Facebook is to Zynga as a Clownfish is to a Sea Anemone?

The days leading up to the highly anticipated Facebook IPO have been met with market excitement.  Comparisons of Facebook to Google and speculation about whether the company is over- or under-valued have been rife for some time.  Facebook has convincingly overcome concerns about negative cash flows and lack of a monetization plan that plagued it in the media a few years ago.  However, concerns about Facebook’s business model seemed to have revivified as investors struggle to identify the company’s bread and butter and more importantly, to understand its relationship with social gaming behemoth, Zynga.

I remember hearing estimates in 2009 that Zynga made up 40% of Facebook’s revenue.  That is why I was taken aback by the market’s surprised reaction when it traded up shares of Zynga upon finding out the company composes 12% of Facebook’s total revenue.

A breakdown of Facebook’s revenues from Zynga shows that Zuckerberg’s company derives its revenue from the gaming company through the sale of virtual goods and other add-on features in games (Payments) and through ads that Zynga buys to cross promote its own games to captive Facebookers (Ads).  Moreover, an increasing proportion of this revenue comes from Payments revenue.

 

In some ways, the Payments model is not very different from the way Apple charges iPhone application developers a cut of the revenues made from the Apple App Store.  Facebook’s cut of Zynga’s Payments revenues is reported to be 30%.  Facebook’s relationship with Zynga deviates from Apple’s relationship with its app developers in at least one key respect—Facebook also reaps ongoing benefits from Zynga’s success in the form of advertising revenue.  The larger Zynga’s customer base grows, the more it is willing to invest in advertising and the more people that fall into the target audience Zynga wants to reach.  Increased advertising by Zynga benefits Facebook.  Additionally, while iPhone app users pay once for an app (say $0.99), Zynga users may keep buying add-ons within the same game (say $0.99 per virtual good).  Finally, while I have not searched Apple’s financials to confirm, I seriously doubt any one app developer makes up 12% of Apple’s app store revenues, let alone 12% of the diversified company’s total revenue.

Thus, Facebook’s near-term future is highly levered to Zynga’s success.  This leverage presents problems in the eyes of some for several reasons.  First, sustaining revenues from gaming alone is not Google-esque.  Google effortlessly fused the worlds of media and technology in a revolutionary way.  It was able to use its technology to appeal to advertisers very broadly.  A dependence on gaming leaves Facebook less diversified, less appealing to advertisers universally, and potentially vulnerable.  This factor doesn’t bother me much because other apps will fit into the Facebook ecosystem as the social networks becomes increasingly ingrained into the way we think about the Internet and computing.  Plus, there is a trend in various sectors to solve problems through gaming anyway.

The bigger problem is a more general business issue.  Dependence on one company can become unhealthy if the equilibrium is rattled.  Right now Facebook and Zynga have symbiotic interests.  Both businesses align well with each other.  However, if Facebook were to decide to invade Zynga’s turf and start competing with the game developer, or if Zynga can successfully create its own network of users outside of the Facebook platform, the relationship won’t be quite as hunky dory.

Some have countered that Facebook has an exclusive arrangement with Zynga whereby Zynga agrees to use Facebook currency and develop certain games only for use on Facebook.   I don’t really see this arrangement mitigating the concern.  Prohibiting development on other social networks is a useless demand since Facebook has won the day as far as general interest social networks go, and gaming is not a fit with other popular social networks such as Twitter, LinkedIn, and foursquare.

More significantly, Zynga has always had a disconnect between its mobile apps and its games on Facebook.  I once tried playing Mafia Wars to get a better idea of what the craze was behind Zynga’s games ahead of an interview with the company.  My profiles on Facebook and the iPhone app could not be synced.  Whether this incompatibility is still an issue with Zynga’s games, I do not know.  However, the recent success of Words With Friends at the very least shows that Zynga is capable of finding success outside of Facebook even with an exclusivity agreement in place.

The fact that the ads portion of Facebook’s revenue from Zynga is decreasing is reassuring, but it still raises issues about Facebook’s ad monetization strategy.  Google found a direct way to relate ads to subjects that directly interests users.  When searching for a person’s profile on Facebook, it is less obvious which ads should pop up than if someone conducts searches about an upcoming vacation on Google.  (This explains why so many people complain about dating advertisements on Facebook.)  The display ads on Facebook are commoditized, and the company’s current advertising strategy is just as shaky as a non-premium online ad network.

These concerns about Facebook’s advertising revenue is not to say the company won’t eventually get it right.  The rich data Facebook collects is highly valuable.  The challenge of utilizing it in a way that doesn’t sound off alarms about privacy remains.  Personally, I thought Beacon was a promising first step, but it was introduced in such a disastrous way that Facebook has been unable to broach the topic again in a privacy-friendly way.

Still, Facebook has to figure out the ad scheme fast.  Other social networks, though not at all threatening in terms of scale, are carving out niches that are more advertiser-friendly.  Pinterest, for example, can make money on ads in a very direct way not too different from Google, and foursquare can capitalize on location-based audiences and local deals.

Utlimately, Facebook is well . . . Facebook.  I don’t think many can imagine life without it, and it is hard to bet against a company with that type of stickiness.  As long as the Facebook-Zynga symbiotic equilibrium does not shift, the fact that 12% of Facebook’s revenues come from Zynga isn’t too troubling.

I’d also note that while I may have painted a rosy picture about Zynga over the medium term, it too has long term concerns, namely the danger of becoming less data-driven/disciplined and more like a media company.  Additionally, while the exclusive arrangement with Facebook might be a pro for the social network, it displays Zynga’s subjugation to Facebook’s terms and power.

In the meantime, I leave it to you to decide which company is the Clownfish and which the Sea Anemone.  For help and more information, see the epic video below.

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