Creating the most lucrative online business in China

By Sherman So and J. Christopher Westland

Editor’s note:
This article has been adapted from Red Wired: China’s Internet Revolution co-authored by Sherman So and J. Christopher Westland. The to-be-published book is aimed at helping readers gain a firsthand understanding of how the Chinese combine successful components from their Western counterparts with innovation to accommodate the unique characteristics of the Chinese market.

With 70 percent of the Internet population younger than 30-years-old ¹, the most lucrative part of China’s Internet business is online games. But to unlock such treasures, someone had to figure out how to get paid first.

Early in the new millennium, credit cards were scarce in China, as were forms of electronic payment. Most transactions were done in cash. So how could an online gaming company efficiently collect small sums from millions of users scattered all over the country?

The problem was eventually solved by Shanda’s founder, Chen Tianqiao. Prepaid cards, each with an access code and password, are sold from corner stores in China.  Chen also created a computer program, called e-sale system, to allow for the virtual sale of prepaid cards in Internet cafés, the main venue for online gaming in China. 

His idea unlocked the treasure chest for online games in China. Millions of teenagers and young adults have become bewitched by them as a result, spending their weekends in endless virtual battles. In 2008, total online game revenue reached $2.69 billion in China, compared with $1.93 billion in online advertising revenue, according to IDC.

Chen’s story began in 1999, when the Internet boom reached its peak. Together with his wife, Luo Qianqian and his brother, Chen Danian, they founded Shanda Networking in Shanghai in December 1999. 

The company’s goal was to develop a Chinese-language online community around cartoons, which teenagers loved. An early player in China’s Internet industry, CDC Corporation (formerly known as China.com), invested $3 million in the startup in 2000.

But as the dotcom bubble burst the following year, the little startup was cash strapped. Most of the seed money for Shanda had been spent; revenue from online advertising never materialized. With about 100 staff, it was running at a monthly loss and CDC Corporation was preparing to pull the plug on its new investment.

¹ According to survey of China Internet Network Information Center

The first mega hit: Mir2

With less than $1 million left, Chen made a bet in mid 2001. He spent most of the sum on an upfront fee to license a newly-developed online game from Korea’s Wemade Entertainment. The game, Legend of Mir 2, was a sequel to a game that had never been particularly popular.   

Chen obtained the operating rights for Mir 2 in China from Wemade’s distributor, Actoz Soft, another Korean company. To run the game, he rented computer servers from data centers run by telecom operators.  

He also managed to line up Ubisoft to distribute the game for him. The French company was one of the first foreign game companies to enter China, where it was selling its games (in CD form) in many computer software shops. During 2001, online games were just emerging in China, and they were mainly sold through software shops.

When it was ready, Shanda’s game, Mir 2, was launched in November 2001. 

In the first three days, it recorded 3,000 to 5,000 users, according a former Shanda executive, but three months after the launch it had 300,000 active users. It was without a doubt a big success. With every user paying on average 30 yuan ($3.75) a month, Chen was estimated to make over $1 million a month.

With such high user rates, Chen decided he did not need Ubisoft anymore. He started his own distribution network for the game in 2002.

Chen was not content with just distributing to software shops. He wanted maximum coverage throughout the country. Prepaid cards for telephone services, such as mobiles and long distance calls, are popular in China. The small paper cards, each with an individual access code and password printed on them, are available in many retail outlets, like convenience stores and newsstands. There are even specialty stores that only sell telecom cards that can be found on almost every street and every corner.

The distribution system is well-organized – telecom companies sell the prepaid cards at a discount to large regional distributors, which in turn sell them to sub-distributors that supply local stores.

Chen thought this would be a good channel and started to contact major regional distributors about selling Shanda’s prepaid cards.

But another problem arose – how to make sure the inventory of prepaid cards kept up with user demand in different locations. 

Tapping into Internet Cafes

As Korea’s experience showed, Internet cafés were a great place for people to play online games. Before the arrival of Mir 2, most users in Internet cafés in China played pirated PC games. Chen wanted to change that. 

Shanda developed a special computer program, called the e-sale system, which allows Internet café owners to buy virtual prepaid cards from Shanda and sell them to customers. 

Since they were taking a cut from each sale, café owners encouraged their customers to play Mir 2. Shanda paid the café owner in cash, and gave them the access codes and passwords electronically.

The café owners settled their bills with Shanda’s distributors in cash. All parties are connected electronically through the system and the transactions are done instantly. 

With the e-sale system, Shanda can see how many games each Internet café is selling. This helps the company figure out how popular the game is in each geographical area and distribute physical prepaid cards accordingly. By tapping into Internet cafés with the e-sale system, Shanda solved not just the payment issue, but also the problem of how to promote the game.

By 2004, Shanda had built a nationwide distribution network that reached over 317,000 retail points of sale throughout China, of which over 40 percent were Internet cafes. Fifty-four percent of Shanda’s revenue came from the e-sales channel, and 42 percent from other retail outlets. 

Shanda developed a sequel to Mir 2 in 2003, called Woool. In 2004, the two games made total revenue of $165 million and Shanda made a net profit of $53 million.

In less than three years since his first game was launched, Chen floated his company on the Nasdaq, raising about $150 million in May 2004, launching him into instant billionaire status. Forbes estimated he was worth $1 billion in 2004, the 10th richest person in China.  

Once payment issues were resolved, the online gaming sector grew rapidly in China. From virtually nothing in 2001, online game revenues reached $110 million in 2002 and $159 million in 2003, according to IDC. 

Many competitors, such as Netease and The9 tried to emulate Shanda’s success and many new games were launched. They started challenge Shanda’s No. 1 position in the online game industry. After World of Warcraft, considered the most popular online game around the world was launched in China, Shanda saw its first significant slide in revenue and profits in the fall of 2005.
 
Next week we will describe in detail how Shanda faced new challenges and, in the end, raised the popularity of online games in China to another level.
 

Chart: Online game market in China (2007-2013)

Source: IDC

Chart: Online Game Supply Chain

 Source: JP Morgan

Note:
-- Licensing agreement with upfront fee and revenue sharing
-- Prepaid card through online system or physical prepaid card. Distributor discounts of 15-30%
-- Prepaid card