By Ryan Olson

If The 4th Coming was a movie, it would be a low-budget indie flick trying to eke out a tiny profit on the art house theater circuit. But you won’t find The 4th Coming on any silver screen—it’s one of a growing number of massively multiplayer online role-playing games that transports players into fantasy worlds where they battle dwarves, consult with wizards, and slay dragons in the quest for virtual wealth, fame, and power.

The force behind The 4th Coming is Marc Frega, a U.S. software engineer who licenses his game to Internet service providers in North America and Europe. These small operators, which translate, modify, and operate the game, have collectively signed up about 100,000 subscribers—each of whom doles out $5 to $10 per month to play. Mr. Frega gets subscription royalties, although he is quick to acknowledge that The 4th Coming isn’t much of a money-maker.

That hasn’t stopped Mr. Frega and scores of other small game developers from challenging Electronic Arts and the handful of other players that have dominated the video game industry for more than a decade. Now, anyone with a lot of creativity, a bit of cash, and a broadband connection can develop a game and put it on the web, where fanatics just might discover it and turn it into a blockbuster. This emerging online gaming model has players salivating, developers scrambling to create new games, and investors trying to figure out how to capitalize on a market that is about to be turned on its head.

“Nobody knows where this is going,” says Alexis Madrigal, analyst at DFC Intelligence.

The major driver behind this shift is the growing popularity of high-speed Internet connections in North America, Europe, and Asia, where broadband penetration rates already range from about 50 percent to about 90 percent of households. The ubiquity of always-on, high-speed Internet is transforming cyberspace from a utility-driven model in which people connect, communicate, and transact, to a leisure-driven model in which permanently connected users hang out, socialize, and play.

This shift is creating a need for new kinds of entertainment developed specifically for high-speed Internet consumption—and games are among the most popular forms of entertainment. Lars Buttler, CEO of video game startup Trion World Network, says the race is on to figure out just what that content will look like. “What is it going to be? That’s the trillion-dollar question,” he says, in reference to today’s $1-trillion worldwide entertainment industry, which includes movies, music, and games.

 Things were much simpler only a few years ago, when practically all video games were developed or published by industry giants such as Electronic Arts, TakeTwo, and Activision. These companies would routinely pump tens of millions of dollars into blockbuster games such as Grand Theft Auto or the Madden NFL football franchise, which were sold at retail stores to fans who would play them on their computers or consoles such as Sony’s runaway favorite, the PlayStation 2. Promising startups, such as mobile game maker Jamdat and Sims developer Maxis Software, were quickly snapped up by industry leaders such as EA, which had the retail distribution contacts and marketing budgets necessary to make any game a hit.

Then came World of Warcraft, a fantasy-world blockbuster title that has blown away all records and expectations for online video games. Gamers have been drawn to WoW, developed by Vivendi Universal’s Blizzard Entertainment, because it is easy to play and has social features that let players unite with others to form “guilds” so they can collectively slaughter dragons and hunt for treasure as they advance to higher levels within the game.

Industry insiders credit WoW’s developers with improving upon the handful of moderately successful online games that preceded it, including Everquest and Lineage. And with 8 million players paying as much as $15 a month to play the game—estimates suggest it pulled in $1 billion in revenue last year for Blizzard—WoW demonstrated that online gaming is a new force. DFC Intelligence has forecast that the worldwide online game market is expected to grow from $3.4 billion in 2005 to more than $13 billion in 2011. “Everybody is trying to develop the next World of Warcraft killer,” says Mr. Frega.

The problem is that no one knows what the next WoW killer will look like. Creating a hit video game, which combines strong characters, a compelling story, and top-notch production values, is part art and part inexact science. Making a hit game can be much more difficult than producing an Oscar-winning movie. After all, the hit video game must be compelling enough to keep players coming back for more. “There are so many moving parts in these games that they are more likely than not to fail,” says Mark Jacobs, co-founder of Mythic Entertainment, the highly regarded MMO game developer acquired last year by EA.

Crowded Field

There is no shortage of companies and investors willing to take their chances. Some of the most popular games on the Internet are “light” games that players can quickly log into through their Internet browsers. That contrasts with regular online games such as WoW that require players to trek down to their local retail store to pick up the software.

The most popular light game is U.K-based Jagex’ RuneScape, a three-dimensional role-playing game with hundreds of hours of medieval narrative scenarios that has attracted more than 9 million unique users a month. Millions of others have also discovered Canada’s Club Penguin, a subscription social game site aimed at youngsters, and Finland’s Habbo Hotel, a teen-oriented community and gaming site, both of which are browser-based.

 “Indie games are smaller, not as complicated, and they have simpler graphics. But they work—and that’s way more important. That’s the lesson the big boys can take,” says Mr. Madrigal.

That may be so, but making money as a small independent online game producer remains a huge challenge. Jagex may claim more than 9 million users, but only 900,000 players actually subscribe to RuneScape, which allows them to step into new terrain, slay more monsters, and collect more loot. Jagex, which counts Insight Venture Partners as an investor, claims it has been profitable since 2002, but it won’t disclose financial details.

