. He attributes this to the funding of Kabam, with its ability to target hard-core gamers with console-like games, not the casual social games of Zynga.

Mobile Social Gaming

Last year was not just explosive for social gaming, but for mobile gaming. This year is expected to top it. More teenagers carry iPhones and iPods, while the iPad and tablets from others offer intriguing new platforms.

That’s what attracts Sumeet Jain, principal at CMEA Capital. “There isn’t yet a Zynga or Electronic Arts” in the mobile social gaming space, and it’s an open question whether Zynga will throw its weight around in mobile, he says. Farmville isn’t optimized for a phone because it doesn’t use location-based services, he says.

Jain sees lots of opportunities in mobile, especially for products with location-based technology. He also argues that operating system fragmentation is less of a concern than many insist. The mobile industry is more condensed than it has been in the past, with Google’s Android and Apple’s iPhone the emerging forces and BlackBerry coming in third, he says.

Jain says one target is mobile monetization technology. Others are tools or techniques for building engagement or for taking personal avatars from one game to the next.

Already money is targeting the sector. In January, Tapjoy Inc. raised $21 million from Rho Ventures, InterWest Partners, North Bridge Venture Partners and D.E. Show Ventures. Earlier in October, Electronic Arts bought Chillingo Ltd., makers of mobile game phenomenon Angry Birds.

For social gaming investors, it appears there is little time to sit idle. Being early is everything, especially with Zynga in pursuit.

Farming is So Last Decade, Game Mechanics is Where it’s at in 2011

Video gaming typically sparks images of neatly hoed FarmVille fields, or grainy Grand Theft Auto cityscapes.

But gaming doesn’t always have to include role playing or stomping a competitor. To the contrary, the emerging business of game mechanics hopes for precisely the opposite.

The idea is that gaming techniques, such as reward points or access to higher tiers of an application, will encourage people to become more excited and use a product longer.

It is widely believed game mechanics will proliferate this year in a broad range of industries, such as health, wellness and financial services.

A boost in venture funding for young companies also is likely, says Anil Mathews, CEO of Hartford, Conn.-based Jume. The company, which has not raised any VC funding to date, is developing an application that lets people manage their to-do lists. It uses game mechanics to motivate people by offering them badges for helping others and points redeemed for product discounts.

Mathews expects many companies will add game mechanics to consumer and enterprise applications. Imagine their use in a program to help people diet, for instance.

Mathews says VCs are wrestling with the question of whether game mechanics is a long-term trend or just a passing fad. Some VCs are convinced it will last; others haven’t quite mastered the concept, he says.

“A lot of them are asking, ‘What are people going to do with the badges and points?’” (The disbelief could be a sign the investment cycle is in its early days.)

Gabe Zichermann, chair of the Gamification Summit, estimates that more than $10 million in seed capital went into game mechanics, or so-called gamification, companies last year. This includes a $2.5 million Series A round of funding for Badgeville in November and a undisclosed amount of seed funding for IActionable Inc. in October.

In January, gamification company SCVNGER raised $15 million from Balderton Capital, Google Ventures, Highland Capital Partners and individual investor Barry Maloney.

One company convinced by the use of game mechanics is location-based social networking site Foursquare Labs Inc. Foursquare awards badges to visitors when they go places and “it definitely works,” says CEO Dennis Crowley, who monitors the stream of feedback on Twitter.

Judging by the volume of tweets generated, it is easy to see what he means.