METANOMICS:

VIRTUAL GOODS: OPPORTUNITIES, CHALLENGES AND ACQUISITIONS

OCTOBER   18, 2010

Metanomics is a weekly broadcast on the serious uses of virtual worlds. Visit

http://metanomics.net. Metanomics is owned and operated by Remedy Communications.

ROBERT BLOOMFIELD: Hi. I'm Robert Bloomfield, professor at Cornell University's

Johnson Graduate School of Management. Today we continue exploring Virtual Worlds in

the larger sphere of social media, culture, enterprise and policy. Naturally, our discussion

about Virtual Worlds takes place in a Virtual World. So join us. This is Metanomics.

ANNOUNCER: Metanomics is filmed today in front of a live audience at our studios in

Second Life. We are pleased to broadcast weekly to our event partners and to welcome

discussion. We use ChatBridge technology to allow viewers to comment during the show.

Metanomics is sponsored by the Johnson Graduate School of Management at Cornell

University. Welcome. This is Metanomics.

ROBERT BLOOMFIELD: Welcome to Metanomics. Our guest today is Mick Bobroff. Mick

is an audit partner in Ernst & Young's northern California technology practice and

specializes in the software, digital media and online games industries. Mick is probably

pretty comfortable with changing and uncertain settings. Before working on social games

and multiplayer online role-playing games, Mick spent six years at the Ernst & Young

offices in Moscow, in Russia, shortly after the dissolution of the Soviet Union. It's a topic

I'm actually very interested in hearing about. So, Mick, welcome to Metanomics.

MICHAEL BOBROFF: Thanks for having me, Rob. Good to be here.

ROBERT BLOOMFIELD: Let me just mention to Treet I'm hearing a little bit of an echo.

Perhaps that's taken care of now, so we'll go ahead. I wanted to start really by just asking

some basic questions, to get your sense of the industry, and we can start with this notion

of a virtual good. In your mind, what is the definition of a virtual good?

MICHAEL BOBROFF: Yeah. I guess a common definition of a virtual good would really be

digital content that enhances a game player's experience within a social gaming

environment. And a lot of the times, virtual goods are, in fact, provided to game players for

free. And, in other cases, when a digital good is rare or provides enhanced abilities for a

user, then a lot of times the virtual good is something that a user has to pay for, and

therein lies a great thing about the business model for virtual goods--a "free to play" virtual

goods-based business model.

ROBERT BLOOMFIELD: It seems like one of the big business innovations in the social

gaming industry is this switch from subscription-based model to the sale of virtual goods.

Where do you think we are in that evolution?

MICHAEL BOBROFF: It's really interesting, if you look back to the gaming industry or the

virtual-goods industry. In Asia, if you go back five, six, seven, eight years, many of the

companies there were initially on subscription models, and, as those businesses began to

mature and develop, many of those companies actually switched to "free to play" and then

generated their revenue by selling virtual goods. And so we've started to see that here in

the U.S. with the social-gaming industry, which really only began two or three years ago.

The social-gaming industry has been dominated by the "free to play" virtual goods-based

business model. And then when you look at the more hardcore multi-player role-playing

games, those have traditionally been subscription models. And what we've been seeing

lately is that some of those games are now experimenting with or transitioning to the "free

to play" model, and they're finding that, in some cases, it's actually more profitable.

ROBERT BLOOMFIELD: What makes it such an attractive and successful model?

MICHAEL BOBROFF: So under the virtual goods-based model, obviously when the game

is available for free to its users, the number of users goes up pretty dramatically when you

compare it to a paid subscription service. Now, in a virtual goods-based business model

and a "free to play" virtual goods-based business model, it's really only a small portion of

players that actually purchase the virtual goods. And, in fact, that percentage could be

anywhere from as low as one percent to as high as ten, eleven, twelve percent, depending

upon the nature of the game. But what a lot of companies have learned is that that one or

two or three or five percent ends up paying a lot more than what that game could generate

under the subscription model.

