Zynga operates a freemium business model where users are able to play a game for free but are charged a premium for additional features and/or functionality. Zynga’s revenues consist of two sources: in-game purchases of virtual goods, and advertisements/promotions. Facebook receives a 30% cut of revenues from in-game purchases through Facebook. Zynga’s costs (outside of the Facebook tariff) consist primarily of web hosting and data center expenses related to the operation of its gaming platforms. Zynga also incurs significant research and development costs related to the development, maintenance, and testing of existing and new games. Sales and marketing efforts are focused on acquiring new players, retention of current players, and the conversion of free play members to premium-content paying members. A portion of Zynga’s sales and marketing budget is directed towards advertisements on Facebook.

Revenue Streams:

Zynga’s revenue stream consists of two sources: In-game sales to players and the sale of advertisement space to advertisers.

In-game sales are done exclusively through Facebook’s proprietary money system, Facebook Credits. Facebook receives a 30% cut of the revenues received by Zynga through these sales, with Zynga receiving the remaining 70% minus taxes and processing fees.

• In-Game sales: Zynga’s freemium model depends on in-game sales of virtual products to generate revenue from active users. Players can earn virtual goods through in-game achievements, gifts from other players, and purchases through an in-game store. Zynga’s gaming platform creates a marketplace for their paid content
• Advertisement: Zynga has a three-tiered advertisement structure where advertisers can brand products and items within a certain game, participate in engagement ads by offering interactive surveys in return for in-game goods, or advertise directly on Zynga’s mobile platform. Zynga’s in-game advertisements also provide cross-promotional opportunities as Zynga often advertise new and upcoming games on its own platform. Companies using Zynga’s ad platform include 7-Eleven, American Express, Coca-Cola, DreamWorks, Discover Financial Services, Farmers Insurance Group, General Mills, Kraft, McDonald’s, Target, and Wal-Mart.
  • Branded Virtual Goods and Sponsorships: This form of advertisement places the ad in a videogame in a way that can be relevant and valuable to a player’s experience within the game. Examples include Coca-Cola’s campaign to allow users to gift coca-cola drinks to their friends for free on Café World and Farmer Insurance Group’s free Zepplin Airship in FarmVille that provided “wither protection” to the users’ crop for 10 days. This form of advertisement has better reception by users compared to direct advertisements since the branded virtual goods serve to enhance the user’s experience in the game as opposed to disrupting it on the screen’s periphery.
  • Engagement Ads: These are sponsored engagement ads where a player can voluntarily answer questions to receive perks like virtual currency. Examples include American Express surveying users about credit card habits in exchange for virtual currency (“Horseshoes”) in FrontierVille and Celebrity Cruises’ survey on CityVille in December of 2010.
  • Mobile Ads: Zynga offers a portfolio of games on the iPhone, iPad, Android, and mobile web platforms. Select games on these platforms have both free (ad-supported) and paid (ad-free) versions. Advertisements on the free versions include a bottom screen banner integrated within gameplay as well as between turns. Advertisers on Zynga’s mobile platforms include Amazon.com Inc., eBay Inc., and HBO.

Expenses:

Cost of revenue: Zynga’s cost of revenue consists of data center and web hosting costs related to the operation of their online gaming platform. These costs include depreciation and amortization, customer support, payment processing, and infrastructure.

Research and Development: Zynga’s main research and development costs are the headcount costs of engineers and developers in relation to the development of new games, software development tools and code modification, and the development of strategic objectives.

Sales and Marketing: Zynga’s sales and marketing costs mainly consist of player acquisition costs including general marketing, branding, advertising, and public relations costs. These costs are designed to drive new players onto Zynga’s platform as well as influencing current players to try out Zynga’s new games.

General Administrative: These expenses reflect the general administrative costs of a software development firm including executive, financial, legal, information technology, and human resources costs.

PrivCo Analysis: Zynga’s Strengths and Weaknesses

Nascent Industry Risk: Zynga operates in a very young and rapidly changing industry. Social and casual games have only recently made headway with the wider public. The industry is new and the business landscape changes with every new game, legal development, VC round. demand and acceptance of Zynga’s new games therefore have a high degree of uncertainty as the tendencies of consumers within this market space have not been fully mapped or explored. Changing consumer demographics, the availability of other gaming platforms, the growth of the personal computer, broadband Internet and mobile consumers, and current economic conditions are also factors that will affect Zynga’s sphere of operations.

