How Google’s Investment In Zynga Helps

This post is written by Guest Author Byrne Hobart, a marketing consultant at NYC-based Blue Fountain Media. Blue Fountain Media helps clients with website design & development, online marketing, graphic & logo design and more.

A few months ago, it would have been fair to treat Zynga as a partially-owned subsidiary of Facebook. The big question for investors was how much Facebook ‘owned’. Since Facebook was Zynga’s platform—their sole source for new customers, and the only way existing customers worked with them—Facebook could theoretical “tax” Zynga, demand a change in strategy, or even shut it down. Owning shares of Zynga was a bet that Facebook would ignore them, lose to them, or buy them out (a situation analogous to Paypal before its eBay acquisition).

But in the last few months, that situation has changed completely.

It started in May: Zynga had an all-hands meeting in which they prepared to leave Facebook entirely.

Days later, they announced a settlement: Zynga will use Facebook credits, and Facebook will give them free advertising. This may have been one of the best pieces of corporate Jiu Jitsu in history: in a single deal, Zynga turned Facebook from a company that basically owned them into the company that gave them a torrent of cheap new users. That was the prior status quo.

But at the same time, Zynga was pushing those new users into interactions outside of the site:

  • FarmVille is one of the top 20 game Apps in the iTunes store.
  • Zynga’s poker app remains popular.
  • is the most popular game site on the Internet. According to, it gets more traffic than gaming stalwarts like,,,, and even (based on Alexa’s estimate of Yahoo’s subdomain traffic, and Compete’s estimate of Yahoo’s total traffic). It’s also an engaging site, with a high ratio of visits to unique visitors compared to other gaming sites (only Pogo is higher, and by a small margin).
  • is the second most popular game site; is third.
  • Farmville is marketing itself through 7-11.

And now, Google has invested at least $100mm in Zynga, and is preparing to launch “Google Games”. If there’s one company that can bring in more attention than Facebook, it’s Google (for the moment). As TechCrunch points out, that’s not the only benefit: Zynga will also have an opportunity to use Google Checkout instead of Facebook credits. Suddenly, their ultimatum from May got a lot more effective: it’s not a choice between Facebook and nothing, but a choice between two companies that can provide an almost equal amount of traffic.

The likely outcome: Zynga is too valuable a prize for either of them to risk. Zynga will be able to keep negotiating to keep an aggressive cut of the revenue their games generate, and they will be able to keep adding new online and offline partners. And of course, Zynga continues to learn more about user behavior, more quickly than their competitors.

Zynga’s competitive position has completely changed. For potential partners, they are a way to turn a large number of pageviews into 1) revenue, and 2) more pageviews. This makes them part of a tiny minority of web services that can be plugged into a wide variety of sites in order to make them more profitable. And if the other services—Amazon Associates, Google Adsense, and Paypal—are any indication, the result could be extremely profitable for Zynga.

Social Gaming Plunge Levels Off In june

The negative impact on social gaming providers from Faceboo’s changes in notifications and requests imposed in March finally seemed to have slowed in June, with total monthly active users (MAUs) of the top 10 game developers dropping by a little over 1% from May levels to 415mm in June month-to-date, after falling 9% in May.

We were very interested to read Mark Zuckerberg’s thoughts on the changes in a recent interview on Inside Facebook where he said that:

“There are two ways that apps get usage that really define the character of the application. One way is viral distribution – spreading to new people. The other is re-engagement. Early on, the viral strength was so much, but there were really no channels for re-engagement. So people were using viral channels to reengage people, and you basically had apps that were growing very quickly, and their best way to get a good user count was to get new users and churn through them. That really optimizes for apps that are very viral instead of apps that are high quality and that people want to reengage. So we intentionally weakened the viral channels recently, and intentionally strengthened re-engagement with emails, so that there will be better apps. It’s going to be a long process, but I think it’s going reasonably well.

One of the things we did recently was re-balance around games. A lot of users like playing games, but a lot of users just hate games, and that made it a big challenge, because people who like playing games wanted to post updates about their farm or frontier or whatever to their stream. They want all their friends to see their updates, and they want to get all their friends’ updates, but people who don’t care about games want no updates. So we did some re-balancing so that if you aren’t a game player you’re getting less updates.”

