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Zynga’s Reliance on Facebook for Sales Spooks Some Investors as IPO Nears

Zynga Inc. has become the most valuable U.S. video-game company by relying on Facebook Inc. to reach users. Now it has to convince investors that its dependence on the social network won’t hinder growth.

Zynga, maker of social games such as “FarmVille” and “CityVille,” said yesterday it will raise $1 billion in an initial public offering, becoming the latest social-media company to announce plans for an IPO.

Founded by Mark Pincus in 2007, San Francisco-based Zynga is the biggest application developer on Facebook, with the four most popular games and eight times the number of users as its closest competitor. Facebook accounted for “substantially all” of Zynga’s $235.4 million in first-quarter sales, which may concern investors because so much of Zynga’s future is at the mercy of decisions made by Facebook.

“It’s a double-edged sword,” said Scott Rostan, a former banker and founder of Training the Street Inc., a New York-based firm that provides educational services for the finance industry. “You’re riding that wave of Facebook and its user base, but the danger would be if Facebook says, ‘Why can’t we capture more of that revenue ourselves?’”

Zynga said in its IPO filing yesterday that revenue surged almost fivefold in 2010 to $597.5 million, compared with 2009. The company also turned profitable last year, recording net income of $90.6 million, following a loss of $52.8 million.

Virtual Goods

Zynga games are free to play, with the company making money from selling virtual items within apps, such as a townhouse in “CityVille” or a shipyard in “Empires & Allies.” The worldwide virtual-goods market will more than double to $20.3 billion in 2014, from $9.28 billion last year, according to ThinkEquity LLC, a San Francisco-based research firm.

While Zynga has developed games for Apple Inc. (AAPL)’s iPhone and iPad, Google Inc.’s Android phones and Yahoo! Inc.’s game site, it has struggled to make money outside Facebook.

“Any deterioration in our relationship with Facebook would harm our business,” as well as stockholders, Zynga said in the risk factors section of its filing. Specific risks include: Facebook limiting the access of game developers, modification of terms of service, favorable treatment toward Zynga’s rivals and the possibility of Facebook building its own games.

Still, Zynga is valued at $15.4 billion on secondary exchange SharesPost Inc., topping Activision Blizzard Inc. (ATVI) and Electronic Arts Inc. (ERTS), which are worth $13.5 billion and $8 billion, respectively, on the Nasdaq Stock Market. Public market investors may balk at that price, said Ken Smith, a money manager at Munder Capital Management in Birmingham, Michigan.

Many Questions

“Expectations will be high, but I think there will be a lot of questions about the sustainability of the business model,” said Smith, whose firm manages about $15 billion. Dependence on Facebook “adds a large element of risk to the business that, I think, will hold back the valuation investors are willing to give it.”

Facebook currently gets 30 percent of all virtual-goods purchases made within games, through a payment system called Facebook Credits, which was rolled out across the social network last year. Facebook and Zynga forged a five-year agreement to use Credits exclusively in most games.

Zynga’s business model has yet to scare away some of the biggest mutual fund companies. T. Rowe Price Group Inc. and Fidelity Investments disclosed this year that they bought stakes in the company. The firms invested at a valuation of close to $10 billion, people familiar with the matter said in February.

‘Big Ecosystem’

“Facebook is going to build a big ecosystem for a range of applications and has proved there will be big, sustainable businesses on the platform,” said Rick Heitzmann, a managing director at FirstMark Capital LLC in New York, who invests in gaming startups. “I don’t think there will be a huge risk to Zynga.”

Pincus, 45, is Zynga’s chief executive officer and the biggest owner of stock, controlling 16 percent of Class B shares, according to the filing. Kleiner Perkins Caufield & Byers owns 11 percent and is the largest outside shareholder, followed by Institutional Venture Partners, Foundry Group and Avalon Ventures, which each own 6.1 percent.

Should Zynga raise $1 billion, it would be the largest IPO for a U.S. Internet company since Google Inc. (GOOG) in 2004. The offering follows the initial share sales of professional networking site LinkedIn Corp. in May and Web-music service Pandora Media Inc. in June. HomeAway Inc., the vacation-rental website operator, went public this week, and online coupon site Groupon Inc. filed for its IPO last month.

IPO ‘Hysteria’

Zynga’s IPO will be managed by Morgan Stanley, Goldman Sachs Group Inc. (GS), Bank of America Corp., Barclays Plc, JPMorgan Chase & Co. and Allen & Co., according to the filing. The company didn’t say how many shares it would sell or at what price.

Fifty-three Internet companies have filed for U.S. IPOs so far this year, the most since 164 companies in the industry announced plans for initial offerings in the U.S. during all of 2000, data compiled by Bloomberg show.

“Zynga is taking advantage of the hysteria right now around social networking,” said Michael Yoshikami, chief investment strategist at YCMNet Advisors, which manages $1.1 billion in Walnut Creek, California. “The valuation of $15 to $20 billion is extremely generous and they’re going to have to execute spectacularly in order to justify that valuation.”