 Daniel James, founder of San Francisco-based Three Rings, has had much more luck with so-called casual games, an emerging category of online games that allows subscribers to log in for short bouts of gaming. Three Rings’ Puzzle Pirates site takes players into a fantasy online world where their goofy swashbuckling characters sail the seas tackling all sorts of puzzle games in hopes of amassing a fortune.

As silly as it may sound, Puzzle Pirates has been a surprise hit with 2 million registered users, 30,000 of whom have signed up as subscribers—worth a tidy $3.3 million in  revenue last year for Three Rings. “There’s a huge audience and they are keen to devour content,” says Mr. James.

Another group of startups is playing on a much bigger scale. They are attractive to VCs because their founders are celebrity developers who have at least one, if not more, hit games under their belts. These startups include Sierra Ventures-backed Red 5 Studios, founded by a trio of Blizzard alumni. Aliso Viejo, California-based Red 5 late last year scored $18.5 million in funding from Sierra and Benchmark Capital and is working on a massively multiplayer online game set to be distributed globally by South Korean game developer Webzen.

Red 5 will be competing with Mr. Buttler and Jon Van Caneghem, industry veterans who received funding from Trinity Venture Partners and Doll Capital Management to found Trion World Network. Mr. Buttler, a former EA executive, and Mr. Van  Caneghem, creator of the Might and Magic fantasy game franchise, teamed up to start Trion, a game developer and publisher that aims to market big-budget games designed specifically for the online market.

A key difference from established game developers, say the partners, is that Redwood Shores, California-based Trion will be a service company providing the kind of content their monthly subscribers want, when they want it. Of course, this will require that Trion constantly update games and develop a top-notch customer support staff to keep customers happy, among other changes. Still, Mr. Buttler is confident that Trion will be a success, because he says it is a radical shift from the outmoded “packaged goods” business model that established game companies long ago adopted.

Creating a Metaverse

Meanwhile, the hottest property in virtual entertainment these days isn’t even really a game—it’s a metaverse.

That’s what the folks at San Francisco-based Linden Lab call their virtual world known as Second Life. Unlike developers behind casual or role-playing games, the programmers of Second Life say their aim is to create a virtual world in which “residents” are free to do as they please, not participate in a choreographed role-playing game.

Joe Miller, vice president of technology and platform development at Linden Lab, says more than 2.5 million people have already created avatars, or digital alter egos, for Second Life. Avatars can do just about anything real people do, and more—whether it be creating, buying, and selling digital goods for real-world money, getting bawdy with other residents, and even flying. Mr. Miller and his team see Second Life as an emerging 3D platform via which real businesses sell real goods, universities teach classes, and artists perform concerts.

But critics say Second Life is vastly overrated. Most “residents” so far have been confused about what to do in the world and many have given up quickly. Detractors also say 3D platforms are too clunky for most people to master. “Show me something that is easy to do in 3D,” Mr. James quips. “Using Second Life is like having your teeth pulled.”

EA, of course, is not about to cede its position as king of the hill. The gaming giant operates casual gaming site Pogo.com and last year snapped up Mythic Entertainment, signaling that it was prepared to get serious about the online market after a false start during the dot-com boom. Mythic’s Mr. Jacobs scoffs at claims that

EA is too wedded to its old business model to be a serious contender in the online game market. He cites EA’s acquisition of his company as proof that the industry giant understands it must evolve.

EA’s deep pockets, worldwide distribution network, intellectual property, and solid relationships with key console makers all make it a force to be reckoned with, says Mr. Jacobs.

Industry analysts are quick to note that EA will remain the leading video game company for years to come. For all the hype about online gaming, the reality is that the vast majority of gamers still buy their games at retail stores to play them on PCs and consoles. Indeed, the total worldwide game market is already worth about $30 billion and is expected to surpass $40 billion by the end of the decade. Online gaming is growing much more rapidly, but will likely account for less than a third of the overall gaming market in 2010, say observers.

Still, the shift to the Internet is inexorable, and most observers agree that subscription-based online games are the future: A successful game could generate high margins—60 percent is not unreasonable—and produce a recurring and predictable revenue stream.

Venture capitalists are often wary of online gaming because they simply don’t have enough consumer experience to pick hits, says Gus Tai, a partner at Trinity Ventures. “It looks and feels like a great market,” Mr. Tai says, “but most VC firms don’t have the expertise to choose among the options.”

That is a sentiment echoed across much of the sector and many investors and industry insiders say the safest approach is to bet on emerging online publishers, or at the very least, to make several small bets to spread the risk.

Whatever bets investors choose to make, they should be prepared for a long, hard slog. A recent report from DFC Intelligence says that as many as 95 percent of online games will fail. Three Ring’s Mr. James expects to see game developers clash in a ruthless and bloody 10-year battle for control of the online game industry—a battle that could well be too bloody for indie games like The 4th Coming.