And so one of the disadvantages of the subscription model is that you effectively, in many

cases, cap the revenue that you can earn from an individual user; whereas, under the

virtual goods-based business model, there will be some that don't pay for virtual goods,

there are some that are comfortable purchasing virtual goods at five or ten dollars a

months. And then there are the whales that will purchase virtual goods and spend, believe

it or not, thousands of dollars a month to play the game. So as a result, the beauty of this

model has been that you have a small number of users that are purchasing virtual goods,

and then a subset of that referred to as the whales that pay a significant amount of money

and then drive a good portion of the revenue.

ROBERT BLOOMFIELD: We often talk about the visible part, I guess, of the revenue

model is the sale of virtual goods. Certainly, online we see lots of other ways to monetize.

In particular, I'm thinking there's advertising, and there's also the ability to extract value

from the customer data. Especially the customer data, does that sort of go hand in hand

with a virtual goods revenue model?

MICHAEL BOBROFF: The other aspect of revenue that social gaming companies earn is,

in fact, advertising revenue, and most of the advertising revenue that is earned currently

really has to do with these in-game offers, whereby, if you don't want to purchase virtual

goods for cash, you can go in and click on an ad for a specific advertiser, perhaps sign up

for something, and then, in turn, you earn some premium virtual currency for that action.

And so that's brought in some advertising, a certain level of advertising revenue to

social-gaming companies. It hasn't been a significant portion, but it is growing, and the

advertising is becoming more sophisticated within social gaming. There are a lot of new

entrants into the market.

But on the free users, free users do play a very important part in the economics of a

social-gaming company because all of these users, when you play these social games, a

critical part of your strategy is to make sure that you're connected to your friends and

you're able to gift certain virtual goods to your friends. And so the way that a lot of these

social-gaming companies look at their free users is (a) they're a source of advertising

revenue, but (b) equally as important is that they're likely to invite friends that are, in fact,

going to be paid users. And so what I've found is that social-gaming companies are

becoming much more sophisticated in understanding that dynamic, understanding that

free users are, in fact, a very important part of their economics.

ROBERT BLOOMFIELD: Well, they almost serve their role of both marketing and being

content themselves for the people who are willing to pay.

MICHAEL BOBROFF: Absolutely.

ROBERT BLOOMFIELD: So let's talk about the risks. And I guess risk number one is: Do

you think that this type of business model and the product itself, the social game, do you

think it's just a fad?

MICHAEL BOBROFF: That's certainly a question a lot of people are asking. I guess the

way that I look at it is social gaming has basically introduced online games to a whole new

demographic. Right? And, all of a sudden, you have people, such as myself, and

stay-at-home moms and professionals that are, all of a sudden, playing online games for

the first time in the last couple of years. I think the reason for that is because many of

these social games you can play for basically five or ten minutes at a time and progress

with the game by just playing five or ten minutes at a time once a day. You have a choice

of whether you want to pay money or not. And, as a result, I think that social gaming has

become a new form of entertainment to a whole new demographic of gamers.

And so, from my perspective, I think that that will continue, that we will continue to play

games through the social networks and, ultimately, I think it'll continue to be a very

successful business. One of the things that I focus on very closely is that only a small

percentage of users currently purchase virtual goods, and I throw out the percentage of

anywhere from one percent to as high as twelve percent, depending upon the category of

the game. But, if you think about it, one of the aspects that all social-gaming companies

are getting better at every day is that they're getting better at changing the game dynamics

such that they create an appetite for purchasing virtual goods by the users.

And the second thing that I think has happened over time is that it has become more

acceptable to purchase virtual goods from a social standpoint and also people just

understand the value of having and purchasing virtual goods within an online game. So if

you have a company that is generating revenue and only two percent of your users are

paid users, just think about what kind of revenue growth you would have if you tick that up

from two percent to three percent, without even growing your user base. So that's one of

the reasons I'm very, very excited about being associated with the industry.

ROBERT BLOOMFIELD: Now, another potential risk here is that it seems like many

social games are dependent on a software platform for their very existence. In particular,

I'm thinking of games that reside on Facebook. I understand many people say anyway the

first game that was a big hit was Scrabulus, a scrabble derivative, and it was only available

on Facebook. I guess, first, do you see that as a risk for a social game to be dependent on

a particular platform? Well, I'll just leave it there.

