As Zynga’s IPO Approaches, a Look Back at Controversies Could Offer Clues to Its Future

If Zynga goes public at what is expected to be a $20 billion valuation, the company will make many people very rich, including a healthy percentage of its roughly 3,000 employees and its earliest venture investors.

The IPO will also turn Zynga founder and CEO Mark Pincus, who owns about 18% of the company, into a multibillionaire.

It’s hard not to be awed by these facts, particularly given that the wealth created by Zynga has come in the midst of an ongoing economic crisis.

Still, anyone who has watched the savvy company evolve over the past four years has probably wondered how it will fare as a public entity. After all, it has come under fire on several occasions for its behavior. The Wall Street Journal dropped the most recent bombshell, reporting that Zynga executives demanded some employees return some shares or be fired.

Zynga declined to comment, citing SEC quiet period rules.

The criticism of Zynga doesn’t appear to have hurt the private company. But one has to wonder if a publicly traded Zynga would be punished if it were discovered to be embroiled in another “Scamville”-type episode. Either way, it’s probably worth revisiting some of the episodes from Zynga’s past for clues about what to expect in the future.

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[slide title=”SPAM”]

Zynga, of course, began its rise by essentially spamming the hell out of people on Facebook.

After getting booted from the Facebook news feed, the company found plenty of other ways to fuel its growth, including having users send game requests to non-users.  Zynga has also built its own, soon-to-launched site dubbed Project Z, which will exclusively host Zynga games. Still, Pincus isn’t above spamming his roughly 1,200 Facebook friends to seed a new game. Invites for one of Zynga’s newest games, CastleVille, were sent from his account earlier this week.

[slide title=”Everything horrible in the book”]

In the spring of 2009, Pincus told an audience of would-be entrepreneurs some of his secrets to success. Among them was his willingness to do “every horrible thing in the book, just to get revenues right away.” One of those horrible things was to give its “users poker chips if they downloaded this zwinky toolbar which was like, I don’t know, I downloaded it once and couldn’t get rid of it.”

It was a stunning public admission by Pincus. On the flip side, you might argue that it was generous of him to talk to those gathered in the first place. (A video of that presentation, held at U.C. Berkeley, is here.)

[slide title=”Scamville”]

In November 2009, TechCrunch founder Michael Arrington dropped a big fat bomb on Facebook and Zynga by reporting how much money was being made off confusing third-party offers to game players. For example, someone playing FarmVille could elect to acquire a new virtual tractor by agreeing to try out Netflix for three months, rather than use her credit card. But many of the offers allegedly tricked users into signing up for recurring subscriptions to services that no one in their right mind would want, prompting Arrington to dub the practice “Scamville.”

How big an issue was it? At the time, Zynga co-founder Andrew Trader told TechCrunch that Zynga “makes about a third of its revenue from advertising and another third from virtual goods transactions. The last third comes from companies that provide commercial offers, trading Netflix memberships and marketing surveys for in-game cash.”

After Arrington’s story hit, Pincus wrote in his blog: “Michael Arrington posted over the weekend about CPA offers within social games and questioned why facebook, myspace, zynga and others would expose these to our users. He raises good points about ‘scammy’ advertisers and the bad user experience they create. I agree with him and others that some of these offers misrepresent and hurt our industry.”

Pincus added that “… we need to be more aggressive and have revised our service level agreements with these providers requiring them to filter and police offers prior to posting on their networks.”

[slide title=”The Andrew Trader Episode”]

Remember Andrew Trader from the previous slide? Well, four months after Arrington’s report, Trader’s title was changed from Executive Vice President of Sales and Business Development to VP of Partnerships and Studio Services. A month after that, Zynga’s co-founder was out the door.

Trader — now a venture partner at Maveron — has never commented publicly about what drove the split, but Pincus’s chilly response suggested that little love was lost. “AT [Andrew Trader] and Zynga have parted ways. He made an awesome contribution. We need to continue scaling the company,” said Pincus at the time.