As a result of this “re-balancing,” since reaching their peak in mid-April, as the Facebook changes were being implemented, total MAUs have fallen over 11%, with virtually every developer seeing a significant fall off:

This large drop off comes amid the emergence of several new hits for the social gaming providers.  Most notable, Zynga’s Treasure Island was the fastest growing game in the history of Facebook, reaching over 20 million MAUs in just three weeks.  However, the entire life cycle of games appears to be compressing, as Treasure Isle peaked just seven weeks after its introduction, and over the subsequent six weeks, Treasure Island has lost over 20% of its MAUs, including a 2mm MAU loss just last week.

Treasure Island hasn’t been Zynga’s only new hit.  More recent, Zynga introduced Frontierville, which has already surpassed 11 million MAUs after just three weeks, but these new hits haven’t come close to offsetting the losses among all the other Zynga games:

It’s interesting to note that the game with the best staying power is Texas Hold’ Em, a classic poker game that was likely the easiest for Zynga to build, and is the most basic of all of Zynga’s games.

The social gaming providers are hopefully finally at the point where things will level off from the Facebook changes, such that growth can begin anew.  We’ll keep you posted.

Lou Kerner owns 50% of this social media site,, and owns shares of Facebook (private company) and is employed by Wedbush Securities ( Wedbush Securities is a registered broker-dealer and member NYSE/FINRA/SIPC. Wedbush Securities makes a market in the publicly-traded securities mentioned herein and its Equity Research Department provides research coverage of Electronic Arts. The information is neither intended to be a complete record or analysis nor a solicitation of an offer to buy or sell any security mentioned herein. This information is obtained from internal and external sources, which is believed to be reliable; however, no guarantee of its accuracy can be made. Additional information is available upon request.

Playdom Announces Expansion In Europe

Playdom has raised $43 million to date and made six acquisitions, including Acclaim Games, and has just announced their intentions to expand into Europe. They plan to create localized versions of their game titles such as Mobsters, Tiki Resorts and Big City Life in French, Italian, German and Spanish by the end of this year.

The first game to be localized is Bola, the 41st most popular application on Facebook according to analytics firm AppData. In aggregate, Playdom has more than 38 million monthly active users (MAU) and is headquarters down the street from Google in Mountain View, with studios in Francisco, Calif.; Seattle, Wash.; Eugene, Ore.; Chapel Hill, NC; Buenos Aires, Argentina and in South Asia.

Zynga has 50 games with over 8 games with 1 million or more daily active users (DAU) and 11 ames with 1 million or more MAU. By comparison, Playdom only has 22 games and 1 game with 1 million or more DAU and 9 games with 1 million or more MAU. So putting an emphasis on European and international users may be the right strategy to grow their reach and compete with Zynga.

Here’s an interesting point, in the last 29 days Zynga lost 7 million DAU according to AppData, which is more than 8x the size of Playdom’s total DAU. So the question is, how much of an impact can this expansion into Europe really have for Playdom?  We’ll see.

Metrics That Matter For Social Gaming Investors

This post is written by Guest Author Byrne Hobart, a marketing consultant at NYC-based Blue Fountain Media. Blue Fountain Media helps clients with website design & development, online marketing, graphic & logo design and more.  In this post, Hobart explains in detail the metrics driving social gaming companies like Zynga and Playfish.
Traditional investment analysis tries to boil a company’s value down to some simple numbers, like earnings or free cash flow. On a slightly more advanced level, some industries have particular ratios that give a more detailed picture of a firm’s operations—in insurance, for example, the “combined ratio” measures a company’s operating efficiency; in trading, income divided by Value at Risk shows whether or not a firm is making safe bets.

In social gaming, the relevant number is different ratio: the company’s churn rate compared to their viral coefficient.