MICHAEL BOBROFF: Yeah. I think many social-game companies are, in fact, focused on

that very issue. There are certain social-game companies out there that are very

dependent on their relationship with Facebook. I would say that almost all are thinking

through that issue and determining how best to diversify their risk by including their games

on other platforms or perhaps launching some of the games or giving the users the ability

to play their games directly on their websites. So as some of these social-game

companies begin to go international, they are also looking at some of the social networks

that exist in Asia and in Europe, and they're finding that that's also an effective way of

diversifying their dependence on a single relationship. But clearly, Facebook is a very

important partner to many of the social-game companies today.

ROBERT BLOOMFIELD: Ultimately I'm going to want to ask you to make some

predictions, but I'll give you time to mull that over while we discuss some predictions from

two and three years ago about the future of social gaming. One set from Ravi Mehta, and

then I've got another one that comes from Jeremy Liew of Lightspeed Ventures. He's a

partner and has published predictions at the end of each year, for the last several years,

about social games and virtual goods. So the good thing here is, you can evaluate these

predictions after seeing what actually happened, and you don't have to criticize yourself

because they're not yours.

You had mentioned that you're seeing a lot of people from 25-and-up age group as part of

these games. This is from Jeremy Liew. He emphasizes in his prediction many users skew

young, and, if you believe the demographics is destiny, then you'll expect this behavior to

spread. So it sounds like that's a prediction that really didn't pan out, that, in fact, much of

the growth has come from the older crowd. First, is that your assessment? And second,

where do you see the growth coming from in the next few years?

MICHAEL BOBROFF: I think the demographic, the high school demographic and then the

early twenties demographic will always be important within the online-games industry, the

social-gaming industry, but I think what has come as a surprise to many has been the

popularity of these games by the 25-to-45 year old demographic. And, as I mentioned

earlier, I would venture to say that I think that will continue because playing these social

games does not require a big investment of your time, and, as a result, it's become a new

form of entertainment for people that historically haven't been playing these games. So I

would expect that to continue in the future.

ROBERT BLOOMFIELD: Another of Jeremy's predictions is, social networks will

monetize by providing virtual currencies. You were talking about the small percentage of

people currently who are buying virtual goods. Do you see something happening, like the

LinkedIn or Facebook or MySpace or whatever, providing their own virtual currencies that

would make it easier for people to buy goods from the games that reside on these

platforms?

MICHAEL BOBROFF: Oh, absolutely. And it's already happening. Facebook introduced

Facebook credits last year, that provides a common currency for games on Facebook, and

that has become an important revenue stream for them. And, if you look at the social

networks around the world, many are now introducing this concept of a virtual currency,

that is sold by the social network, that you then use to either redeem the virtual currency

on a social game that's on the network or to apply that virtual currency directly in game

that's on that social network's platform. So I think that's definitely an evolution that is

already happening, and I would expect will continue to take place with all the social

networks really.

ROBERT BLOOMFIELD: I see there's some commentary going on in our text chat.

Cisop Sixpence is expressing concern about privacy on Facebook in particular, but I think

this is something that a lot of people worry about just generally with these social games,

social networks. So I'm wondering, do you have any, I guess, assessments as to what

degree privacy concerns are restraining growth in social games? And what do you see

happening in the future?

MICHAEL BOBROFF: Privacy is clearly very important to social-gaming companies, in

terms of maintaining trust with its users. If your users lose trust in you, then that would

certainly have a detrimental impact on your ability to grow your revenues, to grow your

user base. So I would say that all social-gaming companies are, in fact, focused on that,

and there obviously has been a lot of press on this. In fact, I think in the Wall Street

Journal this morning there was a page-one article on this very topic so it is, without

question a challenge and a risk for every one of these companies. And I think it's

something that they're all working on and clearly is a very important aspect of their

business.

