Virtual Goods, Real Money: Zynga Goes to Market

On Friday, Zynga went public, and the market greeted the social gaming company with a shrug. The shares priced at ten dollars, the top of the range, and the company raised about one billion dollars on a valuation near seven billion. The stock opened at eleven dollars and then faded, closing at nine fifty, down five percent from the offering price. It was the first big social internet initial public offering to end its first day below its price, and the signal was impossible to miss. This is the December 2011 story, and the story is the lesson: ...

Virtual Goods, Real Money is the subject of this article: the company that turned farm plots and poker chips into revenue, and the market that decided its shares were worth less than their price. The debut is the anchor, the model is the marvel, and the lesson is about the moment when a wave stops lifting everything.

1. The Day

The offering had been built up for months, and the build-up made the landing colder. Zynga priced at ten dollars on Thursday evening, the top of its range, and the bankers told the story of the fastest-growing consumer company on the internet. The stock opened at eleven dollars on Friday morning, a ten percent pop that looked like the start of a celebration. Then the shares drifted, the momentum faded, and the close came at nine fifty, below the offering price. The company had raised its billion dollars, and the early investors had their exit. The first day of trading told a different story from the one the bankers had told.

The close was the headline, because the close was the pattern breaker. LinkedIn had popped more than one hundred percent in May, Groupon had closed up about thirty percent in November, and the social wave had carried every offering. Zynga was the first of the wave to end its first day underwater, and the analysts searched for reasons: the games were a fad, the dependence on Facebook was a risk, the profit was too thin. The company had raised the money it needed, and the story of the day was the disappointment. The market was sending a message, and the message was about the wave, not just the stock.

2. The Company

Zynga was the creation of Mark Pincus, a serial entrepreneur who founded the company in 2007 with a simple observation: people play games, and people pay for status. The company built games for the social graph, games that lived inside Facebook and spread through the news feed. FarmVille arrived in 2009 and became a phenomenon, with millions of players tending virtual plots and sending gifts to friends. Mafia Wars came before it, CityVille came after it, and Words With Friends brought the word games to a wider crowd. The games were free to play, and the revenue came from the players who paid.

The average player paid nothing, and the games were designed so that a small fraction of the players paid for everything. They bought virtual tractors, virtual cash, virtual energy, and the purchases were measured in billions of coins that cost real money to buy. The design was the product, and the design was the controversy. The games were built to hook, to reward, and to convert, and the mechanics were studied as carefully as any casino's. By late 2011, Zynga reported about two hundred twenty seven million monthly active users, a number that made it one of the largest entertainment companies on earth by reach.

3. The Model

The model was free to play, and the phrase meant that the product was the payment system. The games were designed so that progress slowed, resources ran low, and time became the obstacle that money could remove. A player waiting for crops to grow could pay to speed the harvest. A player short of energy could pay to refill the bar. The purchases were small, frequent, and frictionless, and the small purchases added up to real money. The company's revenue ran at about one point one billion dollars annualized, an astonishing figure for a company that gave its product away.

The economics had a second layer. The virtual goods cost almost nothing to produce, a farm plot or a poker chip is just a record in a database, and the margins on each sale were enormous. The costs were in the marketing, the acquisition of players, and the payments to the platform that hosted the games. The model broke when the games aged, the whales moved on, and the marketing bill grew. The company was profitable, but barely, with a reported net income of roughly thirty million dollars in the first nine months of the year. The margins were the debate.

4. The Facebook Machine

The engine of the company was Facebook, and the dependence was total. More than ninety percent of Zynga's revenue came through the social network, and the relationship was the defining fact of the business. Facebook provided the distribution, the friend graph, and the viral loop: every game invitation, every gift, every score posted to the news feed was a free advertisement. Zynga provided the engagement that kept users coming back to Facebook, and the two companies grew together. The partnership was symbiotic, and it was also tense. Facebook took a thirty percent cut of the payments, a tax that Zynga complained about in private and accepted in public.

