Virtual goods have finally been legitimized as a revenue model, rather than a niche (even weird) activity ignored in favor of advertising. Now the concept is spreading beyond its game / virtual world roots, and we’re seeing large numbers of companies trying to figure out a “virtual goods” strategy.

While I believe very strongly in virtual goods as an effective business model, I also think the number of folks trying to get a piece of the market will outstrip the total share of wallet possible. We shall see attempts at virtual goods revenue streams put into place without a clear understanding of the compulsion loops and triggers that drive spend.

I’ve been meaning to write a longer post about vgood compulsion loops for a while now, but time has been limited so I’m just going to start with a few bullet points. If you are thinking about a virtual goods business model, it is worth cross-examining your design against these concepts.

And what do I mean by “virtual good”? Within the context of games and virtual worlds, it is most commonly thought of as a discrete digital item upon which a user/player can exert some level of control, even if temporary. Examples include simple 2D pictures (ex: current Facebook gifts), 2D or 3D avatar or interior design accessories (ex: clothing, animations, furniture), and game pieces (ex: swords, armor, food). They can be functional or purely visual. For the purposes of simplicity, I am also going to treat digital currency and “activity points” as virtual goods.

The Right Environment
Virtual goods businesses don’t work well for hit-and-run or extremely lightweight experiences. They thrive with a game or service with one or more of the following:

• Repeat visitors (high re-playability)
• A sense of community
• A reasonable level of social or gameplay complexity

Purchase Motivations

• Competition: you want to beat others, you are tired of others beating you, or you have strong self-competition and a desire to be the best, thus you purchase virtual items if it clearly helps you achieve that goal
• Impatience: this manifests in two separate ways — the first is a clever use of “activity points” that forces people to pay more to keep on playing (i.e. feed the addiction – this is an example where customer irritation tied with desire leads to opening the wallet); the second is a desire to accelerate progress to “elite” status (tied to competitive motivations).
• Self-expression: often related to aesthetic rather than functional virtual goods (but not exclusively), this ties into the human desire to show off a sense of style / identity / personality, show off an affiliation with a group, or demonstrate a loyalty to a celebrity of some kind
• Gifting: gifting is a strong motivator if you have a definite community (or lots of small sub-communities) — where humans seeks to foster relationships.  As everyone knows, not all gifts are equal, so in a world of free/commodity items, motivated gifters will seek out a more valuable form of expression, either through money or through time (spent earning or creating the gift)
• Entertainment: this seems to appeal more to the female demographic, but shopping (especially if there is a social feedback loop) and/or collecting (especially if there is an overlay of social cooperation or competition) can be strong forms of entertainment

There are two approaches to building a virtual goods business: you can slap them on top of your experience and hope people buy, or you can design the requisite compulsion / motivation drivers into the core fabric of your experience.  The latter strategy ensures a much greater chance of success.

A few months ago, I listened to a panel organized by Battery Ventures called “Monetizing Social Media”.  Perhaps not surprisingly for a New York-based event, the panel spent 99% of the time talking about advertising.  Still, I was surprised to see both the Facebook and MySpace representatives brush off microtransaction business models as niche and not worth discussing.

The total advertising market is certainly much bigger than virtual goods, so I can understand why they keep trying to capture ad spend dollars, but when you look at companies like Tencent and watch the rapid growth of micro-transaction based apps, the dependence on advertising starts to feel a bit like wearing blinders.  However, notwithstanding the panelists statements, both MySpace and Facebook seem to be working on virtual currency strategies, and they are smart to diversify since ad dollars still aren’t racing their way.

eMarketer now forecasts that advertising in online social networks is going to fall 3% in 2009, although they do think it will recover in 2010 and grow 10% above the 2008 levels.

After pouring so much effort into advertising, will they understand enough about virtual goods to capitalize on the new model? That remains to be seen. Facebook’s neglect of its gift system has not been a good sign, but perhaps times are a-changing.

The point is not that micro-transactions are the new savior to socnets.  Advertising will be an important revenue source.  However, as the music industry is learning, diversification of revenue streams is the name of the game.