Half of the world's games are developed using Unity, yet the success of this company's products has not translated into commercial success. It is only a matter of time before an awkward misalignment occurs when a B2B enterprise software company operates with a B2C scale expansion logic.

Unity (NYSE: U), the world's largest game engine company, was established in Copenhagen, Denmark, in 2004 and is now headquartered in San Francisco, USA. A game engine is the tool software used to create games. Half of the world's games are developed with Unity, reaching 2 billion monthly active end-users (game players, not developers). It holds a 48% share of the global game engine market (including mobile, PC, and console), with a staggering 70% share in the mobile gaming market. Renowned game companies such as Tencent, NetEase, miHoYo, Electronic Arts (EA), and Blizzard are all Unity's clients. Popular games like Honor of Kings, Genshin Impact, Hearthstone, Pokémon GO, and Subway Surfers are developed based on Unity.

The high profit margins in the gaming industry are well recognized. Providing SaaS services in the gaming sector is theoretically a very promising business model. Mature SaaS companies typically have customers who renew their subscriptions at the end of quarters and years, which brings in ample cash reserves. Gross margins are usually 60%-80%, and operating profit margins can reach 10%-20%.

Logically, Unity should have been profitable long ago, with healthy profits and cash, or at least on a path of narrowing losses. Surprisingly, this 19-year-old gaming SaaS company has been in the red for 19 years, with no profitability in sight in the near term.

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Unity's mid-2023 performance report shows that in the first half of the year, revenue was $1.03 billion, a year-on-year increase of 67.5%; operating loss was $450 million, with an operating loss margin of 43.7%. Since Unity began disclosing financial data in 2018, its operating loss margin has been consistently above 30%, with the loss ratio continuously expanding.

According to financial statistics, 15 out of the top 30 SaaS companies in the United States (as of October 24, 2023) are in the red, with an average operating loss margin of 17.7%. Unity's loss margin far exceeds the average. In the first half of 2023, its operating loss margin was the highest among the 15 loss-making companies.

Unity's management is trying to make the company profitable. One measure is to change the pricing plan. However, this plan has caused customer backlash in the past two months. On September 12, Unity announced that it would charge an installation fee ranging from $0.20 per installation for customer games that make more than $200,000 in profit and have more than 200,000 installations. Developers collectively expressed dissatisfaction and announced a boycott of Unity. A week later, Unity issued an apology letter stating that it would adjust its charging model. On October 10, Unity's CEO, John Riccitiello, announced his resignation.

Unity's market value has reached a historical low. Unity went public in September 2020 at a good time. At that time, U.S. software companies saw a collective surge in stock prices due to the digital transformation wave brought about by the pandemic. In November 2021, Unity's market value climbed to a historical peak of $57.5 billion. As of the close on October 24, 2023, Eastern Time, Unity's market value was only $10.2 billion, a drop of 82% from its peak.From the perspective of customer scale, Unity is an excellent game engine, but its product success has not led to commercial success. For the SaaS industry, Unity's many lessons are classic examples of what not to do: when a business software company applies a consumer-scale logic to a business-to-business (B2B) model, various awkward misalignments emerge.

Firstly, it took a free/low-cost approach in its early stages. This attracted a large number of small and medium-sized game companies and developers. Later price increases led to continuous protests from developers.

Secondly, the high switching costs and long cycles, while not entirely irreplaceable, are significant barriers. Most of the top 15 global gaming companies by revenue have their own proprietary engines.

Thirdly, when it could not self-generate revenue, it continued to expand through mergers and acquisitions. The consolidated revenue from acquisitions masked the slowdown in the growth of its core business.

Fourthly, it undermined the trust of the developer community built over many years. A controversial pricing plan was introduced abruptly without communicating with developers.

Unity's approach of applying a consumer logic to a B2B business is a common issue among many Chinese SaaS companies. A software industry entrepreneur with 10 years of experience told Caijing that some Chinese SaaS companies hope to exchange losses for scale and demand high valuations from the capital market. They then use these high valuations to acquire other SaaS companies. The ultimate goal is to expand the imagination space and go public. However, this approach is usually only suitable for consumer-oriented business models. Even for consumer-oriented companies, there is now a common problem of unstable foundations and difficulty in making profits.

Losing Money for 19 Years Since Its Inception

Unity is a star company in the gaming industry, but despite dominating half of the game engine market, it has been losing money for all 19 years since its establishment.

Data from third-party market research firm Extern Labs shows that in 2023, Unity's share of the global game engine market (including mobile, PC, and console) is 48%, with a staggering 70% share in the mobile gaming market. Its competitor Unreal's market share is 13%.