Deteriorating profit margins: Top line Zynga is on pace to top $ 1 billion in revenue for 2011 vs. $597 million for 2010.  However, Zynga is on pace to do about the same $127 million in operating income that they did 2010 in 2011, despite the substantial revenue growth.  Zynga’s 2010 results had a higher, blended profit margin based on receiving payments via credit card or Paypal during the first half of the year, pre-Facebook Credits. Zynga remains profitable, but the company's operating profit margin of 21% in 2010 has declined to 13% in 2011. Assuming Zynga can continue to appeal to high-paying gamers, this margin should not fall too much lower, especially if Facebook loses dominance as the go-to Internet gaming platform.

Zynga Operates A Hit-Driven Business, With Massive R&D Costs to Launch New Games:   Video games, whether online or on game consoles, remain a hit-driven business. Zynga's most popular game titles such as Farmville and Cityville are aging and their user purchases have declined. New games are a short-term novelty; game players will be less willing to spend real money on a virtual good for a game that they won’t play a month from now. (Electronic Arts, and Atari have proven how rapidly a company’s revenues can plunge when a hit game’s novelty wears off as it struggles to replace aging titles with new hits.)  Zynga must continue to invest in developing the next hit games.

Zynga's recent R&D spending shows that it is committed to this investment in future revenues. R&D spending, which encompasses new game title development and testing, will exceed $300 million in 2011, more than double the $149 million 2010. Spending on research and development is thus growing faster than revenues are, but these expenditures should allay some concern that Zynga’s next games will flop.

On a positive note, Zynga continues to wean itself off dependence on its top 3 games. In 2008, the firm generated 93% of revenue from its top 3; by the first quarter of 2011, this proportion of Zynga revenue had fallen to 63%. Zynga has also doubled its spending on R&D in 2011, indicating a commitment to developing new games.

Concentration of Revenues from a Small Amount of Users: Despite Zynga's boasting large numbers of registered users who play its games, less than 5% of these registrants have ever spent any money to upgrade beyond the basic, free versions of Zynga's games.  Moreover, according to PrivCo research, of this 5% who pay, a mere 1% of Zynga users generate more than half all of Zynga’s corporate revenues.  While this 1% has shown loyalty to Zynga games, there is no guarantee this 1% won't next become addicted to a hot new game title from Rovio, Electronic Arts, or one of dozens of other major online and social game developers. The reality is that Zynga has no barriers to entry to prevent others from picking off its very small number of "high rollers" - a mere 1% of its users - on which the company badly depends for the majority of its revenues.  Zynga simply does not have a broad committed user base. In fact,  the number of users who spent money on Zynga actually dropped year over year (though the few who did were charged more, resulting in total revenues growing).

Stock Structure: Although Mark Pincus' 70-to-1 super voting stock has been widely reported, many remain unaware that Zynga management and pre-IPO investors hold yet another class of stock that benefits from 7-to-1 voting power per share. So, buyers of stock in Zynga’s IPO (newly issued Zynga “Class A” stock) are behind not only Mark Pincus, but also VC firms and Zynga’s management. This 3-tiered structure is unconventional and a deterrent to investors, as Pincus and his investors could still control the company after selling their own interests.

Summary of Zynga's new stock structure:

- Class C stock: Issued only to Mark Pincus, receives 70-to-1 super-voting per share
- Class B stock: Issued only to all pre-IPO investors and management: receives 7-to-1 super-voting per share
- Class A stock: (To be newly issued in IPO): All buyers in the IPO receive a new lesser class of stock, receives just 1 vote per share

Leading Zynga Games as of Dec. 2011:

CityVille: Launched in December 2010, it is the leading Facebook game with 70 million MAUs, surpassing 60 million MAUs within the first 50 days of launch. In the same sphere of concept as SimCity and Zynga’s breakthrough FarmVille game, CityVille is a virtual world where players are able to build and maintain a city by building homes, businesses, famous landmarks, public buildings, etc. in order to grow their city and increase their wealth.

