CASE: EC-39 DATE: 09/15/10

SOCIAL GAMES

The social games market potential seems truly stunning. Assuming ½ of the Internet world may end up on and ½ of those Facebook users will try a social game at some point, we can say that ¼ of the online world is an approachable market. Yet only 1 to 3 percent of players of social games tend to be monetized, so we’re still at the tip of the iceberg in terms of revenue opportunity.

—Tim Chang, principal Norwest Venture Partners

In November 2009, 70 million people played a game called FarmVille on Facebook where players could pretend to be a virtual farmer, planting and harvesting fruits and vegetables and moving up to other levels by inviting their Facebook friends to be their neighbors. Similarly, 26 million active users per month played a game called on Facebook where players could start a mafia family with friends, run multiple crime “businesses,” then fight to be the ruling family (Exhibit 1). These types of popular online games were called “social games,” games people played on social networks like Facebook, MySpace, Hi5, Orkut, and , with the key motive of socializing with friends and/or meeting new people, with Facebook as the dominant social network in the social gaming space. Social games were generally simple games that anyone could play. Unlike traditional video games, they were less about “killer graphics and quicksilver hand-eye coordination, and more about connecting with friends.”1 And because the mainstream was being lured into social gaming, it was becoming the fastest-growing game market, increasingly popular on social networking sites.

1 Sarah Lacy, “Social Gaming Scores in the Recession,” BusinessWeek, May 1, 2009.

Victoria Chang and Professor Haim Mendelson prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation. Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved. To order copies or request permission to reproduce materials, e-mail the Case Writing Office at: [email protected] or write: Case Writing Office, Stanford Graduate School of Business, 518 Memorial Way, Stanford University, Stanford, CA 94305-5015. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means –– electronic, mechanical, photocopying, recording, or otherwise –– without the permission of the Stanford Graduate DoSchool of Business. Not Ever y effor t has been made Copy t o r espect copyr i ght and t o cont act copyror i ght hol der s as Postappr opr i at e. I f you ar e a copyr i ght hol der and have concer ns about any mat er i al appear i ng i n t hi s case st udy, pl ease cont act t he Case Wr i t i ng Offi ce at [email protected] anfor d.edu.

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By 2009, social gaming was expected to grow to 250 million players, up from 50 million just one year prior.2 By July 2009, an estimated 14,000 social games had proliferated across various social networking platforms.3 Traditional companies were losing top executives to the sector; for example, in June 2009, the COO of game publisher left his post to become CEO of social gaming company Playdom. In November 2009, Electronic Arts agreed to pay up to $400 million4 to acquire social game company , which was reportedly “substantially profitable.”5 While the financial statements of social game developers were not available, others claimed to be profitable as well, and -based social gaming leader was reported to have annual revenues of $200 million or more (up to half a billion dollars by some estimates).6 The total U.S. social gaming market was estimated to be anywhere between $300 and $500 million, possibly even exceeding Facebook’s own revenue (Exhibit 2).7 Mountain View-based Playdom, another major player, was reportedly generating more than $50 million in annual revenues. And more than 10 million people had downloaded Palo Alto-based Social Gaming Network’s (SGN) iPhone and iPod Touch games, with more than a million people playing its games across social networks daily.8 The engine behind these revenues was “virtual goods” or virtual objects such as characters, items like pets and accessories, currencies, and tokens that social game players could buy with real money in order to enhance their play.

U.S.-based social gaming companies had created wildly popular games and applications like Mafia Wars, Sorority Life, Pet Society, and TouchPets, on social networks and other platforms such as the iPhone. In the meantime, Chinese messaging and communications company Tencent, as well as other Asian companies, were already well on their way to monetizing their users. The global market size for virtual goods was estimated to be more than $3 billion in 2010, possibly even as high as $5 billion.9 Selling virtual goods had become a major source of revenues in the online social world in China, accounting for about three-quarters of overall online game revenues.10