Churn rates are familiar to anyone who has analyzed a subscription-based business like cable television or phones: the churn rate is the percentage of customers who will stop using the product in a given month. In social gaming, that means the percentage of users who will stop playing a given game in a month. From the analyst’s perspective, every new customer is a rapidly ticking time-bomb; they’ll get bored fast, and move on to another game. Some social games have churn rates of 50% per month, or more; if their revenue per user is $5, and the churn rate is 50%, the expected value of each new user is $10 ($5 + $2.50 + $1.25… technically, you would discount these future values based the time-value of money, but since the relevant numbers are in the first few months, it’s not worth it).

The viral coefficient is in some ways the opposite of the churn rate: it’s average organic growth rate in users in a given month. If 100 Farmville users are likely to cause five of their friends to join in a given month, that’s a viral coefficient of 1.05.

Combine these two numbers, and you have the “Expected user-months per new user”—for each user, the total number of months you expect to be played by that user, plus the people they recruit.

In the case of a 50% churn rate and a viral coefficient of 1.05, this means each new player is expected to generate 2.10 months of play time. At a viral coefficient of 1.10, that number jumps to 2.22. At a churn rate of 40% instead of 50%, and a coefficient of 1.1, the number of player-months per new player is 2.92. Keep in mind that these increases can be multiplied by the game’s average monthly revenue per active user. In other words, a bump in player-months per new player adds directly to revenue, at a gross margin of basically 100%.

One thing this illustrates is the strong economies of scale in the social gaming industry. Zynga can afford to invest millions of dollars in making Treasure Isle marginally more addictive; going from 2.10 months of play to 2.92 months of play on a userbase in the millions will more than pay for itself. And the techniques a company develops in one game can be easily applied to others (while the biggest games are months or years old, the biggest launches are more recent).

Finally, quantifying this number can also show a company when it makes sense to start spending money to acquire new users. There’s a reason Zynga can afford to blanket Facebook in ads—once they’ve figured out the average value of buying one new user, they can fine-tune their bids to maximize profitability.

A more robust model would also consider the total size of the market. Even a massively popular game like Farmville can eventually reach all the people it’s able to reach; while it might take several Farmville requests before a given user signs up, but after a certain point they’ll be desensitized. Thus, a site with high virality and high churn will peak faster and fall faster than a site with low virality and low churn, simply because it will be seen, used, and then discarded by more of its total audience.

(It’s likely that the narrower a game’s target audience is, the lower its virality and churn rate are. Tens of millions of people play Farmville, Zynga Poker, and Treasure Isle, and they get bored of it quickly. But a niche game like Fashion Wars will not get shared as aggressively, but will provide deeper interactions between the friends who do play together.)

There is a wide range of actual values that can make a game a winner, for example:

  • A game that spends $5 to acquire a user with a 50% churn rate, a viral coefficient of 1.05, and revenue per user of $5 will earn about $5.52 in profit per user acquired.
  • A viral site with the same revenue per user, but a viral coefficient of 1.2 and a churn rate of 20% would earn $51 in revenue for each new user acquired (this kind of math explains why Groupon can spend so much on Adwords and Facebook ads).
  • A site with revenue per active user of $5 and a churn rate of 40% with no viral characteristics will lose money paying $13 per new user.
  • A more traditional subscription-based business with a lower churn rate and a very modest viral coefficient is also worth considering. For example,’s monthly churn rateis 3.8%. If their viral coefficient is 1.005, and their monthly subscription averages out to $80, their expected revenue per subscriber is $856—in the first year alone. But viral effects account for only $23.15 of this, meaning that TheStreet won’t significantly benefit from enhanced viral effects.

When social media companies start to go public, I believe that investors should call for them to prominently disclose these numbers. Giving investors an idea of how viral a product is, and how high its churn is, can tell them how quickly to expect it to grow, how soon it will peak, and whether or not they should expect the company to lose money early on in a race to acquire customers. In the case of a viral, low-churn game, it’s irresponsible not to run at a loss early on in order to acquire players. But once a game starts to peak, and the churn rate increases while the viral coefficient approaches 1, paying for growth becomes a similarly poor decision.