FarmVille: Zynga’s breakthrough hit that put it on the top of the Facebook gaming charts. Launched in June 2009 and receiving booming success by the end of 2009, FarmVille puts players in a virtual farm where they can plow, plant, and harvest crops as well as care and nourish farm animals. Currently with 37 million MAUs, FarmVille released an expansion pack, FarmVille English Countryside, where players are able to create a second farm styled after an English country farm.

Zynga Poker: Zynga’s first social game and the largest free-to-play online poker game in the world, Zynga Poker was launched in July 2007 and now has over 35 million MAUs across the Facebook, MySpace, Yahoo!, Android, and iOS platforms. Zynga Poker has been a top 10 grossing app at the Apple App store for iPhone.

Game and Platform breakup as of Dec. 2011:

Blackjack - Facebook
Zynga Poker - Facebook, MySpace, Android, Yahoo!
Maffia Wars - Facebook, Yahoo!
CafeWorld - Facebook
CityVille - Facebook
Empires&Allies - Facebook
FarmVille - Facebook, iPad
FishVille - Facebook, Yahoo!
FrontierVille - Facebook
PetVille - Facebook
Treasure Isle - Facebook
YoVille - Facebook, MySpace
Chess with Friends - free and paid - iPhone
CityVille Hometown - iPhone
Drop7 - iPhone, iPad, Android
Hanging with Friends - free and paid - iPhone
Scramble: Challenge Edition - iPhone
Words with Friends - free and paid - iPhone, iPad, Android
Mafia Wars: Atlantic City - iPhone, Android, Mobile Web
Indiana Jones Adventure World - Facebook
CastleVille - Facebook

Corporate History

Beginnings

Founded in 2007 by Mark Pincus, Michael Luxton, Eric Schiermeyer, Justin Waldron, Andrew Trader, and Steve Schoettler, Zynga has a relatively short history preceding its meteoric rise to the top of the Facebook application charts. In 2007, Zynga’s founders were scattered throughout the United States. In fact, between June and September 2007, Zynga’s founders worked 100% virtually through AIM chat and over the phone. By September, their first game, Texas Hold’em Poker, was considered a success on Facebook and the scattered group decided to combine and relocate to San Francisco where they ran their operations out of an office building owned by Mark Pincus.

The company is named after Mark Pincus’ late American bulldog that is also featured as the company’s logo.

2007-2008: Early Development

In a presentation at Startup@Berkeley in the spring of 2009, Zynga co-founder and CEO Mark Pincus has admitted that Zynga’s initial revenue model depended on tricking users to sign up for promotional offers by its advertising partners in exchange for in-game perks. Zynga sponsored these promotional offers oftentimes knowing it was a scam, charging the user hidden fees once the user entered their credit card information. Another example of these scam deals is requiring the user to download and install a toolbar that was purposely very hard to uninstall and effectively acted as adware/spyware on the user’s computer. Pincus defends his actions by stating that he wanted to grow revenues very fast so Zynga could evolve into a legitimate business. Since then, Pincus has publicly stated Zynga is adding safeguards to remove said scam deals from its games and have already removed the worst offender, ad company Tatto Media.

Zynga received its first round of VC funding in February 2008 led by Union Square Ventures, as the company began to show profitability. Zynga Poker began offering virtual goods transactions between players in an effort to transform Zynga Poker into a social media-based game. Mark Pincus claims the vision for Zynga Poker was to replicate the home poker game in the virtual setting, allowing players who live far away to play poker and socialize with their friends in a casual manner.

With Zynga Poker’s success, the company released Mafia Wars on Facebook in June of 2008. Mafia Wars is a social role-playing game that allows users to join and build virtual crime empires by participating in mafia-related activities such as completing crime jobs, fighting and robbing other mafia syndicates, running underground businesses, and acquiring weapons. The game operated on a freemium model: normal play was free but players have the option of paying for premium content. The game became a huge success and by August 2010 had 45.5 million monthly active users. The game received controversy the same year however, as David Maestri, a rival social media gaming developer, sued Zynga for copyright infringement of his game Mob Wars. The parties settled the case in September 2009 for an estimated $7-9 million.

