Zynga shows the importance of friends

When Zynga filed for its initial public offering, investors were concerned about its substantial reliance on Facebook, the social networking platform on which the vast majority of its games are played.

But it turns out that Facebook is just as dependent on CityVille, FarmVille and other Zynga titles as the gaming addicts who buy digital tractors, mansions and landmarks for their virtual worlds.

Facebook takes a 30 per cent slice of any purchases of these virtual goods in games made by Zynga and its rivals, such as Electronic Arts and Wooga. Zynga is also one of Facebook’s largest advertisers. Together, revenues from Zynga users’ purchases and its advertisements made up 12 per cent of Facebook’s revenues in 2011, or $445m, its single biggest source of income.

That dependence is growing, too, up from less than 10 per cent of sales in 2010 and 2009, according to Facebook’s IPO filing on Wednesday.

“If the use of Zynga games on our platform declines, if Zynga launches games on or migrates games to competing platforms, or if we fail to maintain good relations with Zynga, we may lose Zynga as a significant platform developer and our financial results may be adversely affected,” Facebook warned.

Similarly, at the top of Zynga’s own list of risk factors was the warning that it needs to stay friendly with Facebook: “If we are unable to maintain a good relationship with Facebook, our business will suffer.”

Zynga is also among the peer group of companies that Facebook will use to benchmark its executive pay. Mark Pincus, Zynga’s chief executive, was an early investor in Facebook, though that stake is now worth a fraction of 1 per cent, while the social network’s former chief operating officer, Owen Van Natta, sits on Zynga’s board.

The companies’ interdependence could cut two ways, says Simon Mansell, chief executive of TBG Digital, a social marketing agency that counts gaming groups among its clients.

“In a negative way, they have a dependency there on one customer, which is never what you want,” he says. “But in a positive way, that business was created on the Facebook platform. As more businesses build on the platform, it shows what can happen when Facebook opens up to more segments.”

In 2010, at the same time as Facebook required all games developers to adopt its virtual currency credits, the company also clamped down on how app providers such as Zynga could send messages to users.

Some users saw excessive amounts of postings from their friends’ Mafia Wars as spam that cluttered up their newsfeed. But for Zynga, automatically inviting friends to play along was a vital part of its growth strategy. When it was removed, the relationship between the two groups cooled to a freeze for a few months until they agreed that Facebook would take a maximum 30 per cent cut on gamers’ purchases on Zynga games.

The knock-on effect of the changes was that without that free viral channel, Zynga had to start buying a lot more advertisements to maintain its growth rate.

“These changes limited the level of communication among users about applications on the Facebook platform. As a result, the number of our players on Facebook declined,” Zynga said in its filing. “Any such changes in the future could significantly alter how players experience our games or interact within our games, which may harm our business.”

After tense negotiations in spring 2010 between Mr Pincus and Mark Zuckerberg, Facebook’s chief executive who is 18 years his junior, the pair struck an agreement guaranteeing Zynga will use Facebook credits as the “primary means of payment” for games on the site, in exchange for Facebook taking a commission of “up to” 30 per cent (other games companies hand over a straight 30 per cent). That deal expires in just over three years, in May 2015.

Facebook’s description of the events leading up to this in its S-1 filing almost reads like an apology to Zynga, noting that its action “reduced distribution from, user engagement with, and our monetisation opportunities from, apps. In some instances, these actions have adversely affected our relationships with platform developers”.

The 16 per cent climb in Zynga’s shares in early trade on Thursday underscores how important the relationship remains in spite of those changes. “We believe the relationship between Zynga and Facebook is far more symbiotic than investors believe,” wrote BTIG analyst Richard Greenfield. “We believe Facebook wants/needs Zynga to be successful.”

Analysts at Macquarie, who have a neutral rating on Zynga stock, said the details revealed by Facebook suggests the gaming group may miss its fourth-quarter revenue estimates.

But Zynga investors already seem to be looking past such concerns. Its shares have recently surged from $8 to above its $10 IPO price, and opened more than 16 per cent higher on Thursday morning in the wake of Facebook’s filing, to $12.34.

Additional reporting by Chris Nuttall in San Francisco

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