As IPO looms, Facebook confronts its game addiction

Five months after Zynga was center stage on Wall Street, Facebook is readying for its own IPO. And the parallels between the two companies are startling. At the time (and since it began trading), FarmVille house Zynga was criticized for its over-reliance on the social media site. Investors grumbled that the offering was a dog and pony show -- and investors would have no real say in the company's operations, since the majority of shares remained controlled by Mark Pincus. And the company's valuation seemed impossibly high. Flash forward to today... Facebook has increased the price range of its IPO from $28-$35 per share to $34-$38, giving it a valuation of between $93 billion and $104 billion. And power of the company remains firmly in the hands of Mark Zuckerberg, who will retain 57.3 percent of the voting rights in the company -- meaning he's still free to do whatever he wants. But it's the game space where it really gets interesting. While Zynga is obviously more reliant on Facebook for earnings -- the bulk of its income comes from games on the site -- there are some symbiotic aspects to the relationship. In its S-1 filing with the Securities and Exchange Commission, Facebook estimated that 19 percent of its 2011 revenue (and 15 percent of its Q1 revenue in 2012) was tied directly to Zynga. Put in hard dollar figures, this means Zynga accounted for roughly $159 million of the $1.06 billion in revenues Facebook reported in the first quarter of the year. The bulk of that came from payment processing fees that were related to the sale of virtual goods in Zynga's games. Facebook receives 30 percent of the face value of user purchases in those games. (The two companies struck that deal in 2010 and it runs through 2015.) "To date, games from Zynga have generated the majority of our payments and other fees revenue," the company said. The tide could be shifting, though. Sterne Agee analyst Arvind Bhatia, in a note to investors, said he believes other publishers -- including Electronic Arts and King.com -- are going to eventually be just as critical to Facebook (as Zynga strives to diversify onto other platforms). The reason for that isn't microtransactions. It's advertising. Remember when we all scoffed about in-game ads, saying they would never be a major source of revenue? For a while it looked like that was true -- but we never thought to look beyond traditional games. Game companies buy a lot of ads on Facebook, and they host even more on the pages that house their game. That's a win-win for the site, and looks to be a giant windfall. "We believe Facebook is in the early innings of revolutionizing the $600 billion worldwide advertising market, particularly the sub-segment of online advertising," said Bhatia. While EA and others are on the rise, they're still mere shadows of Zynga today. the company boasts nine of the top 10 games on the site and has a customer base of over 50 million players. On an average day, Facebook users spend 2 billion minutes playing Zynga games. "Zynga was one of the key developers that turned Facebook from a relatively passive communications medium to a more active and engaged social platform," says Colin Sebastian, senior research analyst at Robert W. Baird & Co. The relationship between the two companies extends beyond hosted games, as well. Zynga CEO and founder Marc Pincus was an early investor in Facebook, putting in a reported $40,000 in 2005. Today, he holds some 5.3 million shares -- though he plans to sell 1 million in the public offering. In 2015, when the current agreement ends, there's the potential for a shakeup, though. Both Pincus and Zuckerberg are headstrong CEOs, who aren't afraid to make moves that seem, on the surface, outrageous. (Look no further than the mind-boggling prices the companies paid for OMGPOP ($200 million) and Instagram ($1 billion) in the past two months.) That could lead to a Facebook faceoff, of sorts. "Under the terms of its current agreement with Facebook ... Zynga is limited in its ability to offer the same games it offers on Facebook to other platforms," says Michael Pachter of Wedbush Securities. "Therefore, each time it chooses to launch a new game, the company makes the rational decision that it should launch them first on Facebook, as the Facebook platform offers the greatest potential for a successful launch. In our view, as Zynga approaches the May 2015 expiration date, it will become increasingly likely to debut new releases on Zynga.com, and not Facebook." How's that a problem, if EA and other game companies are growing? It comes back to the symbiotic relationship between the Facebook and Zynga. Because Zynga is such a big part of Facebook's finances, the company gives it a lot of love -- and that could come at the expense of other game makers. "Facebook's attitude is that it doesn't need to accommodate or work with game developers," says P.J. McNealy, founder of Digital World Research and author of the book "Early Days: The Market for Social Gaming and Facebook's Potential Achilles' Heel. "We have talked to a wide range of developers, and they're frustrated because they perceive that Facebook devotes its resources and its promotions to Zynga, giving little incentive for developers to engage with Facebook. "Facebook's hubris could be its biggest problem -- rather than setting rules and limits, it needs to remember that it can very quickly lose this important sector. Once lost, getting it back will be very difficult." And if Facebook loses that audience, it could be a game changer for its bottom line.