Zynga made its first major acquisition in June 2008 when it acquired YoVille from its developers. The game features a virtual environment where players could work in factories for virtual money in order to buy furniture and decorate their apartment. Players are able to visit places such as stores, nightclubs, and diners as well as other players’ apartments.

With the commercial success of its games, Zynga moved its headquarters to 444 De Haro St. in San Francisco.

2009-present: Rapid growth

By early 2009, Zynga Poker became the number one game on Facebook, and Zynga as a developer became the number 1 Facebook app developer with over 40 million monthly active users.

Zynga’s released FarmVille in June, which quickly went viral, claiming the top spot for the duration of August 2009 and December 2010. FarmVille is Zynga’s most iconic social media game.

In early 2010, Zynga began an aggressive growth campaign, acquiring 15 game developers in 14 months. The acquisitions of XPD Media, Unoh Games, Dextrose AG, and Five Mobile spearheaded Zynga’s operations in China, Japan, Germany, and Canada, respectively. Zynga also acquired many US-based developers such as Challenge Games, Bonfire Studios, and Area/Code to increase its core base of developers. Fueled with over $350 million in funding from the likes of KPCB, Union Square Ventures, Digital Sky Technologies, Andreessen Horowitz, Softbank Capital, and Google, Zynga increased its total employee count nearly ten-fold between 2008 and 2010.

Zynga’s acquisition of Words with Friends creator Newtoy Inc. was among the largest of these acquisitions, with an estimated price of $53.3 million. Newtoy Inc. is the creator of Words with Friends, a Scrabble clone developed for the mobile platform. Zynga’s investment in Newtoy Inc. signals its vested interest in the growing mobile app market. Zynga ported Words with Friends to the Facebook platform as its first game to go from mobile to Facebook. Building on the acquisition, Zynga released Hanging with Friends on the iPhone and iPad platforms in July 2011.

Recent News:

June 2011: Zynga v. Vostu re Copyright Infringement

Zynga filed a complaint in early June 2011 alleging that the social gaming company Vostu has been copying its games “lock, stock, and barrel”. Zynga’s argument highlights Vostu’s launches of games very similar to Zynga’s games just a couple of months after Zynga’s launch. For example, Vostu launched MegaCity in April 2011, 4 months after Zynga launched CityVille. Vostu has since responded calling Zynga’s claims “frivolous”, denying the allegations.

Vostu is a social gaming company launched in May 2007. Founded by 3 students in Harvard, Daniel Kafie, Mario Schlosser and Joshua Kushner, Vostu has grown to become the largest social gaming company in Brazil with over 35 million registered users. Vostu is backed with over $45 million in VC funding from Intel Capital, Accel Partners, General Catalyst Partners, and others.

August 11, 2011: Zynga files second amendment to S-1

Zynga supplemented their S-1 filing for a second time, citing “material weakness” in the developer’s financial controls. The amended S-1 raised revenues in Q1 2011 by $7.5 million in conjunction with a $7.5 million drop in deferred revenue. The difference results from a change in the way Zynga recognizes its revenues, now focusing more on strict revenues as opposed to the “bookings” system that allocated the revenues over the lifetime of an account. The SEC had questioned Zynga's use of "bookings" in financial reporting.  (While the term "bookings" is used by manufacturers to indicate orders for future delivery, it is not known how this term would apply in the context of sales of virtual goods to gamers.

The amendment also revealed a $1 billion revolving credit line from Morgan Stanley, Goldman Sachs, and other banks. Zynga paid $2.5 million upfront in fees with $625,000 in additional fees per quarter. This raises questions, as most private tech companies do not seek a revolving credit line while they are filing to go public, which highlights Zynga’s IPO may be in trouble and the credit line is Zynga’s contingency plan if its IPO were to be delayed.