Unity and Unreal have formed a differentiated competition, becoming the duopoly in the game engine market. Unity is known for being lightweight, easy to use, and low-priced, which is favored by startups and small and medium-sized enterprises and is widely used in the mobile gaming market. Unreal's characteristics are strong graphics, comprehensive features, and high barriers to entry, which are widely used in AAA titles (high-cost, high-volume, high-quality large-scale games). Unity follows a low-price strategy, mainly profiting from game engines and game advertising. Unreal follows a high-price strategy based on a revenue share from games.Unity holds an absolute dominance in the mobile gaming market. Ninety percent of the top 100 grossing mobile games worldwide are developed using Unity. Renowned global gaming companies such as Tencent, NetEase, miHoYo, Electronic Arts (EA), and Blizzard are all Unity customers. The engines behind popular games like Honor of Kings, Genshin Impact, Hearthstone, and Pokémon GO are powered by Unity. A set of data disclosed in Unity's 2020 IPO prospectus is sufficient to prove its global influence: it reaches 2 billion monthly active end-users (game players, not developers), with a total of 80 billion hours of gaming time per month.

Lightweight, easy to learn, and low cost are the main reasons why Unity has captured half of the game engine market. Its pricing is significantly lower than that of its competitor, Unreal.

Unity has long offered free student and personal editions. Before March 2017, Unity had two paid models: a $75 monthly subscription and a one-time payment of $1,500 for a perpetual license. An enterprise software professional stated that common SaaS software is typically subscribed on an annual or quarterly basis, with the perpetual license being a one-time deal. The $1,500 perpetual license is notably underpriced.

Before 2020, Unity usually adjusted its pricing every three years. After 2020, Unity announced price increases four times, with each increase ranging from 10% to 20%. The Unity official website shows that there are currently three subscription models. The first is the free student and personal edition products, the second is the professional edition at $2,040 per year per account, and the third is the industry edition at $4,950 per year per account.

Even with price increases, Unity's pricing is usually still far lower than Unreal's. Unreal charges a revenue share based on the total game revenue. When game revenue exceeds $1 million, a 5% share fee is required—equivalent to at least $50,000. However, there is no charge if the revenue is less than $1 million.

A Unity developer told Caijing directly that most Chinese mobile game companies only consider Unity during the game's initiation phase. This is because there are more Unity programmers, lower costs, lower development barriers, and it is sufficiently friendly to mobile games. In contrast, Unreal has hardly any successful small to medium-sized mobile games on the market, with high technical selection risks and high development costs. Another Unity developer stated that some small and medium-sized enterprises even use free student accounts for development before the game is officially launched, switching to paid accounts for release when the game goes live.

After establishing a scale advantage in the gaming market with its lightweight, easy-to-learn, and low-cost approach, Unity has gradually expanded into two commercialization paths: one is creating solutions (game engines), and the other is growth solutions (game advertising).

Creating solutions (game engines) refers to game developers purchasing Unity game engines to develop their own games, for which Unity charges software, consulting, and service fees.

Growth solutions (game advertising) refer to some small and medium-sized game developers giving Unity the rights to sell in-game advertising spaces. Unity helps developers match advertisers. Unity and game developers share advertising revenue, with a combined share rate of about 30%-40%.

Similar to the logic of many To C internet companies, Unity's commercialization is a "baa in the sheep's clothing" model. Its biggest monetization method is not the game engine but game advertising.Unity's revenue from game advertising has long exceeded its game engine income, but both businesses have been operating at a loss. Between 2022 and 2023, Unity's two main engines, game advertising and game engines, have seen a consecutive slowdown in growth rates. This is the case even with ongoing operating losses. In the second quarter of 2022, Unity's performance hit a historical low, with revenue growth of only 8.6% and an operating loss rate of 66.7%.

The "Rule of 40" is a golden rule in the U.S. SaaS software market. It suggests that a healthy SaaS company should have a combined revenue growth rate and operating profit margin exceeding 40%. This rule can encompass the growth models of SaaS companies with different profiles. It includes companies that trade losses for growth (e.g., with a revenue growth rate of 60% and an operating loss of 20%) as well as more stable companies (e.g., with a revenue growth rate of 20% and an operating profit of 20%). Clearly, Unity is some distance away from this benchmark, indicating that it is not as healthy as it could be.

In the face of slowing growth and expanding losses, Unity acquired the digital advertising company ironSource through a stock swap in July last year. This did not consume Unity's cash flow and indeed brought about revenue growth and profit improvement.

Starting from the fourth quarter of last year, Unity's revenue growth and operating profit have seen significant increases. In particular, advertising revenue grew at a staggering rate of 126.7% in the first half of 2023.

However, this is not the result of improvements in Unity's original business but rather the contribution of ironSource's consolidation in the fourth quarter of 2022. Before the consolidation, ironSource's revenue was $370 million and its net profit was $30 million in the first half of 2022. If the data from ironSource's consolidation is excluded, Unity's original business has actually seen a revenue growth rate below 10%.

