Is Zynga’s Dependence on Facebook the Key to Its Success — Or Its Downfall?

By most measures, Zynga — creator of social games such as FarmVille and Mafia Wars — is a success. The profitable company has users in 166 countries and 60 million daily active users who engage in two billion minutes of play a day. But this otherwise solid business has a potentially fatal flaw — its dependence on Facebook’s platform and user base. While Zynga was able to get broad distribution with little upfront investment by partnering with Facebook, there are disadvantages to their intimate relationship since Zynga’s fate is largely in the hands of Facebook. “It is critical in the long-term for Zynga to diversify beyond Facebook,” says Kartik Hosanagar, an operations and information management professor at Wharton.

Yet, according to Kevin Werbach, a Wharton legal studies and business ethics professor, Zynga represents what could be the dominant business model for the future digital world, a strategy that revolves around what he calls “real-time value webs.”

“We’re seeing that model play out today with the rise of digital platforms such as Facebook, Google, Apple and Amazon.com. They are offering services to customers directly, but also providing the infrastructure for ecosystems of other companies,” Werbach notes. “In a digital era, everything is potentially interconnected. Companies are no longer isolated islands.”

For Zynga, this interconnected business model means it can grow faster. The company, which recently filed with the Securities and Exchange Commission for an initial public offering, reported net income of $90.59 million on revenue of $597.5 million for 2010. For the three months ended March 31, Zynga reported net income of $11.8 million on revenue of $235.4 million. In 2009, Zynga lost $52.8 million on revenue of $121.5 million. Like a number of other recent start-ups, Zynga has built its technology infrastructure on Amazon Web Services, which sells computing power by the hour.

The challenge of co-dependent business models is that firms have to pick and choose partners carefully, Werbach suggests, noting that Zynga and Facebook are two companies that need each other — at least for now.

Zynga’s leadership team outlined the risks in the firm’s regulatory filings, acknowledging that its business today largely depends on Facebook. “We generate substantially all of our revenue and players through the Facebook platform and expect to continue to do so for the foreseeable future. Any deterioration in our relationship with Facebook would harm our business,” according to Zynga’s IPO filing. The company also cited policy changes made by the social networking site that have hurt Zynga’s business. For example, in 2010, Facebook made the Facebook Credits payment system the primary way that players could pay for virtual goods needed to advance in Zynga’s games. As a result, Facebook took a larger cut of revenue. Facebook has also limited the level of communication its users may engage in about applications on the social network’s platform, a move that led to a decline in Zynga players, the filing said.

At a July 6 event launching a partnership with Skype, Facebook CEO Mark Zuckerberg said the last five years in social networking were about connecting people. The next five years will be about building applications on “social infrastructure.” He added that the company with the best infrastructure to enable connected applications will win.

If Zuckerberg’s theory is correct, Zynga will be the first of many companies built on Facebook’s underpinnings.

Would You Cut This Deal?

How the Zynga story turns out largely depends on timing, according to experts at Wharton. Today, Zynga has access to Facebook’s 750 million users. Facebook needs Zynga to keep those users active on its network. “It would make no sense for Zynga to try to recreate Facebook’s social graph,” Werbach notes. “At the same time, Zynga’s success has been a huge boon to Facebook, both directly and indirectly. The two companies need each other.”

Zynga’s motives are clear: Become the leading social gaming company. In a letter to potential shareholders on July 1, Zynga CEO and co-founder Mark Pincus said the company was founded on the belief that “play — like search, share and shop — would become one of the core activities on the Internet.” But Facebook has exclusive access to some of Zynga’s most popular games under a deal that runs through 2015. As a result, Zynga cannot diversify the distribution points of its strongest games.

“From a theoretical standpoint, a firm that is entirely dependent on another firm is in a temporary position, and will likely either be acquired by the other firm, or will diversify. There is just too much risk that the power asymmetry will be exploited by the dominant firm,” says Karl Ulrich, an operations and information management professor at Wharton.

Hosanagar adds that Zynga has some time to figure out which path it wants to take. “In the short term, Zynga is chasing top line growth and is getting that on Facebook. So this is unlikely to be an issue of concern for Zynga in the next couple of years.”

But Eric Clemons, a Wharton operations and information management professor, argues that Zynga needs Facebook more than the other way around. That puts Zynga in danger, he says. He likens the Zynga-Facebook relationship to the airline industry when carriers depended completely on Sabre, a central ticketing system developed in conjunction with American Airlines. On the surface, it appeared that each side needed the other. Ultimately, however, Sabre wielded its dominance by imposing hefty fees on select airlines. “By 1984, American Airlines was making more money on Delta flights than Delta,” notes Clemons, who has written about the topic extensively. “Partners discovered that there was nothing codependent about the relationship.”