ROBERT BLOOMFIELD: Okay. Here's another prediction that comes from Ravi Mehta,

and it's actually just from not too long ago, July of 2009, so a little over a year ago. The

prediction is traditional game companies will continue to stand on the sidelines. Let me just

read a little bit of this. It says, "What was the very first hit social game? It'll probably sound

familiar: Scrabble. Well, actually Scrabulus launched shortly after the release of the

Facebook platform. Scrabulus is a social game based on Scrabble, released by two

brothers who became the first lucky prospectors in the social-game gold rush.

Rather than recognizing their good fortune in finding a new rapidly growing medium for

their games, Hasbro quickly got to the business of shutting Scrabulus down and didn't find

time to release its own version of Scrabble on Facebook, until months later, after major

players such as Zynga had staked their claim. None of the traditional game companies

played a significant role in social games to date, and this will likely continue until the major

players, such as Electronic Arts and Activision, wake up to the opportunity and start

acquiring players, like Playdom and Zynga, is what they mentioned. So this is now 14, 15

months old or so. What's your take on what has happened, and where do you see the

traditional game companies coming in over the next few years?

MICHAEL BOBROFF: I think all the traditional game companies or most of the traditional

game companies now have a public strategy of transforming to digital, including getting

into social games. And some have done it by creating their own games in-house, and

others have done it through acquisition. So Playdom ended up getting acquired by Disney.

Disney also had some other acquisitions in the social-gaming space. Electronic Arts ended

up acquiring Playfish. And then there are many other smaller acquisitions that are now

being made by the traditional video-game companies and also the traditional media

companies. The traditional media companies also see a lot of advantages and a lot of

synergies to this business, and they're getting involved as well. So new players are being

added in this space every day, as more people realize how lucrative the space is.

ROBERT BLOOMFIELD: What is the venture-capital appetite for investing in these types

of businesses?

MICHAEL BOBROFF: The VCs have been very active in the social-gaming industry, and

when they look at social-gaming companies or at least the history of social-gaming

companies to date, which has been short, the period between inception of the company to

exit has, thus far, been much shorter than a traditional technology company. And many

social-gaming companies have been able to scale their business within a relatively short

period of time and so, as a result, have been viewed as very attractive by the venture

capitalists. Now, valuations for these social-gaming companies in M&A transactions have

been very high recently because of all the interest by the new entrants into the market,

and so that has also made the space very attractive to venture capitalists.

ROBERT BLOOMFIELD: Just to clarify, you're saying that's primarily because of the

quick turnaround from development of a game to their realization of revenue?

MICHAEL BOBROFF: That's right. That's right. I mean one of the interesting things about

the model is that the way that many social-gaming companies operate is that they spend

anywhere from six weeks to three months developing a game, doing a launch, and then

they update that game on a weekly, regular basis as they receive feedback from their

users. So compare that to a traditional console-game publisher [AUDIO GLITCH] game up

front and then basically throw it over the wall for users to purchase. It's actually great to be

in a position--the social-gaming companies are in a great position [AUDIO GLITCH]

adjustments and tweaks as users provide them feedback.

ROBERT BLOOMFIELD: Okay. Very interesting. I see there's a question from an

audience member, Pooky Amsterdam. Hello, Pooky. What limitations traditional media

companies encounter by not being part of this landscape? And she mentions, and this is

something a lot of our audience members will be familiar with, that a lot of companies

came into Second Life and threw their money in, but had no plan at all. What's your

impression on whether the traditional game and media companies, do they know what

they're getting into? Do they know what they're doing? Or are they primarily relying on the

young folks who have a vision?

MICHAEL BOBROFF: In terms of the development of social games, obviously the

traditional media companies are hiring people within the industry, that have previously

developed social games. But I guess the way that I look at it, with traditional media, is that

they've found another way, and they've been doing this for some time, but they've found

another way to distribute their branded content. And I think that's another thing that we'll

start to see as the traditional media companies get more interested in the social-gaming

industry. Many of these social games will start to become branded social games, and

you'll start to see some of the brands that we see in other forms of media.