2 Ibid. 3 “Social Gaming Turns Two,” Virtual Goods Insider, July 6, 2009, www.virtualgoodsinsider.com/2009/07/06/social-gaming-turns-two/ (June 14, 2010). 4About $300 million in cash and retention arrangements and an earn-out (payment contingent on future performance metrics) of $100 million. 5 Tameka Kee, “Interview: Playfish COO de Halleux On How Facebook Has Changed Gaming Forever,” PaidContent.org, September 18, 2009, http://paidcontent.org/article/419-interview-playfish-coo-de-halleux-on- how-facebook-has-changed-gaming-fo/ (June 14, 2010). 6 Eric Eldon, “The Latest Stats on Zynga: New Traffic, Revenue and a $1 Billion Valuation?” Inside Social Games, November 23, 2009, http://www.insidesocialgames.com/2009/11/23/the-latest-stats-on-zynga-new-traffic-revenue- and-a-1-billion-valuation/ (June 14, 2010). 7 Zynga’s CEO Mark Pincus assumed that there would be 1 billion people on social networks over the next three to five years. Assuming that one-quarter of those people would engage in games, then there would be 250 million people that could be monetized anywhere from $1 to $3 per user per year. Atul Bagga, “Social Games: Interview with the CEO of Zynga,” ThinkEquity, February 24, 2009, p. 3. 8 Sarah Lacy, “Social Gaming Scores in the Recession,” BusinessWeek, May 1, 2009. 9 In July 2009, Piper Jaffray estimated the 2010 global market size at 3.1 billion, and others had higher estimates. See, e.g., T. Lehtiniemi V. Lehdonvirta, “How Big is the RMT Market Anyway?” Virtual Economy Research Network, March 3, 2007. http://www.insidesocialgames.com/2009/04/20/virtual-goods-booming-in-asia-25x- bigger-than-american-market/ and http://www.plus8star.com/. Do10 “Online Gaming,” Not Nomura Securities , JanuaryCopy 2009. or Post

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By the middle of 2010, social gaming had gone from being considered the “wild west” of gaming to being hailed as a bright spot in the gaming industry, which was suffering from the recession. The world of social gaming was exciting and had an open-ended future. As the industry continued to grow and develop, U.S. social games players had their eyes on Asia, where companies had invented new monetization models, new platforms, and new game content. They also had begun to worry about how to grow, whether being expansion into other social networks beyond Facebook, launching their own destinations sites (e.g. Zynga.com), going international into other social networks that already existed around the world, or expansion into other platforms such as mobile.

SOCIAL NETWORKS BACKGROUND

Social networks like Facebook and MySpace focused on building online communities of people who shared interests, activities, or backgrounds. A study by Deloitte suggested that 56 percent of working visited social network sites at least once a month. Over 80 percent of those that used social networks visited them more than once a month.11 The two major social networks were Facebook and MySpace, with traffic at the former increasing quickly. Facebook caught up with MySpace worldwide in April 2008, with 115 monthly unique visitors each, and in the U.S. in May 2009, with 70 million unique visitors each. By December 2009, Facebook had more than 100 million U.S. unique visitors, about twice the number for MySpace. Neither player charged users for services on their sites, but generated revenues mainly through advertising, although their advertising woes have been widely discussed.12 Other major social networks included Bebo, Hi5, , LinkedIn, and Classmates.com.

Facebook and MySpace

In 2004, Harvard student and other classmates, , , and founded Facebook. According to the company’s website: “Facebook is a social utility that helps people communicate more efficiently with their friends, family, and coworkers. The company develops technologies that facilitate the sharing of information through the , the digital mapping of people’s real-world social connections. Anyone can sign up for Facebook and interact with the people they know in a trusted environment.”13 Facebook users could create and update personal profiles, add friends, send them messages, receive status updates about them, share information with them and join networks based on common interests or background. In December 2009, the average Facebook user had 130 friends.14

Facebook was initially limited to Harvard students only, but expanded to Boston area colleges, the Ivy League schools, Stanford University, then any university student, high school students, and finally anyone aged 13 and above. By December 2009, Facebook had more than 350 million active users, of which more than two-thirds were outside of college. In fact, the fastest-growing

11 Gene Munster, Michael Olson, Douglas Clinton, Andrew Murphy, and Nicholas Gallus, “Pay to Play: Paid Internet Services,” Piper Jaffray, July 2009, p. 6. 12 “Facebook Takes a Dive: Why Social Networks Are Bad Businesses,” TIME, April 1, 2009, http://www.time.com/time/business/article/0,8599,1888796,00.html (6/14/10). 13 “Factsheet,” Facebook, http://www.facebook.com/press/info.php?factsheet (6/14/10). Do14 “Statistics,” FacebookNot, http://www.facebook.com/press Copy/info.php?statistics (6/14/10).or Post

