The Effects of the Imminent Zynga IPO

Given that most analysts are predicting Zynga’s IPO this month, I wanted to express my thoughts on how it will impact the overall social game ecosystem, as I think the effects will be profound and far-reaching. I am not going to comment on the valuation issues, there are much more sophisticated analysts who have spent hundreds, if not thousands, of hours reviewing the S-1 offering and underlying financials. Instead, I will examine how it could affect other companies in the space

Less M&A Activity

First, we are going to see much less M&A in the space. Although Zynga has not publicly said the IPO would change its acquisition strategy, realistically they are likely to slow the pace of acquisitions. At the current stage of its business, acquisitions are an important part of building the story to investors to justify the valuation they will go public at. Although they will be sitting on more cash after the IPO, they will no longer be creating a story for investors. Instead, they will be focused on improving their core business to satisfy the investment community. We have seen similar cycles with other companies following acquisitions or IPOs, most notably Playdom following its acquisition by Disney. Although companies with unique IPs or strong technology will still be in demand, the second and third tier social game companies, who have benefitted from Zynga’s need to acquire talent, will no longer be in play.

More Realistic Valuations

With less acquisitions, valuations are likely to fall for many social game companies. To use a sports example, you can compare Zynga to the New York Yankees. When they are interested in a player or potentially interested (the agent can convince someone the Yankees will be a bidder), the terms the player gets goes up exponentially. If the Yankees declare they are not a bidder, it costs the players millions of dollars. We are going to see the same in our space. Without Zynga bidding or used as a stalking horse, many early stage companies are not going to see valuations that others have experienced the last couple of years. The days of a social mobile start-up with mediocre games being able to claim a $1 billion valuation will be a distant memory.

Performance tied to Traditional Metrics

Related to the lower valuations, we will see valuations based much more on traditional financial measures. With Zynga, there will be clear, public metrics that other companies can be compared to. While both EA and Disney have social media groups and are publicly traded, their social game revenue and profitability is not clearly spelled out nor is their effect on the stock value measurable. By contrast, Zynga is a pure play social gaming company. As soon as it goes public, it will have clear price to earnings and price to revenue multiples that will then be used to value other social game companies. Moreover, as a public company, these metrics should represent a premium over a privately held company, so they will provide a ceiling for valuing other social game companies. Again, the days of a social mobile start-up with mediocre games being able to claim a $1 billion valuation will be a distant memory.

The Far-Reaching Impact

Much of my analysis has been tied to how the IPO will affect valuation and opportunities for sale by social game companies, but there will also be a cascade effect on the entire industry. As valuations shrink and acquisitions slow, there will be less capital coming into the industry. Thus, companies will have to focus on profitability and not growth. We are already seeing this to a degree, yesterday’s news about RockYou cutting staff to increase profitability (http://www.insidesocialgames.com/2011/11/02/rockyou-cuts-54-of-staff-shelves-cloudforest-spins-out-playdemic-drives-up-arpu-on-zoo-world-2/) is indicative of what many companies will need to do. Not only will they have less capital available to pursue less- or non-profitable businesses but with valuation tied closer to traditional metrics there will be more of a focus on improving profitability. Thus, we are likely to see more rationalization, fewer projects by companies with a focus on the ones with the highest ROI and also a need to get more done with less people.

We are also likely to see a greater emphasis on using external vendors for functions previously done internally. Rather than building a large (and costly) BI or UA team, many companies are more likely to reduce this expense by relying on third party vendors like Mixpanel, Kontagent, TBG, etc. Thus, they will have more control over their costs and potentially create stronger multiples.

With this rationalization, there is also likely to be a greater pool of talent available. I have already noticed on Facebook and LinkedIn that there are more people currently in “transition.” This trend is likely to accelerate as companies downsize or even close as they cannot raise more capital. Thus, the situation earlier this year where it was nearly impossible to find social game professionals is likely to become a more robust market place for personnel, helping the smart, fast growing companies get good talent.

Overall, the Zynga IPO is likely to change the entire social gaming landscape. It will have impact from the individual developers and contractors to the medium and large size companies and into the investment community. My guess is that this impact will happen faster than people expect and by early 2012 the industry will look very different than it does today.

Author: Lloyd Melnick

I am GM of Chumba at VGW, where I lead the Chumba Casino team. Previously, I was Director of StarsPlay, the social gaming vertical for the Stars Group. I was also Sr Dir at Zynga's social casino (including Hit It Rich! slots, Zynga Poker and our mobile games), where I led VIP CRM efforts and arranged licensing deals. I have been a central part of the senior management team (CCO, GM and CGO) at three exits (Merscom/Playdom, Playdom/Disney and Spooky Cool/Zynga) worth over $700 million. View all posts by Lloyd Melnick