Social gaming companies have shortened the fuse and narrowed the range of outcomes for subscription-based businesses. Someone operating an online game can use simple measurements like viral coefficients and churn rates to determine exactly where they’ll earn the most money. A traditional game company (not to mention a phone or cable company) could spend years trying to determine the average value of their customers; for Zynga and the rest of the industry, knowing this information is almost automatic. For their shareholders, disclosing this data will make it easy to tell whether the company’s growth represents free cash flow in the future, or merely an impressive number of users in the short term.

David Kirkpatrick Video Interview – Author of “The Facebook Effect”

We had the opportunity to sit down with David Kirkpatrick, the author of “The Facebook Effect” for a 35 minute interview a few weeks ago.  The book’s subtitle, “The Inside Story of the Company that is Connecting the World,” is about Facebook’ss history and massive global impact. David’s been writing about technology and the Internet since 1991, and the book is much anticipated  around the world.

The interview is about 35 minutes long, and all worth listening to. But if you want to search for a particular topic, below the video is a brief Table of Contents:

David Kirpatrick Interview – Author of “The Facebook Effect” from SecondShares on Vimeo.

Minutes 0 – 3 : David’s background and the impetus for writing the book
Minutes 4 – 10 : Who David talked with including his interaction with Mark Zuckerberg, VCs, competitors and predecessors
Minutes 11- 15 : The book, how Facebook has evolved, how the company will make money and transform the world
Minute 16 : Social gaming and Zynga
Minute 17 : Yuri Milner, the Russian who has spent more money ($500mm) than anyone else on Facebook shares
Minutes 18 – 22 : The privacy issue
Minutes 23-25 : Search, Google and the social graph
Minutes 26-28 : How much is Facebook worth and when will it go public
Minutes 29-31 : Particulars on the book
Minutes 31 -33 : Who bailed to early, who comes off bad in the book
Minutes 34 – 36 : Final thoughts

Zynga’s Losing Streak Continues

Zynga’s total Monthly Active Users (MAUs) declined last week for a third straight week, and the pace of MAU decline continued to accelerate, with a total decline of 5.9 million MAUs, or 2.4% of Zynga’s massive total user base, which now stands at 238 million.  The MAU loss grew from the previous week’s drop of 4.2 million MAUs, and the loss of 3.1 million users the week ending May 1st.  Treasure Island remained the only major Zynga title to add users last week, although the 900,000 net adds was modest compared to the 6.7 million it added week just three weeks ago.     With 238mm MAUs, Zynga is now down over 5% from peak MAU levels reached mid-April.

Farmville, Zynga’s biggest game, was also Zynga’s biggest MAU loser last week, declining by 2.3mm MAUs last week, to stand at 75.5mm, and is now down by 7.7 million MAUs, or 9%, from its peak in early April.   However, Fishville is Zynga’s biggest decliner in terms of numbers of MAUs lost from its peak MAU count, having dropped by 9.6 million MAUs, or 37% from its peak of 26.2 million MAUs reached last December.   While Treasure Island still growing, Zynga’s seven other major titles are all below their peak MAU counts.  The chart below highlights the MAU decline from peak levels of Zynga’s major hits other than Treasure Island:

It’s critical to recognize that MAU declines are not unique to Zynga, as every major game developer but Mindjolt lost MAUs last week.  In addition, every one of the 11 major Facebook game developers we follow is off from their peak MAU levels reached over the last few months.  The MAU loss from peak levels range from Playdom’s modest 1.7% drop (due to the recent growth of Big City Life) to Mindjolt’s staggering 37% drop.  In fact the average MAU loss of 11% of the top 11 developers from peak levels is more than twice Zynga’s 5.2% total MAU decline from its peak.  As a result, Zynga has continued to grow its MAU market share of the top 11 developers, reaching a very impressive all time high of 53.5% this week, or 238 million of the total MAUs of 445mm of the top 11 game developers.   While the seven Zynga games highlighted above have lost a combined 31 million MAUs from their peak, Treasure Island has added over 27 million MAUs in the past six weeks.