ROBERT BLOOMFIELD: Very interesting. I'd like to move on to another topic here, which

is measuring revenue on the sale of virtual goods. And here’s the part of the show where I

have to remind everyone that we're both accountants. Right? You're an auditor. I work on

financial reporting and standards setting. Deciding when firms can recognize revenue is

always one of the most challenging parts in financial accounting, and it's been a particular

challenge in the software industry. You have written a white paper, and actually I'm going

to copy this link and paste it into the chat window so that everyone can see that and click

on it, if they want to. This is a white paper from Ernst & Young, called Revenue

Recognition on the Sale of Virtual Goods. Could you start just by setting this up, the big

picture for us? What is the challenge in revenue recognition for virtual goods?

MICHAEL BOBROFF: Right. Revenue recognition on virtual goods: many accountants

when they first encounter their revenue models within a social-gaming company or just

online games in general their initial reaction is, "Well, I sell virtual currency. That virtual

currency then needs to be converted into a virtual good. I have no legal obligations after I

sell the virtual currency. Why can't I simply recognize the revenue at the point of sale of

virtual currency?" Although there is certainly a theoretical argument for recognizing

revenue at that point in time, the way that we look at it and the way the industry really

looks at it is that you really have to look through to see what is the user's expectation

when they purchase a virtual good with virtual currency.

In the white paper, we introduced three different types of models, and those models are

really based on the level of information that's available to the social-gaming company. But

the theory behind it is that, if I purchase a virtual good with my virtual currency--and I'll use

an example of a rare online schoolhouse that remains on my game board within a game,

and I purchase it for five dollars--the theory behind it is that, as a user, although the terms

of service may, in fact, state that the social-gaming company has no obligation to the user

after that transaction occurs, the fact of the matter, as a user, when I log in tomorrow, into

the game, it is my expectation that that schoolhouse will be there, and it's my expectation

that that schoolhouse will continue to be on my game board for as long as I continue to

play the game.

By the same token, if I purchase something such as virtual fuel for my virtual vehicle, the

revenue really doesn't get earned until you use the virtual fuel for your vehicle, until it's

consumed. So the basic model is that you recognize revenue on the sale of virtual goods,

not on the sale of virtual currency. But at the time that the virtual currency is converted into

a virtual good, revenue recognition commences, and you recognize durable items ratably

over its estimated useful life, and consumable items, such as the virtual fuel example, as

it's consumed.

ROBERT BLOOMFIELD: I understand the logic of the basic model, that the company that

is selling the virtual good, they're getting cash right upfront, and they're making a long-term

commitment to the person who has purchased it, and so it makes sense to consider that in

recognizing revenue. But I do have a couple problems with this model. And the first one is

that, as I understand your description of the revenue, basically the business model for

these companies, they are selling virtual goods to only a tiny fraction of the people who

are playing the game. And so I'm assuming that, if I look at a particular virtual good, the

cash that the customer gives me right upfront must be huge relative to the actual cost of

providing that good to the player for however many months or years are involved. It just

seems a little odd to me that users would be delaying the recognition of revenue, if they

have just a trivial sort of de minimus duty to the customer from then on, do you find that

reasoning persuasive at all?

MICHAEL BOBROFF: I absolutely agree with you that the cost of actually providing the

virtual good is generally very small/insignificant. The theory behind recognizing the

revenue over a period of time is really driven by an implied obligation by the social-gaming

company to continue to deliver the virtual good for as long as that user wants to access

the game. And I guess another way of looking at it, Rob, is another industry that I spent

some time in is the softwares and service sector, whereby, in many ways, social games

are a form of service to the end users, and you're effectively paying a fee upfront for a

service over an undefined period of time.

So as a result, I see a lot of parallels between the social-gaming industry and in the

softwares and service industry. And then the softwares and service industry, you obviously

recognize the revenue over a defined period of time, over the period of time that you've

committed to providing the service to the customer. The only difference here is that the

period of time is not defined.

