Umair Haque / Bubblegeneration
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Design principles for 21st century companies, markets, and economies. Foreword by Gary Hamel. Coming January 4th. Pre-order at Amazon.

Saturday, September 11, 2010

Five Reasons I Wouldn't Have Invested in Zynga

It’s Silicon Valley’s latest darling, full of promise and potential, the new enfant terrible on the block. Or is it just terrible? Here’s a quick take on why I wouldn’t have invested in Zynga.

NB - You can see Fred's response - he was one of the original investors - in the comments below, disagreeing and criticizing. I think all his points are probably much more interesting than mine.

1. Product and Platform Risk

Zynga’s dependent on the latest, greatest blockbuster game. Just as venture investors rarely invest in movie studios, because they’re rife with the mega risk of a single failed project, so Zynga’s got to keep on churning out the hits. Or imitating them, rapidly, consistently, frequently, and frictionlessly, from others. If it can’t, then it’s in a bind: it’s got to go right back to the grindstone, and try, try, try again. That’s vastly different from a business where’s there’s a steady supply of products and services for which there’s ongoing demand. Then, of course, there's monopsony: the fact that Zynga's in a poor strategic position, heavily dependent on a single buyer, or platform, Facebook, to reach it's market. That means, of course, that should Zynga fail to deliver even a single hit, it's monopsonist can extract maximum concessions from it. No one wants to be dependent on a single platform, after all - but Zynga is.

2. Market risk

Zynga’s market isn’t just gamers. It’s the least profitable, least loyal, least sophisticated segment of gamers – casual gamers. Now, I don’t say that to disparage people. But when we fund a great business, what we want is sophisticated customers, who’ll pay significantly more for innovative products and services – not just people who are highly sensitive to price, willing to bid the lowest for the lowest common denominator, and willing to defect to a rival for a penny less. Unfortunately, Zynga’s economics resemble the second more than the first. Consider, for example, Zynga's ongoing problem with customer complaints - hard-to-please, easy-to-anger customers more interested in instant gratification than with shared experiences are how many businesses end up with decent revenues, but poor margins - because service and marketing costs quickly spiral out of control.

3. Business model risk

Zynga’s got a great set of revenue streams, right? Wrong. Half or more of its ad revenues flow from “offers”, which are in turn dependent on a tangled web of middlemen, all of whom are angling for their own cut. Selling virtual goods is interesting, right? Wrong. It’s just about as interesting as selling physical “product” – an industrial age revenue stream in disguise, rife with rapid commoditization, marketing expenditure, price wars, and with none of the upsides of services. And traditional banner advertising – well, that’s a low-margin, high risk, commoditized revenue stream to begin with. Zynga’s business model is more like the combination of mystery meat that goes into a fast food burger than fine cuisine.

4. Deep risk

Zynga’s games benefit little, if at all, from truly 21st century economics. There’s little higher purpose, that commands higher margins. There’s little, if any network effects, to drive network economies and increasing marginal utility, and softly lock people in. And there are few viral meaningful effects at work. The deep economics of Zynga are more like a risk-dominated, low-margin, high-volume, high-velocity, capital hungry subprime lender than like, say, a search engine.

5. Macro risk

Would you invest in a business that extracts value, rather than creates it – that fails to make people better off in tangible, enduring ways? In that case, here’s the countercyclical bet you’d be making, in reality: that you could prosper while everyone else faltered. That’s essentially the bet at the heart of Zynga. Is it a bet worth taking? Well, that depends just how dire the economic situation is. Today, it looks like we’re in the midst of a Great Stagnation – and it’s questionable just how long value-extractive business can extract value from people who don’t have much left to give in the first place.

Here’s how I’d summarize it. There’s a lot to like about Zynga. It’s original vision of an open platform for mini-games was interesting and compelling. But Zynga, is a little bit like the venture equivalent of subprime debt. You might get a steep return – but only at a steeper than usual risk. The art of investing, of course, isn’t just about assuming risk willy nilly – but evading, neutralizing, and vaporizing the downside, and doing exactly the reverse to the upside.

So I wouldn’t have invested in Zynga for a simple reason. No matter how much cash a business it generates today, the first measure of a great business is how much real economic value it has the potential to create over it’s lifetime. The second is how much of value is net new marginal value - value that's created for, not just extracted from. And I can think of quite a few companies that fit that bill just a little better.

-- umair // 1:46 PM // 6 comments



you are wrong about a number of things in this post

first, offers represent a tiny portion of zynga's revenues. nowhere near 50 percent.

second, what zynga does is it offers entertainment for free for most of its users and for those who do choose to "power up" with paid tools like tractors and such, the monthly cost of the entertainment is way less than traditional video games, movies, music, and pretty much any other popular form of entertainment

when many people in the developed world are facing the prospect of less income, less wealth, and need to make ends meet, low cost high value entertainment is a great benefit to them

and it is a great and highly sustainable investment opportunity

i did invest in Zynga and it is the best investment i have ever made in twenty five years of venture capital investing
// Blogger fred // 2:03 PM

Umair, I think you were correct in the first place, although you probably missed the portion of offers (which is a side issue).

I do not dismiss entertainment, but the point about people losing income in a recession/depression is pathetic. The valuable enterprises will lead us out of the hole.

Plus, there's Zynga's "idea" strategy:
// Anonymous Anonymous // 2:51 PM

During the week I saw this said on Twitter "If the product is free to use, you are the product". In such freemium models it's usually specific data you produce in your use that is useful to the premium user or third parties.

The second point Is that maybe FV is a horizontal layer of "social grooming", casual, gestural, meaningful in a tertiary ties kind of way. It has lots of potential to demonstrate the effect of collective action by showing us "how easy it is to fix a flooded field, get clean water to a town etc".

It's just that we are learning that the FV company culture is the usual billion dollar cut throat business culture that has made great companies such as PayPal, and Skype. Can you see where that point is going?
// Blogger Unknown // 3:48 PM

Might be a good investment, but is it good for society?

// Anonymous Anonymous // 5:58 PM

@fred "low cost high value entertainment" hum... low cost yes but, come on, it's crazy to call that high value entertainment ! Many poeple seems to be playing from work to escape meaningless jobs (i'm working for an offer provider and revenues are at their highest during office hours...and drop during the WE - at least for Facebook apps).

People are so depressed they would do anything to forget about it, starting with "clicking"
What value do they get from farmville ??

Hey poeple, stop complaining about not having enough money to live correctly, you can play Farmville for free !!
// Anonymous Mael // 1:47 AM

I'd love to hear Umair and Fred discuss this AFTER reading this post by Alex St. John:
// Blogger Unknown // 11:11 PM
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