We believe there are multiple factors driving the MAU declines being experienced by every major Facebook game developer.  There are seasonal factors, as people go outside more in spring than winter.  We estimate that Facebook’s gaming notification and gift request changes have impacted MAUs significantly more than the weather.  We also believe that new/smaller developers are taking an increasing share of new MAUs, with last week rapid growers including Family Feud by iWin (up 900,000 MAUs last week), Kingdom of Camelot from Watercooler (up 500,000) and Nightclub City by Nightclub City (up 400,000).    Finally, there appears to be some game fatigue occurring as well, as social games don’t yet engender the long term loyalty experienced by hard core games like World of Warcraft.

Current declines notwithstanding, we continue to believe that social gaming is emerging as the next major force in gaming.  However, we also recognize the social gaming industry remains in the early stages of its evolution, and the success of today’s leading social gaming companies like Zynga, EA, Playdom and CrowdStar will depend on their ability to evolve in this dynamic environment and provide gamers with ever evolving gaming experiences.  We also continue to believe that Zynga’s massive scale and the resulting inherent marketing advantages, positions Zynga to continue to drive new mega hits like Treasure Island and remain the dominant player in the social gaming industry.

User Loss Accelerates For Zynga

After losing 3.1mm Monthly Active Users (MAUs) across its vast Facebook gaming empire two week ago, Zynga’s MAU decline accelerated last week with the loss of 4.2mm more MAUs.

While Treasure Isle continued its growth, the growth curve flattened significantly, adding 1.6mm MAUs last week after gaining an average of 6.6mm the previous three weeks.  Every other major Zynga title lost users last week, with Farmville (-600k), Texas Hold ‘Em (-600k), CafeWorld (-700k), Mafia Wars (-300k) Fishville (-600k) and YoVille (-500k) combining to lose over 3.8mm MAUs.  On a positive note, the losses from the six losing major titles decelerated from the previous week, when they combined for a total loss of 6.5mm MAUs.  The weekly loss totaled 1.7% of Zynga’s total MAUs, which now stands at 244mm, still dwarfing its competitors, the next ten which combine to total only 215mm total MAUs.

The second straight week of MAU losses comes on the heels of reports that Zynga is readying for a major battle with Facebook given the rise of Facebook Credits and its 30% fee structure, as well as Facebook’s elimination of notifications and Facebook’s pending Gift Request changes.  While Facebook’s changes in communications cuts down on the noise in users newsfeed, the elimination of the free communications/advertising is forcing the gaming companies to increase their advertising to drive usage.  As a result of these changes, Zynga appears increasingly focused on lessening its dependence on the Facebook platform.

While Zynga MAU loss accelerated last week, every other major developer but Playdom (which added a modest 300k MAUs last week) also lost MAUs last week, and Zynga’s share of the total MAUs of the top 11 game developers actually increased last week from 53.1% to 53.2%.  So if Zynga’s players aren’t leaving Zynga for the other major gaming providers, where are they going?

The lost gamers are either doing other things than playing games on Facebook, like taking advantage of better weather in the seasonally slower spring and summer months for gaming, or playing the games of smaller developers.   Among the many risks we highlighted in our original Zynga report was the risk of “branded” games coming to Facebook that come with a built in audience given the strength of the brand.  Case in point is the recent rise of the Family Feud game introduced in to the Facebook ecosystem just two months ago.  Family Feud grew its MAUs base by 700k last week to pass 4mm total MAUs.   While Family Feud doesn’t appear poised to enter the pantheon of top 10 Facebook games, where 17mm MAUs is required, the deluge of new gaming companies introducing games on the Facebook platform, including those with branded games, are likely to be increasingly meaningful in the Facebook gaming ecosystem.  All that said, we always caution readers to not read too much in to the weekly gyrations of MAUs, but rather use them as context over longer periods to divine the trends that will be meaningful in the long run.

Tough Week For Zynga Could Get Worse

While Zynga’s Treasure Isle continued its ascent last week, adding over 4.2mm Monthly Active Users (MAUs)  to pass 25mm total, and become the 4th biggest game on the Facebook platform (passing Mafia Wars and Petville) every other major Zynga title lost MAUs for the week.