[slide title=”70-to-1 voting power”]

In late August, Zynga amended its stock structure to give Pincus an astonishing 70 times more voting power than people who buy the company’s shares in its eventual IPO. The amendment also calls for current shareholders and pre-IPO investors to have seven votes per share.

No one has had much to say about the new structure, but they may eventually. “While management ownership of equity is a good thing as measured by enhanced firm value, the greater wedges between voting rights and ownership share are actually detrimental to firm value,” Harvard business professor Josh Lerner said to me in September.

Of course, public market investors can always choose not to buy the stock if they’re really nervous about it. As an IPO specialist told me in September: “I do think investors should be concerned. But [buying stock] in the company is investors’ own decision. I guess they either trust the whole shebang to [Pincus] or they don’t.”

[slide title=”Zyngametrics”]

As DealBook observed this fall, Zynga has been using a Zynga-created metric to highlight its high growth while downplaying sliding profits.

It’s a very big deal, according to PrivCo, a New York-based research company that focuses on private companies. The accounting treatment, which centers on how long Zynga’s virtual goods have a “useful life,” has dressed up Zynga’s numbers and its IPO, PrivCo says. PrivCo published a report in September that said its analysis of a Zynga SEC filing showed Zynga’s “first ever usage declines.”

PrivCo founder Sam Hamadeh explained to me on Wednesday: “For 2011, Zynga declared, without any apparent reason, to deem its virtual goods — virtual tractors, fertilizer, tanks and such — to have a ‘useful life’ of just 15 months, rather than the 18 months in 2010.” In Hamadeh’s view, Zynga “just decided that it wanted to recognize its revenue faster to make its 2011 numbers look better.”

A source close to Zynga argues that’s hardly the case. He attributes the decision to alter Zynga’s accounting metrics to SEC requests to do so. “The SEC basically said, ‘We need you to look at how you advertise your revenue; you have to go back and figure out which parts are durable and which are consumer consumable and you have to do as much as you can to figure out the lifetime value of a gamer,'” the source said. He adds: “These are absolutely not decisions made to move Zynga’s profits or revenue in a particular way.”

In the end, says Hamadeh, the accounting change basically means that whereas Zynga booked just $1 per month in 2010 for a virtual good that sold for $18, it now it books $1 every 15 months, or $1.20 per month, which equals $14.40 more for the year. Hamadeh says the change added $48.5 million in revenue for 2011.

And while Zynga doesn’t spell out the impact on net income in its filings, PrivCo crunched the numbers and says the accounting change resulted in Zynga showing a profit of $30.7 million for the first nine months of this year. “Zynga net income for the first nine months of 2011 without the accounting maneuver? A $9.7 million loss,” Hamadeh says.

[slide title=”Zynga’s Stock Reclamation Project”]

Last week, Zynga found itself to be the subject of more criticism in a story by the Wall Street Journal. According to the story, “Early last year, as Mr. Pincus began preparing to take Zynga public, he and several other executives decided the company had doled out too many stock rights to certain people in its early days, say people familiar with the matter. The executives chose an unusual solution: They began demanding that certain employees surrender some shares or be fired.”

Pincus quickly maligned the story. In a memo leaked to Fortune.com hours after the WSJ story began to spread, Pincus told Zynga employees:

The wall street journal posted a story last night (copied below) which paints our meritocracy in a false and skewed light. The story is based on hearsay and innuendo which is disappointing but is to be expected as we move towards becoming a public company.

We have nothing to hide in our past and present policies and I am proud of the ethical and fair way that we’ve built this company.  As many of you have heard me say — we’re building a house that we want to live in.

Being a meritocracy is one of our core values and it’s on our walls.  We believe that every employee deserves the same opportunity to lead. Its not about where or when you enter zynga its how far you can grow. This is what our culture of leveling up is all about and its one of our coolest features.

we want everyone to put zynga first and contribute to the overall success of our company and all of you have.

It’s not clear what Pincus means by “leveling up,” but a source close to the company tells me that the practice is “not just [restricted to] a few isolated cases.”

The same source says that those employees, some of whom have had millions of dollars worth of shares yanked from them, have mostly stayed on because they’re still expecting a very big payout when the company goes public.

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