August, 2011: Zynga & Patent Infringement Cases

A lawsuit was filed by Agincourt Gaming LLC in federal court in Wilmington, Delaware alleging Zynga infringed on two patents covering processes for credit-based online gaming and a prize-redemption system. Agincourt is seeking unspecified damages and a court order barring the conduct. The patents allegedly cover Zynga’s most profitable games including FarmVille and Mafia Wars.

The suit was Zynga’s second in less than a month as it faced another patent infringement case filed by Segan LLC in Delaware. The patent covers the viewing of network content and allegedly covers Zynga’s games including FarmVille and Mafia Wars.

Shortly thereafter, the SEC questioned Zynga's reference in its filings to the term "bookings" under which an unknown portion of Zynga sales are deferred to future periods, ostensibly to signal future growth.  (While the term "bookings" is used by manufacturers to indicate orders for future delivery, it is not known how this term would apply in the context of sales of virtual goods to gamers.)

Zynga’s IPO

In July 2011, Zynga filed for an IPO. The filing set the IPO for September 2011, but American and European debt worries created a pessimistic equity market that summer, and Zynga rescheduled its IPO for November 2011. Subsequently, Zynga’s IPO was rescheduled for mid-December, and, its valuation was more than halved. The downward revision was commended by analysts in spite of the 29% loss some pre-IPO investors stand to make at the lower valuation. Also deviating from its Internet peers, Zynga’s IPO will raise $1 billion by issuing 14% of the company’s stock. This contrasts capital markets tactics used by Groupon and LinkedIn, which issued very small portions of equity in their IPOs. Analysts infer that these small issuances have helped the valuation “pop” during the first few days of trading, as high interest and low supply pumps up share price.

Zynga added an amendment to the company’s S-1 detailing their extensive relationship with Facebook, centered around a 5-year agreement of exclusivity of Zynga’s present apps on Facebook’s platform. According to the addendum, current Zynga games on the Facebook platform will be exclusive to Facebook, and all in-game virtual goods revenues are subject to a 30% fee. Many stipulations about specific growth targets have been redacted from the public version of the addendum.  Developers and investors have largely panned Facebook’s terms with Zynga and other game developers.

Other Initial Public Offering Concerns

In late August, Zynga's IPO began meeting investor resistance.  PrivCo.com research on Zynga's pending IPO filing concludes:

1. That Zynga's IPO delay is more than a routine "adverse market conditions" delay.  Zynga's IPO delays are due to company-specific issues.

2. Total number of Zynga's users purchasing goods are currently down year over year (as Zynga is almost entire dependent upon Facebook usage for its revenues, and Facebook usage has also dropped, this was foreeable).  As tech IPO investors typically demand a rapid growth story, prospective investors are likely to hold off on investment commitments before seeing further financial metrics indicating renewed momentum.

3. Zynga founder Mark Pincus intends to direct an unusually large portion of the IPO proceeds to cashing out his stock rather than into Zynga, a negative signal for potential IPO investors.  In addition, Pincus seeks to retain control despite selling a large portion of his stock in any IPO, which would make him a minority shareholder.  As a result, Pincus has recently converted his Zynga stock into an unusual 70-to-1 separate voting class (i.e., each 1 share of his Zynga stock Pincus retains gives him 70 voting rights, leaving public shareholders with little to no say in the company's decisions post-IPO).  

Says Sam Hamadeh, founder and CEO of PrivCo.com, "Pincus has overreached, both in the amount of any IPO proceeds he wants to receive personally, and in issuing new super-voting stock to himself. While occasionally private company founders have issued 3-to-1, or even 10-to-1 voting stock pre-IPO - as was the case with Google and as Facebook's Mark Zuckerberg did last year, both done at 10-to-1 - an issuance of 70-to-1 super-voting stock is unheard of. In the context of every other negative signal coming from Zynga, and on the heels of its initial omission of the terms of its Facebook contract, these are the latest of many missteps Zynga has made in trying to become a public company."

4. In mid-August Zynga's General Manager Jeremy Verba left Zynga (and therefore the majority of his stock and stock options) to become the CEO of privately held eHarmony, effectively giving up on Zynga's IPO prospects and betting that eHarmony is more likely to go public than Zynga. Jeremy Verba had been responsible for, among other recent hit games, Zynga's Treasure Island game.