ROBERT BLOOMFIELD: Mm-hmm. You mentioned that there are three models. This is

the game-based revenue model, the user-based revenue model and the item-based

revenue model. And so first, I guess I have a question. You're an auditor. You've written

this white paper for, well, it's available to anyone, but presumably reflects how you guide

your own clients. I'm hoping you can not just walk us through these models, but also tell us

a little bit about what is--are these things actually being done? Or is it more of just a theory

on how one might recognize revenue for virtual goods?

MICHAEL BOBROFF: Sure, absolutely. And that is correct. This is a white paper that is

publicly available and is consistent with how we guide our clients on these issues.

Obviously, every company has its own set of facts and circumstances so it is a general

white paper. But what the white paper does cover is, it covers three models of revenue

recognition: the games-based model, the user-based revenue model and the items-based

revenue model. At the highest level and the easiest one to apply is the game-based

revenue model, and the theory there is, you recognize all revenue ratably over the

estimated remaining period of the life of the game. And you would apply that model if you

simply don't have the data to apply the user-based revenue model which requires a lot

more user-behavior data.

The next model is the user-based revenue model, and here what you're required to do

under the user-based revenue model is determine the estimated life of the user. And so

you recognize revenue on the sale of virtual goods ratably over the user life. And this does

require some work for many social-gaming companies because coming up with a

calculation to support an average user life is not easy. It's typically defined as the first date

of purchase [AUDIO GLITCH] that user's termination date. And although the first date of

purchase can be objectively determined, the termination date is more difficult to determine

because--and I'm a good example of this--many people come in, play the games, leave,

try other games, return, and so coming up with a definition as to when a user is considered

terminated is an important aspect of that.

And then, finally, the most detailed of the three revenue-recognition models is the

item-based revenue model, and here, in this situation, you actually look to the

characteristics of the virtual goods that are being purchased. So what that means is that, if

you buy a durable good, a virtual good that you continue to expect to see within your game

board, within your game environment, as long as you continue to play the game, that

revenue gets recognized ratably typically over the estimated user life. Then you have the

consumable items that get recognized upon consumption.

And then I guess the third category really is the rental items so to the extent the gaming

company sells virtual goods that have a rental period associated with them, you would

recognize that revenue ratably over the rental period.

In terms of who is applying these models, it's interesting as if you look at the Chinese

companies that are SEC registrants that report in US Gap, and there are about six or

seven of them, all of those companies, in fact, apply the item-based revenue model. And

we work with some of them, and they actually have very sophisticated IT and

business-intelligent systems that enable them to do that. And that has largely become

industry practice within that group of companies.

What I would say that I see the most among all the companies that I talk to, especially out

here in California, is that many companies find the item-based revenue model very

burdensome because it does, in fact, require a significant amount of data. It does require

some technology infrastructure, and that data may not necessarily exist. So most

companies that I come across initially apply the user-based revenue model. When you

think about it, the user life is a not only an important data point for revenue-recognition

purposes, it's also an important data point for operating the business. User retention is

obviously very important for all of these gaming companies, and so to the extent you can

come up with a user-life calculation that makes sense from both a revenue-recognition

standpoint and helps you operate the business, it obviously helps everyone concerned.

ROBERT BLOOMFIELD: Yeah. And that was going to be my next question: How helpful

do you believe these types of models are for operating the business? Can you envision

firms pulling these types of models together, even if they weren't worried about adhering to

financial reporting standards?

MICHAEL BOBROFF: Let's take the durable goods/consumable goods as a data point.

So for applying the item-based revenue model, you would need to be able to distinguish

the difference between durable goods and consumable goods [AUDIO GLITCH] so that

you could separately recognize those as revenue. But another way of looking at it from

operating the business, is consumable items are, in fact, important in operating the

business because presumably, if you've got users that are purchasing consumable items,

there's a continuous appetite for those consumable items. So what I've started to see is

that some of the social-gaming companies are, in fact, looking at the activity of their

consumable items, and that does result in earlier revenue recognition, as compared to

durable goods, but to the extent you can get a nice stream of consumable items, that

obviously drives some pretty good revenue growth.

ROBERT BLOOMFIELD: We have a couple more audience questions. Linda Sautereau,

from the Kelly School of Business at the University of Indiana, says, "We've got two

accountants talking about this. Would marketers have a totally different take on it?"