Farmville had it largest weekly MAU decline, dropping 2.3mm users to finish with 78mm.  Farmville is now 18% below its peak Daily Active Users (DAUs) of 32.5mm, as the behemoths best days appear to be behind it.  Zynga’s Café World (-1.3mm MAUs) and Fishville (-1.0mm MAUs) also experienced big declines.  Interestingly, Treasure Isle was the only Top 10 game on the Facebook platform to increase its total MAUs last week, but even its growth slowed dramatically when compared to the 6.7mm MAUs Treasure Island added the week before.   As a result, Zynga’s total MAUs across all its properties declined by more then 3mm to finish the week at 248mm.  The only other major winner this week was EA’s Hotel City, which gained 1.8mm users (to 13mm MAUs total) to help EA eke out a gain of 0.1mm MAUs for the week (to 58.6mm MAUs) as EA’s other tow major titles, Restaurant City (-0.4mm MAUs) and Pet City (-0.8mm MAU;s) both suffered declines.   As we always point out in our weekly updates, we don’t put too much weight on what happens with MAUs in any one week, but it is always provides additional context.

The last few weeks have seen Zynga, and its CEO Mark Pincus, receive significant press, some good (e.g. Business Week and Details), some not so good (e.g. Valleywag), as Zynga ups its PR push.  But at the least, the company is keeping itself front and center as interest in the Facebook ecosystem explodes.

Most importantly, while a down MAU week, and some bad press is notable, potential changes to come on Facebook portend some additional tough days down the road for Zynga.  Everyone following Facebook is aware of the Facebook’s continued interest in cutting down on noise in the newsfeed and increasing revenue.  This played out in Facebook’s elimination of application notifications which took effect on March 1.   While many in social gaming feared the worst, the impact has proven to be pretty minimal to gaming companies (although dating sites which rey more on notifications were hurt).  However, when the notification announcement was made, Facebook stated that they were also going to change how requests function.   It appears now as though Facebook is going to make some major changes to the gift channels and how gift requests function.    Facebook perceives that the Facebook channel is polluted by gift requests.  While the pending changes aren’t exactly clear yet, the gift channels are a very major driver of traffic to social games.  In fact, many game players struggle to navigate to games outside of the gift channels.  So this change will likely force the game companies to spend an even greater percentage of revenue on advertising, which is of course is what Facebook wants.  On one hand, Zynga, as the largest company in the space, has the most resources to pour in to advertising.  On the other hand, companies like CrowdStar that have put more resources in to viral channels they control, like forums, may be better positioned to weather the change.

With the pending changes to requests, Zynga is likely going to advertise even more, and thus experience lower margins than the 40% long term margins we have modeled.   While this may ultimately have a negative impact on our $5 billion valuation of Zynga, we sense the company is tracking ahead of the $529 million in 2010 revenue we forecasted.   For the moment, we are maintaining our price target.  We further understand that since our initial Zynga research report was published  on April 6th, Zynga’s shares have risen about 50% in the private market, to a high of $14 in a meaningful transaction last week.    However, the rising share price may not be great news to Zynga employees as the company considers limiting employees ability to sell their shares.

On a last, positive note, Zynga filed papers in Delaware two weeks ago authorizing the issuance of an additional 1.9 millions shares of Series B-2 Preferred Stock, at an issue price of $12.87 per share, implying a value of about $4 billion for the company based on the estimated 320 million shares outstanding.  While no deal has been announced, the filing is typical of shares issued around a strategic partnership, with Softbank often mentioned as a good potential partner for Zynga in Japan.

DST Buys ICQ For $187 Million – Did Zuckerberg Miss The Writing On The Wall?

SocialBeat’s Dean Takahashi reports that Digital Sky Technologies (DST) has agreed to pay AOL $187.5 million for ICQ, the largest instant messaging service in Russia, and a number of other markets.  According to Time Warner, ICQ has over 100 million accounts registered, and more than 32 million unique visitors per month, which was started in 1996 by Israeli firm Mirabilis, which AOL acquired for $407 million back in 1998.

While DST for a long time has been an owner in Eastern block countries of significant social media assets, more recently they have become known as a secondary investor in companies like Facebook, Zynga, Groupon and Tencent.  Yuri Milner, CEO of DST, said “the acquisition of ICQ is a strategic enhancement of our business in Russia and Eastern Europe.”

