When Metanomics first began broadcasting, virtual goods economies were just starting to be taken seriously. Now, the virtual goods industry has moved well beyond Silicon Valley and has the interest of Wall Street. The virtual goods industry has seen rapid growth over the past few years. They have redefined games where subscription-based models have been replaced by free-to-play games that sell virtual goods to a thin sliver of their player base: what are often called the ‘whales’. Click here for the video http://www.metanomics.net/show/virtual_goods_opportunities_challenges_and_acquisitions/

1. 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?

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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.

10. 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

11. 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

12. 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.

13. 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

14. 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,

15. 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.

16. 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

17. 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