In fact, from the perspective of operating profit and operating cash flow, Unity is not considered a sufficiently healthy SaaS company. Unity's cash flow is not abundant, and its operating cash flow is relatively tight, with several quarters showing negative operating cash flow.

Unity's management has also tried to make the company profitable. In the fourth quarter of 2022, Unity's management stated in the earnings call that they would take decisive action to improve profitability and expected to be profitable in every quarter of 2023 (using Non-GAAP measures, which exclude stock-based compensation, amortization of intangible assets, depreciation, acquisitions, restructuring, interest, income taxes, and other non-operating activities).

Unity's management announced in the fourth quarter of 2022 that they had achieved a Non-GAAP profit of $13 million. Their financial report claims that Non-GAAP metrics are more consistent and comparable. However, equity has always been an important tool for Unity's external mergers and acquisitions and internal incentives. Unity has been known for its high stock-based incentives, and in many past mergers and acquisitions, it has used stock swaps. In the long-term operating loss and tight operating cash flow situation, measuring profitability with a Non-GAAP standard that excludes stock-based incentives is too lenient.

Compared to truly achieving operating profit, Unity still has a long way to go.

With its main business not solid, Unity has embarked on diversification.SaaS companies, such as the well-known customer relationship management software Salesforce, typically follow a growth path that involves substantial R&D and customer acquisition investments in the early stages to form competitive barriers. As the customer base expands and renewals increase, profits gradually stabilize. The entire cycle, from initial losses to eventual profitability, usually spans around 10 years.

SaaS companies are not precluded from expanding while incurring losses, provided they can turn profitable at any time or if the losses continue to narrow. The issue with Unity is that despite nearing a 50% market share, it remains in long-term deficit. While Unity's management has attempted to make the company profitable, they have expanded and diversified their strategy while the core competitive barriers are not solid, leading to continuous losses. Each new battleground cannot generate profits in the short term and only adds to the costs.

Firstly, the game engine market is not as high-profit as one might imagine. In this sector, both the leading Unity and the second-place Unreal are operating at a loss.

Secondly, Unity's primary customer base consists of small and medium-sized game companies, which do not have strong payment capabilities. While Unity's large game company clients have the ability to pay, most are developing their own engines. Unity has high replacement costs and long cycles, but it is not irreplaceable. Increasing pricing could lead these clients to strengthen their in-house development.

Thirdly, there is no short-term possibility of profitability in their diversified strategy. When the game engine business is not profitable, they venture into the game advertising battlefield. When the game advertising business is not profitable, they then explore markets in industries such as automotive, manufacturing, energy, retail, and construction.

In the game engine market, the leading Unity is in the red, and the second-ranked Unreal is also experiencing losses. However, Unity has to rely solely on itself, while Unreal can depend on its parent company.

Unity has taken a lightweight, easy-to-use, and low-cost approach, which has resulted in losses. Unreal, on the other hand, has chosen a path with strong graphics, comprehensive features, and higher prices, yet it still ends up in the red. Unlike Unity, Unreal has the financial backing to sustain losses. It can support its engine business through its game operations.

Unreal's parent company is Epic Games, one of the top 10 global gaming giants in terms of revenue. Its business includes games, publishing, and engines. Market research firm Statista estimated this year that Epic Games' revenue exceeded $6 billion in 2022. Although the company is not publicly traded, some financial data was disclosed during its legal disputes with Apple. From 2018 to 2019, Epic Games' game Fortnite generated $9.3 billion in revenue with profits over $4.6 billion. Unreal's revenue was $240 million over two years, accounting for less than 3% of the total market share at the time.

Several game developers have told "Caijing" that Unreal is also losing money, but because it focuses on large enterprise clients and charges higher fees, its overall health is much better than Unity's. For Epic Games, Unreal is like a signboard that conveys a sense of industry responsibility and showcases its technical capabilities to developers and gamers. In contrast, Unity's main business is the game engine, and it lacks other businesses to support itself.

Unity finds itself in an awkward position in both the small and medium-sized game companies and the large game companies markets. The former lacks sufficient payment capabilities, while the latter has the ability to replace it.Unity's financial report indicates that as of February 2023, the number of customers with revenue exceeding $100,000 is 1,330. Its customer base is relatively even, with no single company accounting for more than 10% of its revenue. This is a healthy customer structure brought about by Unity's early reliance on small and medium-sized enterprises (SMEs) and developers.

Unity's initial foundation was built on developers and small to medium-sized game companies, but their willingness and ability to pay are generally not strong. A cloud computing technology professional told "Caijing" that low-cost/free software attracts developers. However, the mindset of developers is different from that of corporate IT procurement; the former has a low willingness to pay, while the latter follows procedures and processes. Relying on a low-cost/free software strategy for the B2B market in the long term can easily turn a potentially profitable market into a negligible one.

