Looking at the Zynga IPO, A Patent and Business Perspective

After weeks of speculation Zynga, the company known for creating such social games as Farmville, Empires & Allies and Hanging with Friends, has filed for an Initial Public Offering (IPO). The company is expected to raise $2 billion in the IPO, which would create a valuation for the business in the neighborhood of $20 billion.

Zynga, founded in 2007, is the world’s leading social game developer with 232 million average mean monthly active users (MAUs) in 166 different countries. Zynga has launched the most successful social games in the industry in each of the last three years and has generated over $1.5 billion in cumulative bookings.  According to the company they have generated positive operating cash flow since the fall of 2007. During the first quarter of 2011, 94% of Zynga’s $235 million in revenue came from virtual goods, while the remainder was generated by advertising.

The question remains in the mind of many, however, whether Zynga is a company worth investing in given its near complete dependence on Facebook for revenue. If you actually read the Zynga S-1 filed with the Securities and Exchange Commission you will likely be scared out of your wits by the risk the company lays out in exceptional detail. Facebook is the primary distribution, marketing, promotion and payment platform for Zynga games, and the company generates substantially all of its revenue and players through the Facebook platform. Not exactly the kind of diversification that one would wish for, making Zynga completely dependent upon existing Facebook agreements and the extension thereof.

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You will likely also be underwhelmed by their IP portfolio, particularly their patent portfolio, and the admissions that there are many large competitors in the industry, as well as many patents that cover the very core of social gaming.

From a business standpoint, one of the biggest problems for Zynga is the reality that most social games are free to play and only generate revenue through the in-game sale of virtual goods. This point leads to several issues to consider. First, is the hefty percentage taken off the top by Facebook. In July 2010, Zynga began migrating to Facebook Credits as the primary payment method for games played through Facebook, and by April 2011 the company had completed this migration. Facebook remits 70% of the face value of Facebook Credits purchased by Zynga players for use in games played through Facebook. In other words, they keep 30% of Zynga revenues for the privilege of the partnership. Don’t get me wrong, that is probably a reasonable deal given the reach of Facebook and the fact that virtually all of Zynga revenues comes from Facebook, but 30% seems high.

In terms of patent protection, according to the company they actively seek patent protection covering inventions originating from the company and acquire patents believed to be useful or relevant to its business model. Zynga claims to currently own one issued U.S. patent which expires in 2021 and 78 patent applications pending worldwide. A search of U.S. patent records shows the company owns U.S. Patent 6,884,172, as well as two pending patent applications — U.S. Patent Application No. 20100045670 and U.S. Patent Application 20100227675.

The ‘172 patent relates to an invention that permits a user on a connected device to interact with a persistent game world. According to the patent, the user may be playing a game any type of connected device, either wired or wireless, such as wireless phones, personal digital assistants (PDAs), personal computers, etc. The game world allows for multi-user capability, including users on a wide variety of platforms, so that users can play each other, even if they are on different types of devices. The user also experiences a persistent game world, so that if the user is disconnected, either voluntarily or involuntarily, the user can return to a game world that is consistent with what they would expect, such as the exact same game world or a game world that has advanced in a reasonable fashion.

Claim 1 of the ‘172 patent, which is the broadest method claim, really is just that — very broad.  It covers:

1. A method of playing a game on a server by a user on multiple client devices, the game containing a persistent game world, comprising: establishing a game state on a game engine running on the server, wherein the game engine includes a protocol handler that supports multiple content protocols simultaneously and facilitates communication between the multiple client devices and the game engine; disconnecting from the game on the server at a time when the user is at a particular state of the game, wherein the disconnection ends a first session, wherein the first session is played on a first client device having a first device type, and wherein the first client device and the game engine communicate using a first protocol; reconnecting to the game at a later time; transmitting identifying information to the server; and playing the game in a second session, wherein the state of the game at the beginning of the second session is based on the state of the game at the end of the first session, wherein the second session is played on a second client device having a second device type, and wherein the second client device and the server communicate using a second protocol that is distinct from the first.

The patent, issued on April 26, 2005, has a priority date of October 25, 2000, making the priority date quite old, the coverage quite broad and not nearly as easy to invalidate as many will want to believe.  Nevertheless, it does quite broadly cover social gaming.

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The ‘670 Patent Application covers the rendering of three-dimensional objects on a two-dimensional display screen, but it is the ‘675 Patent Application that should capture the attention of most because it seeks to cover the way that Zynga monetizes its social games.

The ‘675 Patent Application relates to a multiplayer online game system where players within the game can acquire virtual currency. Such virtual currency represents units of value for use in the online game system, and is analogous to legal currency. This virtual currency, which cannot be redeemed for legal currency, can be purchased in actual cash or credit transactions by a player. Virtual currency can also be earned by the players. This virtual currency, once acquired, can then be used in multiplayer online games.

