The standard development model

Once a game concept has been mapped out (usually in the form of an extensive design manual) and approved, a development team is assembled and responsibility for specific parts of the game's creation are allocated to specialist personnel.  The days of single programmers being able to fashion a hit game by themselves are long gone and there is now a thriving games industry recruitment market catering for the demand for artists, 3D modellers, animators, audio and artificial intelligence specialists to name but a few. It is important to note that the development process varies significantly from company to company and game to game. The creation of a title, once begun, cannot easily be transferred to a new team and even replacing one programmer with another is fraught with difficulties.
Game development costs have risen sharply over the last decade. A typical game in 1997 would have been developed by a team of around 7-14 people, have taken around 15 months and cost between £250,000 and £500,000 from start to finish. A typical AAA potential game now costs £3m to £6m and takes 30-60 people around 18 -24 months to complete. Some games have as much as 3-4 year development periods budgeted, can involve as many as 70-100 development staff with total development costs reaching in excess of £8m to £10m as a result.
Funding for a game's development can either come from internal resources, third party finance providers, the publishers and, less commonly, distributors of the game. Since developers do not handle the manufacturing or distribution of retail-bound products and almost all rely on some level of publisher advance funding, they receive a royalty percentage of the net wholesale receipts to the publisher (i.e. gross wholesale price less cost of goods, returns provision - usually 5%-15%, and in some cases distribution costs). This royalty rate can vary from around 10% to as high as 45% (industry average is 15-25%) depending on a number of factors including the following:

1. The extent to which the game has been funded by the publisher. If funding is required, a publisher will pay the developer a non-refundable advance on anticipated royalties. Thus, once the game is released the developer receives no royalties until sales have exceeded the amount paid out in the advanced funding. However, the majority of titles fail to progress significantly past this level and many entirely fail to do so. The smaller the amount of funding required the higher the royalty that can be commanded and, of course, the sooner post-advance revenue can be attained. Should a title be completely self-financed, the royalty rate will be maximised and royalty revenues will commence with the first unit sold;

2.The saleability of the title. A well known development team with a track record of successful products can command considerably more favourable terms with publishers and distributors. There are very few developers that can command royalties in excess of 25% although royalties of 35%-45% are known to have been awarded;

3.The role of the publisher. The extent to which the publisher takes on responsibilities and other non development funding related risk such as the game's promotion, localisation, multiplayer server hosting etc… also affects the royalty rate.

4. Who owns the intellectual property rights (IPR) to the title. In their contracts with developers, publishers will normally seek to control the IPR on titles that they are proposing to fund irrespective of who devised the original game concept or who develops the title. This is a critical issue as the spin-off and sequel rights for a successful game can be worth considerably more than the original title. Should a developer seek to retain the IPR, they will likely face a trade-off in the form of a reduced royalty rate. Where a developer is working on a game based around external IPR licensed by the publisher (such as the games rights to a film), the developer can expect a considerable reduction in royalty rate but much greater sales potential.

Because there are very few publishers that can handle the publishing and distribution of a game for all territories in the world, a developer will either hand over global re-sale rights to the publisher or, more rarely, seek separate deals for each of the territories. In such situations, it is not unusual for the developer to seek advances on sales in those areas from the local distributors/publishers. A developer, therefore, can approach a publisher at any stage of a game's development although most developers do seek some form of advance out of financial necessity.  As a result, games development, at least for the established outfits to whom publishers will readily give advances, can be reasonably risk-free compared to publishing although the rewards of a hit game are commensurately less. Consider this simple model for a premium-priced PC title:

Thus, if the game costs £3.5m to develop and the company receives an advance of £3.5m (thought most developers try to build in a 5%-10% operating margin on the advance), then it would not see any profit until 933,334 units (@ £3.75/unit) have been sold as opposed to the 583,334 units (@ £6.00/unit) needed for the self-funded game. It should be stressed that this is a vast oversimplification of the model as, for example, gross wholesale prices vary widely throughout the life of a product and returns provisions are rarely realised (thus releasing funds at a later stage, typically 1 year after sales). Further complications are the increasingly common use of variable-rate royalties (where different royalty rates are triggered by sales exceeding pre-agreed milestones) and cross-collateralising (where there is a multi-title development deal, the developer would not receive any royalties until the aggregate of the advances has been recouped, i.e. not on a title by title basis). However, there is no denying the attractiveness of self-funding as the rewards with a hit product demonstrate above.