Unfortunately, you can't turn yourself into a marketer right away, but no doubt you have a

lot more interaction with people on the marketing side than people who aren't accountants

might suppose. Do you care to hazard a guess on how marketers view this data, and I

suppose the virtual-goods issue more generally?

MICHAEL BOBROFF: If you look at it from what is the best way to market virtual goods to

your users, I think the durable-consumable distinction is, in fact, an important distinction

and that this concept that I mentioned earlier about consumable virtual goods resulting in

accelerated revenue recognition, I believe, from a marketing standpoint, also drives

revenue growth if you've got the game mechanics nailed down such that you can create

an appetite for your users to continuously purchase these consumable goods. So I do look

at it as being an issue that is broader than an accounting issue. It really is an issue on how

best to monetize your virtual goods and how you continue to drive revenue. And then how

you drive more paid users, how do you increase the percentage of paid users to total

users.

ROBERT BLOOMFIELD: We've got a couple people boggling at this notion of a virtual

durable good. Do you mind just giving another stab at describing what you mean by

something that sounds a bit like an oxymoron?

MICHAEL BOBROFF: Sure. There are some that refer to them as perpetual goods, or

durable good is probably the more common term that I've heard used within the industry,

but the basic concept behind it is that it's a virtual good that the user continues to have

access to, as long as that user continues to play the game, and there's no deterioration in

that virtual good. It just continues to be displayed. So an example: In a farming game

would be a virtual pink tractor and perhaps the pink tractor is rare as compared to the

typical tractor that you sell. And that tractor will continue to be in the game, and any

actions that you do will not, in fact, have any impact on that pink tractor. Other examples of

durable goods would be sometimes you see virtual clothing or a virtual barn, a virtual

schoolhouse, etcetera. Those are the type of virtual goods that you would typically see,

and that would be defined as a durable virtual good.

ROBERT BLOOMFIELD: Okay, yeah. Looking at the chat, it looks like that helped so I

appreciate that. Let's see. We don't have a whole lot of time left. There are a couple more

topics I'd like to hit. One is that when we spoke earlier, you mentioned that there were

some interesting tax challenges associated with virtual goods and that virtual goods might

even be, for example, subject to sales tax. What are the tax issues people should be

aware of, with virtual goods?

MICHAEL BOBROFF: Virtual goods are, in fact, subject to sales tax in certain states, and

so what many social-gaming companies have to face is to determine which states they

have a taxable presence in, and, if then if they have a taxable presence, then in a state

that requires companies to charge sales tax on virtual goods, then you theoretically need

to charge the users sales tax on virtual goods. That, unfortunately, is hitting a lot of

companies by surprise.

ROBERT BLOOMFIELD: Well, let me ask. You talked about revenue recognition in the

models on the financial-reporting side. How exploratory is income reporting at this point,

the law on the tax side? Do you see this as a work in process?

MICHAEL BOBROFF: Sorry, Rob, on the sales-tax side or what?

ROBERT BLOOMFIELD: I'm thinking more just on net income. In corporate income taxes

or however these organizations are set up.

MICHAEL BOBROFF: Right. No, I think just the same as it is on the financial-reporting

side, there's a whole slough of complexities on the tax side. Yeah, it's really beyond my

core of expertise to really go into that.

ROBERT BLOOMFIELD: Okay. That's perfectly understandable. I'd like to really change

gears significantly here. You lived and worked in Russia shortly after the dissolution of the

Soviet Union, and I know that sometimes when I hear people talk about the state of

business in those transitional years, it sounds a lot like Silicon Valley. I'm wondering if you

could tell us a little bit about what it was like when you were there and whether there are

lessons you learned, in those freewheeling days, that you continue to find useful in the

gaming industry.