So does this acquisition of ICQ position them as a competitor, or better yet – frenemy, to their existing or future social media investments?  Although DST has been an owner operator largely in the Eastern block countries, and it now appears they have more global aspirations, so it will be interesting to see how the market reacts to DST in future investment opportunities.

In a BusinessWeek interview in February 2010, Yuri Milner says “I am making big investments… You just have to be personally involved.”  He goes on to say, “I’d like to see DST as a significant global investment company in the Internet arena.”

As we understand it, DST hasn’t taken board seats in their late stage deals at companies such as Facebook and Zynga, but its hard to believe that their hundreds of millions of dollars of investment hasn’t yielded them with a wealth of confidential information that Facebook, Zynga and others wouldn’t want their competitor to get a hold of.  And now DST could just be that competitor?

Sure, Facebook and others probably aren’t worried about ICQ as a competitor, but DST has certainly proven that they have access to nearly unlimited capital and they’re willing to pay a premium or above, so what’s next on their acquisition horizon and how much are they willing to pay?  Were they paying premiums in these companies for a strategic reason we didn’t quite see at the time?  Is this something their current or future portfolio companies should be worried about?  Did Mark Zuckerberg miss the writing on the wall?  Tell us what you think.

Should Zynga and LinkedIn Limit Their Employees From Selling Their Stock?

Last week Bloomberg reported that LinkedIn and Zynga may begin placing limits on employee sales of their company shares.  In fact, we’ve heard from investors that new Series A documents will begin implementing similar limitations from the start of their portfolio companies, making it harder for employees to liquidate their stock options that they helped create shareholder value within.

Management at LinkedIn and other hot pre-IPO social media startups hope that by adding limits on employee sales of their shares they can keep employees focused on their business rather than their share price.  However, the reality is that these employees are largely 20-something year olds earning small salaries but may be sitting on shares worth many multiples of their salary, which they are largely responsible for the value creation of those shares.

So, should the companies be adding limitations on their employees ability to sell the shares that they have helped create shareholder value in? This is a challenging question because generally there is a great disparity between the personal financial alignment of management, the investors and the employees working for these companies.  While management and their investors want to keep employees focused on their core business versus the share price, their motives are financially driven to increase the share price for a future exit of the company that they control.  The employees seeking to sell their shares within the secondary market are simply seeking to optimize their wealth position so they can remain more focused on the core business versus their personal financial situation.  Clearly both parties are acting in their own best interest, so how can they align these interests?

The IPO process has slowed and there are fewer exits due to many factors, including Sarbanes Oxley compliance and higher required revenue run rates, particularly for small cap companies.  For many venture backed companies, an acquisition remains a compelling exit strategy.  However, the secondary market has emerged as a new form of an exit for investors, founders and employees, and placing limitations on their employees ability to utilize this form of an exit could be driving misalignment sending the wrong message.

One of the most compelling reasons employees pursue a career in the technology startup industry is the ability to create wealth through their stock options.  A lot of employees will trade a higher paying salary in another industry for a lower paying salary plus stock options at a technology startup for the upside potential of that stock. Depending on how these companies and their investors draft the limitations on the sale of their shares, it may have a negative impact on the talent the technology startup community has been able to recruit.  Or worse, it may engender a lot of ill will.

Companies generally don’t tell their investors when they can sell their shares, in fact, its the VCs who are largely driving the growth in secondary market transactions.  Increasingly, you’ll find enlightened companies will leverage stock options, not restrict them to dramatically improve alignment.   One company we know well, is in the midst of a large raise, in which $5 million is being used to buy back shares from their employees.  However, rather than just purchasing the shares from the employees in a cash transaction, the money will be escrowed for four years, and paid out monthly, if the employee remains with the company.  Also, given the dramatic increase in the employee’s monthly income, the employee must agree to no raises over the four year period.  What’s the net impact?  A happier, more productive employee base, higher retention for the company, and lower costs – and of course, the employees are focused on the business, not the share price.  This appears to be a better path than companies like Zynga & LinkedIn blocking their employees from selling their shares.  But these are early days in the developemnt of the secondary market.  They’ll learn.