Alternative development and funding models
 

• Equity-funding.  For those developers that cannot fund a new title from internal cash flow and do not want to use publisher funding there is the alternative of seeking to raise the funds needed to develop the title via external investors. This is usually done by either issuing and selling new shares in the development company (thus diluting the existing shareholders) but could also be done by creating a single purpose vehicle (SPV). The SPV would retain the full intellectual property and royalty rights to the title and since it would be this company that external investors invested in, there would be no dilution of the core development company shareholders' stakes. SPV-based equity funding is a rarity as most investors prefer to invest in the development company itself. 
• Debt-funding. A less common method of gaining the money to self-fund development is by securing a loan. However, it is unlikely that a commercial bank would fund a full development project (too risky) unless that company was both large and had a substantial tangible asset base or consistent cash-flow (to use as security). However, more creative use of debt is possible, especially where the money is secured from a non-banking and thus more flexible source (e.g. from investors). There are examples of loans used to form a revolving internal development fund which is used to take development to a certain stage and then replenished using publisher/distributor advances. More often than not, debt raised from investors is in the form of convertible bonds (debt which can be converted to new equity after a pre-set period).
• Completion bond/Gold-master funding. Completion bond funding is a more complex derivative of debt-funding, aimed principally at publishers not developers. Completion bonds are explored in more detail in the publisher section.
• Games production funds. A few territories such as Germany and Singapore provide sufficiently favourable tax regimes to allow the creation of dedicated games production funds which give investors exceptional tax benefits for investing in games development. The use of this funding mechanism is strictly controlled and, like completion bonds, these are largely aimed at publishers. A few developers, however, have begun to explore their use.
• Work for hire: Because of the number of different games platforms, there exists a market for companies that specialise in converting (frequently referred to as "porting") fully or partially developed games to run on other platforms. For example, a publisher may want a version of an original PC game made for the Xbox 360. Because the developers of the original game might have no experience of (or desire to do) Xbox 360 programming, the publisher commissions other developers to port the game to these platforms.
  Conversion work frequently involves heavily reduced royalty rates, capped post-advance royalty quantities or, as is often the case, no royalties at all (so the developer receives up-front payments only). The challenge for the developer is far more technical than creative and those companies that can keep to budget and schedule can secure a profitable existence from such work.

Development trends: a consolidating industry with rising barriers to entry
Following a period of considerably proliferation during the late 90s, the independent games developer market contracted sharply with European developers in particular suffering. From around 2000 to 2005 the number of developers in Europe fell by almost 50% as a result of a number of factors:
Oversupply: Splinter teams, off-shoots and VC-backed start-ups flooded the games development market during the latter half of the 1990s grabbing at the opportunity to increase personal reward potential, independence and exploit a rapidly expanding games market. This was combined with a wave of independent developer acquisitions by publishers and the ramp up of internal studios. This resulted in there being far more independent development companies in Europe, in particular, than could be supported by the market.
Poor management: It is a truism that the larger the development company, the more difficult it is for that company to retain the same level of creativity and commitment that are fostered in smaller developers. Creativity, appealing work environments and the ability to attract the most skilled personnel are more often than not inextricably linked but these can be seriously undermined with overbearing management strictures. Since this, in turn, has a direct affect on the company's ability to generate hits and thus profits, the management infrastructure is of critical importance.  Unfortunately many developers, including the new wave of development companies created in the late 90s, lack the management nous or experience to grow their companies profitably. Although there are a few  development companies in North America and Europe with headcounts over 300, there are no large listed developers in the USA nor are there any traditional development companies (public or private) in Europe with turnovers over £30m.
Consolidating demand: With the start of the PS2-lead cycle, publishers began to divert their focus away from PSOne and began to focus an increasing proportion of their development investment on a smaller number of PS2 projects. Average development costs had increased considerably since 1999, especially for the larger publishers who regularly spent $5m-$7m on a single project an approximate doubling of the amount spent on releases in the previous cycle. This increased risk model forced publishers to focus their development investment on the larger, more established developers and away from the smaller development companies who could not, for example, support budget over-runs or other development delays. An additional corollary of this is that publishers began signing new product at a later stage of development in an effort to reduce their risk even further. This shift resulted in a rapidly decreasing number of developers that are able or willing to invest in the creation of original IP, a trend that continues to this day.
Increasing development complexity: partly due to the ever-improving standard of games development but also due to the difficulties of getting to grips with new console technology, skilled, up-to date developers are increasingly difficult to come by. This is partly mitigated by a blossoming games development tools and middleware market although many developers are resistant to using third party technology believing that the creation and ownership of their own technology is of greater value.
 
The development market in 2007
Despite this, the independent games development market is currently at its healthiest for 7 years. As the PS2 cycle has continued to progress, so publishers have increased their product output and their demand for development services from third party development studios. Unlike during the last transition, publishers intend to support the incumbent platform (PS2) long after its successor has launched. For cost and risk reasons, PS3 and Xbox 360 projects amongst independent developers remain few and far between - most publishers have handed such projects to their own internal studios to allows them to better control and amortise the initial R&D costs. However, demand for PS2, handheld and Wii development (despite it being a "next-gen" platform, development costs for the Wii are more in line with current gen, i.e. PS2 development) remains strong and this is providing a greater degree of market buoyancy than has been experienced since 1999. 

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