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VENTURE CAPITALISTS BYPASS STRON VIDEOGAMES MARKET

Strength of Industry's Major Players Makes it Hard to Pick Small Winners

NEW YORK -- The videogame industry is booming, but venture capitalists aren't playing.

VC investments in games-related start-ups have been sporadic, even as sales of videogames are surging. One factor is the broader downturn in VC activity since the late 1990s, which has hit start-ups in most categories. But a specific obstacle has been the videogame industry's hit-or-miss nature, VCs say.

"Historically, in the games business, a lot of companies really succeeded by hitting it big with one blockbuster," says Jon Callaghan, managing director at Globespan Capital Partners in Palo Alto, Calif. "As a VC, it's very hard to invest in that."

Only $37 million was invested in games-related firms in the U.S. during 2002, down from $66.9 million the year before and a peak of $295.3 million in 1999, according to Thomson Venture Economics, which tracks VC data.

At the same time, U.S. sales of videogames and consoles jumped 10% to a record $10.3 billion in 2002, according to NPD Group, a consumer market-research firm. Titles ranging from "Grand Theft Auto" to "Madden NFL" to "Super Mario" led the way.

The videogame market is dominated by established players such as Electronic Arts Inc., Sony Corp. and Microsoft Corp. Electronic Arts is a venture-capital success story, but it has been around since 1982, and its VC backers, including Ben Rosen, the co-founder of Compaq Computer, have long since cashed out.

These market leaders dominate the shelves of retail stores, making it hard for start-up publishers and developers to get attention. Also, for every top-selling game there are dozens that don't catch on, making the business a low-margin proposition for many firms.

Even online and downloadable games, which independent developers have had some success with, aren't drawing a lot of VC interest. Independent developers that aren't controlled by leading publishers have a tough time getting funding because VCs want to see a meaningful revenue stream and a track record of titles that sell.

"The whole gaming area for VCs hasn't been a big item for them in a while," said Jesse Reyes, vice president at Venture Economics. "The barriers to entry are too low and it's a fairly low-margin business."

There have been some bright spots. Sorrent Inc., a San Mateo, Calif., publisher of games for wireless devices, raised $5.5 million in Series B financing in April. The round was led by Globespan Capital Partners, with Mr. Callaghan taking a seat on Sorrent's board. Previous investors New Enterprise Associates and Sienna Ventures also chipped in.

Some investors see a lot of potential in cellphone gaming because the wireless distribution is inexpensive, leading to higher profit margins. Also, the market is still small enough that it hasn't prompted the industry leaders to make a big push into wireless.

"It's a big market for a nice little start-up," Mr. Callaghan said.

Sorrent develops and publishes games that wireless carriers sell to customers for anywhere from $2 for a 30-day license to $8 for permanent ownership, said Chief Executive Scott Orr. Games like basketball and football can be played on phones with color screens.

Globespan typically doesn't invest in entertainment firms. But Mr. Callaghan said he was drawn to wireless gaming because it could be the first big premium data service for cellphones, which aren't just for talking anymore.

Mr. Orr said Sorrent had an easier time raising money in the Series B round than the first round in 2001. But the hunt for VC funding remains difficult for most games start-ups. Just ask Adeo Ressi, chief executive of Game Trust, a New York developer of software used to run multiplayer videogame tournaments on various devices.

Formed in February 2002, Game Trust is still running on angel and management funding. Mr. Ressi has spent much of his time searching for VC backing, including a public pitch at a business forum sponsored by the MIT Enterprise Forum NYC.

So far, Game Trust hasn't raised a penny, although Mr. Ressi said some term sheet offers are pending. "I would say by far it's the most difficult financing market I've ever experienced," said Mr. Ressi, who previously raised financing for other start-ups.

Mr. Ressi thinks some segments of the gaming market, particularly on the infrastructure side, have higher potential to draw VC interest than other industries. It's just that few VCs are pulling the trigger on deals.

"The VCs are waiting for demonstrable results," he said.

Write to Peter Loftus at peter.loftus@dowjones.com

Updated July 3, 2003 12:22 p.m.