A Unity developer candidly stated that the profitability of game products is highly contingent. Many small game companies do not even know how long they will survive, which limits the revenue Unity can generate from the SME market. Some companies, after growing into large corporations, tend to develop their own engines.

In the market for large game companies, Unity's customers indeed include global top 15 revenue-generating game companies such as Tencent, NetEase, miHoYo, Blizzard, and EA. Most of these game companies have developed their own game engines. When Unity charges them excessively, customers may switch to self-developed engines.

Many developers believe that Unity is irreplaceable in the mobile gaming market. However, another game developer explained that Unity's irreplaceability is mainly reflected in the high sunk costs of switching engines for games initiated with Unity and the high cost for programmers to learn a new engine. When a large game company is truly determined to change engines, it may go through more than three years of pain, but it is not completely irreplaceable. Taking NetEase's self-developed Messiah engine as an example, it has developed many good products such as "Knives Out."

Unity can only provide general, standardized products. AAA titles or large-scale games are highly customized, and in such cases, Unity's value is limited. Some large game projects are highly customized, and some core game scenes still need to be developed independently. Even game companies like miHoYo, which do not use self-developed engines, only use Unity's framework, and a large number of systems need to be rewritten.

The subtle relationship between Unity and large game companies puts it at a disadvantage in price negotiations with these large game companies.

SaaS companies generally start by developing tools, then platforms, and then expand into sub-industries. However, Unity is exploring markets in industries such as automotive, manufacturing, energy, retail, and construction with its 3D rendering capabilities before its main businesses of game engines and game advertising are fully solidified.

These businesses are indeed closely related to Unity, but each new software business and industry business means the need for high R&D investment. Mature software companies typically have a research and development expenditure rate of less than 20%, but Unity's R&D expenditure rate has long been higher than 50%. Research and development costs are the largest part of Unity's cost structure.Another challenge lies in the fact that there are established digital twin companies in the European and American markets for industries such as automotive, manufacturing, energy, retail, and construction. These companies possess specialized industry knowledge, and Unity's competitiveness as a general-purpose software entrant remains to be seen.

Management Undermines Developer Trust

At the inception of Unity in 2004, the founding team's original intention was "everyone can make games." Leveraging the rise of the iPhone and mobile gaming, Unity indeed assisted a large number of developers and accumulated product reputation. Developers are the foundation of Unity as a company.

Long-term operational losses and changes in company strategy were not enough to drive Unity's game developers away. However, Unity's pricing adjustment plan on September 12th this year severely damaged the trust of developers.

Several Unity developers told "Caijing" that the pricing plan was announced suddenly without prior communication. This led to serious damage to the credibility and trust that Unity had built up over the years. There are numerous ambiguous and unreasonable terms within it.

Firstly, the pay-per-download model is almost unheard of in the software industry.

Secondly, the number of game downloads does not necessarily correlate with the revenue of game manufacturers, nor does it consider the situation of malicious downloads or multiple installations due to repeated downloads.

Thirdly, the pricing strategy did not clarify at the time of its introduction whether downloads would be retroactive. If retroactive, game manufacturers would have to pay again for historical downloads.

Some small and medium-sized game manufacturers calculated that Unity's new pricing plan would lead to the bankruptcy of their companies, thus calling for a boycott of Unity. Game manufacturers and players jointly initiated this wave of resistance. At the end of September this year, an alliance consisting of 1074 game companies issued a collective letter, calling on all game companies to close Unity advertisements. The official website of the alliance shows that the game installations of these 1074 game companies exceed 25 billion times.

Subsequently, Unity apologized, stating: "We apologize for the confusion and anxiety caused by the new charging plan. We are listening to the opinions of team members, the community, customers, and partners, and will make changes to the plan. We will release the latest news within a few days."At present, there are no game companies in the top 15 of global revenue that have joined the boycott. The loudest voices of resistance come from small and medium-sized game developers. In fact, Unity, which has been suffering from long-term losses, has limited room for strategic maneuvering and can only squeeze profits from a few business segments. A technical person in the gaming industry told "Caijing" that large game companies have other options, such as replacing Unity with self-developed engines or Unreal. However, small and medium-sized game developers have limited choices. Therefore, their motivation to boycott is also the strongest.

After the controversial pricing storm, on October 10th, John Riccitiello, who has managed Unity for nine years, announced his resignation as chairman and CEO and left the board of directors. James Whitehurst, a former IBM executive, took over as interim CEO.

The lessons Unity has left for the software industry have become a classic case study of what not to do. After the CEO change, Unity still has to face the issue of losses honestly. The practical issue is that the U.S. capital market is adjusting the growth expectations for enterprise-level SaaS. In such a capital environment, how to lead a company that has been losing money for 19 years out of the quagmire will be a huge challenge for Unity's new CEO.