The ‘675 Patent Application was filed on March 3, 2010, and claims priority of a provisional patent application filed on March 6, 2009. The application continues to await substantive consideration by a patent examiner, and likely will continue to wait for another two years or so. Nevertheless, the broadest method claim, Claim 1, seeks coverage for:

A method, comprising: receiving, at a server, a purchase order for virtual currency from a player, wherein the purchase order was made with legal currency, and wherein the virtual currency is usable within the context of a computer-implemented game; crediting an account of the player with virtual currency, wherein the virtual currency is not redeemable for legal currency; receiving a second purchase order for a virtual object within the context of the computer-implemented game from the player, wherein the second purchase order was made with virtual currency; and debiting the account of the player based on the second purchase order.

While I have not done any kind of patent search myself it is my educated guess that there will be quite a lot of prior art and any claim issued will be substantially less broad.

As can be seen, the Zynga patent portfolio is quite weak, which means investors cannot be going into any acquisition of Zynga stock in the IPO with any real belief there is a meaningful competitive advantage as the result of significant intellectual property protections.  Nevertheless, the S-1 files does explain:

We regard the protection of our trade secrets, copyrights, trademarks, trade dress, domain names and other product rights as critical to our success. We strive to protect our intellectual property rights by relying on federal, state and common law rights, as well as contractual restrictions. We enter into confidentiality and invention assignment agreements with our employees and contractors and confidentiality agreements with parties with whom we conduct business in order to limit access to, and disclosure and use of, our proprietary information. However, these contractual arrangements and the other steps we have taken to protect our intellectual property may not prevent the misappropriation of our proprietary information or deter independent development of similar technologies by others.

We pursue the registration of our domain names, trademarks, and service marks in the United States and in certain locations outside the United States. We are seeking to protect our trademarks, patents and domain names in an increasing number of jurisdictions, a process that is expensive and time-consuming and may not be successful or which we may not pursue in every location. We may, over time, increase our investment in protecting our innovations through increased patent filings that are expensive and time-consuming and may not result in issued patents that can be effectively enforced.

Notwithstanding, the worldwide market for the sale of virtual goods was $7.3 billion in 2010 and is expected to more than double by 2014, which will likely be lure with great gravitational pull.  But before you do jump in feet first despite a weak patent position and complete and utter dependence on Facebook, take a look at the “risk factors” identified by Zynga in the S-1 filing:

• if the company is unable to maintain a good relationship with Facebook, business will suffer;
• social gaming is a new and rapidly changing industry, which makes it difficult to evaluate our business and prospects;
• the business model is new and has a short operating history, which makes it difficult to evaluate prospects and future financial results;
• the company relies on a small percentage of players for nearly all revenue;
• a small number of games have generated a majority of revenue;
• a significant majority of game traffic is hosted by a single vendor, and any failure or significant interruption in the network could impact operations and harm the business;
• security breaches, computer viruses and computer hacking attacks could harm business and results of operations;
• growth prospects will suffer if unable to develop successful games for mobile platforms;

Indeed, the social game industry is highly competitive, with low barriers to entry and Zynga as a weak patent position at best.  The company in the S-1 filed with the SEC says it expects more companies to enter the sector and a wider range of social games to be introduced. Current competitors vary in size and include publicly-traded companies such as Electronic Arts Inc./Playfish Inc. and The Walt Disney Company/Playdom Inc. and privately-held companies such as Crowdstar, Inc., Popcap Games, Inc., Vostu, Ltd. and wooga GmbH. In addition, high-profile companies with significant online presences that to date have not developed social games, such as Amazon.com, Google Inc., Microsoft Corporation and Yahoo! Inc., may decide to develop social games, which would obviously cut into Zynga’s profits and growth.  Of course, if Facebook were to decide to develop their own social games that would virtually, and likely irrevocably, cripple Zynga.

Of course, Zynga will also inevitably be the target of patent infringement litigations moving forward.  In fact, the S-1 filed explains it has already faced allegations associated with the infringed of trademarks, copyrights, patents and other intellectual property rights of third parties. Flush with cash coming off an IPO look for that to only increase.

In terms of a prediction? If investors continue to dream of unrealistic returns many grew accustomed to in the 1990s leading up to the dot-com bubble, then it would seem likely the Zynga stock will go on a meteoric rise opening day, akin to what recently happened with the LinkedIn IPO. See What Does the LinkedIn IPO Mean for Economy, Jobs? and LinkedIn IPO Huge Success, Valuation of $8.79 Billion. I just see too much doubt on the horizon for Zynga, I am completely turned off by the total dependence on Facebook and see no reason to be excited by a patent portfolio but know Zynga will be a huge target for the likes of the non-practicing entities (aka patent trolls).  I am going to sit this one out and watch from afar.  I do expect it to be interesting though.