In looking at partnerships in multiple industries, Clemons concludes that one party typically has the power, and truly codependent relationships in business are few and far between.

Despite the risks, most experts at Wharton say they would have taken the same deal that Zynga signed with Facebook. “The terms of the deal spell out the limits on its ability to go elsewhere,” Werbach says. “That deal has been hugely beneficial for both companies. Zynga is about to go public at a valuation that would have seemed insane two years ago, based on revenues and profits that have similarly exploded. It’s hard to argue with that.”

The Race to Diversify

The catch for Zynga is that the Facebook gravy train may not last forever, and the company will eventually need more distribution partners. “Zynga and Facebook will continue to exist in a relationship of cooperative competition,” according to Werbach. “Zynga can’t afford to put all its eggs in Facebook’s basket, but neither can it live without the enormous push that it gets from its Facebook relationship.”

Google, which recently launched a new social network called Google+ to compete with Facebook, would seem to be a natural diversification option for Zynga. However, Zynga would still be dependent on what Clemons calls parallel monopolies. “Suppose that in five years, the world is 50% Google and 50% Facebook,” Clemons says. “Zynga will still need both. Half of its revenues go away if it gets into a fight with either. Distribution does not diversify as easily as other resources.”

In 2010, Zynga cut a distribution deal with Yahoo to feature games, including poker, FishVille and Mafia Wars, on the search engine’s games channel. The company has not disclosed revenue generated from the Yahoo partnership. In its broadest global diversification move to date, Zynga on July 26 announced that it has partnered with Tencent, one of China’s top Internet service providers. The move could give Zynga a much broader reach and keep the company’s Facebook deal intact because the social network does not operate in China.

Under its deal with Tencent, Zynga will launch a game called Zynga City, which is a localized version of its game CityVille. Zynga City will launch in Chinese. The game will be built on Tencent’s platform and be introduced on the Internet provider’s various properties.

Another option for Zynga would be to begin distributing games through its own website, a move Hosanagar supports.”I think Zynga should plan on becoming a destination site,” he says.

The End Game

History is littered with companies that partnered with others in codependent deals; the results are mixed. For instance, companies such as FinancialForce, an on-demand financial software provider, have built their applications on the platform of enterprise cloud computing company Salesforce.com. Salesforce CEO Marc Benioff has also acquired firms that have integrated closely with his company.

In Japan, mobile application developers were completely reliant on cell phone carrier NTT DoCoMo, and did well because of the wireless company’s dominant position, Hosanagar notes. Meanwhile, wireless carriers like Virgin Mobile and Boost Mobile thrived in the U.S. by marketing prepaid services without investing in any infrastructure of their own. “These companies were focused on front-end branding, marketing and sales,” Hosanagar says. “Eventually, these companies got acquired [by Sprint].”

Ulrich agrees that an acquisition would be a logical end point for Zynga. “The Facebook-Zynga symbiosis is extreme,” Ulrich notes. “If the company’s entire future is based on Facebook, then Zynga would be likely to be acquired by Facebook.”

According to Wharton management professor Lawrence Hrebiniak, most strategic alliances — unless they result in an acquisition — fail over time. If Zynga is able to diversify, the company could continue as an independent game developer. But that outcome also has its challenges. “Zynga’s business model depends on developing cool games and new titles to replace older ones. How long can Zynga do that? By the time the Facebook deal expires, Zynga may not be viable.”

Based on Zynga’s IPO filing, the company is well aware of fierce competition in the gaming space. The firm cited Electronic Arts, Walt Disney, mobile game developers such as Rovio (which makes Angry Birds) and other companies as competitors. Zynga also noted that companies that do not make social games today may decide to enter the market in the future. These potential rivals include Amazon, Google, Yahoo and, ironically, Facebook.

Zynga faces multiple potential outcomes, Werbach notes. It could separate from Facebook and grow into a powerhouse on its own, sell out or become the benchmark of an emerging trend — a company that remains successful and viable despite being dependent on someone else’s infrastructure and audience. At the same time, Facebook could cement its status as a dominant platform for other emerging companies.

“Facebook has been laying the groundwork for its platform strategy for years. It requires both significant technology investments in both infrastructure and software, as well as a business model that provides value for both sides of the equation,” says Werbach. “Once Internet companies get to a certain scale, the platform model provides the best opportunity for continued growth. Google, Apple, Facebook and eBay have all redesigned their businesses as platforms.”

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