The tension was the risk at the heart of the offering. The platform that made Zynga could also break it, and everyone knew that a change in the news feed or the payment rules could change the economics overnight. The two companies were negotiating their relationship as the offering came together, and the talks of a Facebook public offering were in the air, which only sharpened the question of who needed whom. The investors asked the question in the roadshow, and the company answered with the growth numbers. The growth numbers were real, and the dependence was real too. The market was about to price both.

5. The Numbers

The numbers in the prospectus told a story of a company that was big, young, and thin. The revenue was on pace for more than a billion dollars, and the growth had been spectacular, from almost nothing a few years earlier to nearly eight hundred thirty million dollars in the first nine months of 2011. The user base was enormous, with the monthly active users counted in the hundreds of millions. The profit, however, was small, with the roughly thirty million dollars of net income in the first nine months amounting to a sliver of the revenue. The company was spending heavily to acquire players, to market the games, and to keep the machines running.

The thin profit was the target of the skeptics. A company growing that fast should have been generating cash, the argument went, and a company that depended on the generosity of one platform was one negotiation away from a different story. The defenders argued that the spending was investment, that the players would stay, and that the virtual goods business was only beginning. The numbers were not wrong, and the numbers were also not reassuring. The valuation of seven billion dollars implied a belief in the future, and the future was the part of the balance sheet that no one could audit.

6. The Wave Cracks

The flat debut was read as the first crack in the social internet wave, and the reading was hard to avoid. The pattern had been set in May, when LinkedIn closed its first day up more than one hundred percent, and the pattern had been repeated in November, when Groupon closed up about thirty percent. Zynga broke the pattern, and the break was the story. The company was the purest expression of the social economy, the most dependent on the platform, and the most exposed to the question that every social company faced: are the users a business, or are they a fad?

The analysts offered explanations, and the explanations added to the unease. The offering was large, the supply of shares was heavy, and the insiders had sold into the pop. The company's own guidance had been cautious, and the whispers about slowing growth in the games had been circulating for months. The market was not rejecting Zynga specifically, the defenders said; the market was finally asking for profits. The social wave had been priced for perfection, and Zynga was the first company in the wave that did not pretend to be perfect. The wave had cracked, and the crack was public.

7. The Critics

The critics had their say, and the critics had a point. The games were built on compulsion, the argument went, and a business built on compulsion is a business built on sand. The players who paid were chasing status, and the status was digital, and the digital status was worth whatever the next game made it worth. The defenders answered that entertainment is entertainment, that the players were paying for fun, and that the line between a game and a product had always been blurry. The movie tickets, the concert seats, the paychecks spent on leisure: all of it was buying experience.

The deeper criticism was about the games themselves. The games were designed for engagement, and the engagement was measured in minutes per day, and the minutes were the product sold to advertisers and the whale hunters. The design choices, the timers, the rewards, the loss aversion, were all tuned to keep the players in the loop, and the tuning was the company's core competency. The players were having fun, and the fun was also a machine. The metrics said the players were engaged, the revenue was real, and the profit was thin. The market was deciding what the honesty was worth.

8. The Lesson

The lesson of the IPO week is that the market rewards stories until it starts rewarding numbers. Zynga's story was the fastest growth in consumer internet history, the hundred millions of players, and the virtual farms that paid for real buildings. The story was true, and the story carried the company to a seven billion dollar valuation. The numbers, the thin profit, the dependence on one platform, and the cost of growth, were the counterweight. The flat debut was the market's way of saying that the story had been told and the numbers were now in charge. The company had raised its billion dollars, and the company had also received its lesson.

The social wave had carried LinkedIn, Groupon, and everything in between, and the wave had made the ordinary look inevitable. The company that follows the trend is the company that pays for the turn. The lesson for the builders was the lesson for the buyers: the growth is real until it is not, the platform is a friend until it is a landlord, and the first day of trading is a negotiation, not a verdict. Virtual Goods, Real Money is the December 2011 story, and the story is the lesson: the wave lifts, and the wave picks who it drops.

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