MICHAEL BOBROFF: Sure. It was a fun period of my life for sure. I lived and worked in

Russia from 1992 to 1996, and arrived there shortly after the fall of the Soviet Union, so it

was a very interesting time in the country's history. Back then I did serve clients in a

variety of industries while I was there, but, without question, the highlight was spending a

lot of time in Siberia with clients in the oil and gas industry. Some of the friends that I made

as a result of spending many, many long days and long weeks in Siberia, serving the oil

and gas industry and trying to figure out, okay, how do you take these sets of books that

are prepared under Russian accounting standards, and how do you account for all of

these transactions under US Gap or--international accounting standards at the time was a

huge challenge and was also a lot of fun.

It's interesting that you draw parallels between what I did back then and what I do now, as

I certainly enjoy looking at complex situations, complex transactions and then stepping

back and trying to understand what that all means within the context of financial reporting

under US Gap or under international standards.

ROBERT BLOOMFIELD: I was going to say, one of the analogies that occurs to me is

that, well, I guess in the U.S., in more established industries, the rule of law is quite clear,

you know, notions of ownership of real property or steel or something like that are fairly

straightforward. And so, if we look up and down the supply chain at the agreements

between buyers and sellers, it's been fairly straightforward and static relative to either.

Russia, as things were being opened up and completely new channels and completely

new legal environments were being created.

And then maybe I'm just stretching this too far, but I feel like I also see this in Silicon

Valley, where we have such complex forms of partnerships, complex strategic

relationships. I talked, for example, before we discussed the issue that, if you're a

social-gaming company, you may have your platform on Facebook, and it seems to me, as

not a lawyer, that it's still not entirely clear the legal rights and responsibilities that

everyone has because they haven't yet been sorted out in the court. Do you see any--am I

just pushing this too far?

MICHAEL BOBROFF: No. No, absolutely. That is something that we have to deal with

fairly frequently here in Silicon Valley is seeing brand new revenue models that haven't

been tried before or revenue models that have unique aspects to them, partnership

agreements between companies that no one has seen before. And, again, as we're put in

a situation where both we and our clients have to step back and truly understand what the

substance of these arrangements are, the substance of the revenue arrangements, the

substance of the partnership agreements, and then put the best minds together and

determine how best to account for that.

Because a lot of the times we have a lot of clients that do things for the first time and, as is

the case in many industries, you always have three or four companies that soon follow,

doing the same thing if the first one is successful. And so it is important, from a

financial-reporting standpoint, that any accounting conclusions that are reached on a new

revenue model or on a partnership agreement is well thought out and can be replicated

once a new entrant does the same thing.

ROBERT BLOOMFIELD: Thank you. So we're just approaching the top of the hour. I'd

like to ask you to stick your neck out a little bit and make some predictions. What do you

see as being the most important trends we should keep our eyes open for in the

social-gaming and virtual-goods industry?

MICHAEL BOBROFF: I see a couple of things on the horizon. As I mentioned earlier, I

think one trend that we will start to see is that the purchase of virtual goods will become

increasingly accepted and increasingly more mainstream by users. And so, if only a small

percentage of the publisher's users are purchasing virtual goods, I expect that percentage

to continue to increase as acceptability of purchasing virtual goods increases and as game

designers get better at designing game mechanics that increase the monetization. Right? I

think we'll also continue to see the console-game publishers having a digital

transformation strategy and start investing more and more into the social-game market.

And I would expect that there will be many more new entrants with deep pockets, including

the traditional-media companies. So as a result, I do expect to see continued growth in this

industry, in the foreseeable future, and I think it'll be really exciting to watch.

ROBERT BLOOMFIELD: Great! Well, I will let you have the last word on that. I really

appreciate your taking the time to speak with us today.

MICHAEL BOBROFF: Well, thanks for having me, Rob.

ROBERT BLOOMFIELD: So today our guest has been Mick Bobroff of Ernst & Young, an

expert in the virtual-goods and social-gaming industry. We'll actually be on a short hiatus

for a couple weeks and probably coming back in November, when we will be bringing you

more Metanomics, looking at business and policy issues in the Virtual Worlds and

online-media industries.

So thanks a lot. This is Rob Bloomfield, Beyers Sellers, signing off. Bye bye.

Document: cor1090.doc

Transcribed by: http://www.hiredhand.com