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demographic was people over 35 years old. Moreover, the majority (70 percent) of Facebook users were not in the .15

MySpace was founded in 2004 by former eUniverse employees, Brad Greenspan, Chris DeWolfe, Josh Berman, and Tom Anderson. It started as a technology company connecting people through personal expression, content, and culture, with an emphasis on music. MySpace was acquired by News Corp. in October 2005. MySpace was the most popular social networking site in the U.S. from 2006 to 2009, when it was overtaken by Facebook.16 In April 2009, News Corp. hired away from Facebook to run MySpace. MySpace promptly halted its global growth and changed the site’s focus. According to Van Natta, MySpace was no longer interested in competing with Facebook: “We’re very focused on a different space…. [MySpace will be] the place where content gets socialized…. If you and I had never met before but had similar tastes in music, I can connect with you on MySpace and discover that you like movies and TV shows that I hadn’t discovered yet. MySpace can foster discovery in a way that others can’t.”17

Social Network Platforms and Applications

In May 2007, with one stroke, Facebook changed the world of social networking, becoming a technology platform on which anyone could build applications for social computing, including gaming companies and developers. This platform enabled companies and/or developers to deeply integrate with Facebook, gaining access to millions of users. According to the Facebook website: the “is a part of millions of people’s lives all around the world providing unparalleled distribution potential for applications and the opportunity to build a business that is highly relevant to people’s lives.”18 The Facebook Platform enabled developers to serve their own advertising within their applications and keep 100 percent of the revenue.

The day of the announcement, 65 partner companies unveiled more than 85 additional applications that Facebook users could install immediately. In 2007, Zuckerberg discussed his rationale behind the Facebook Platform: “We want to make Facebook into something of an operating system so you can run full applications.”19 Zuckerberg likened the Facebook Platform to the Windows platform where outsiders could write programs for Windows, not needing permission or relationships with Microsoft. By late 2009, more than a million developers and entrepreneurs from more than 180 countries had written programs for Facebook. There were more than 350,000 active applications on the Facebook Platform. In fact, the growth of applications led to the direct growth of Facebook users, as well as an increase in user engagement, as users spent more and more time on Facebook. Zuckerberg and Facebook never imagined that social games would explode as much as they did; rather, they had thought that

15 Ibid. 16 Facebook overtook MySpace worldwide in 2008. 17 “The Rise and Fall of MySpace,” The Financial Times, December 4, 2009. 18 “Factsheet,” Facebook, op. cit. 19 “Exclusive: Facebook’s New Face,” Fortune, CNNMoney.com, May 25, 2007, http://money.cnn.com/2007/05/24/technology/fastforward_facebook.fortune/index.htm?postversion=2007052511 Do(June 14, 2010 ).Not Copy or Post

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utility-oriented applications like educational applications or recruiting applications would be the primary drivers of application growth.20

In November 2007, Google announced OpenSocial, an open social networking platform that directly competed with the Facebook Platform. Third-party developers and engineers could access most of the core data of any participating social network such as profile information, friend list, activity history, etc. Unlike the Facebook Platform, which was proprietary, OpenSocial used open standards such as XML, HTML and Javascript. MySpace and all other major social networks, other than Facebook, joined the OpenSocial Foundation. Among application developers, however, OpenSocial adoption lagged significantly behind the Facebook Platform.

SOCIAL GAMES

Social games had their roots in casual games, where users usually played alone and sometimes paid a small fee to download games. Unlike casual games, though, social games were meant for sharing (multiplayer) with friends through social networks (and other platforms like iPhone and Twitter). Games were often designed to enable and encourage users to invite friends to interact with each other, taking advantage of the “social graph” or a map of people and how they are related. Some social games were more “social” than others. For example, Zynga’s Texas Hold’Em Poker had some social aspects like chatting, but players usually played with strangers. Mob Wars and mob games were more intimately social because users did better if they could get more friends to join their clan.

To play social games, users did not need to be online all the time. In fact, social games were often “asynchronous,” meaning players took turns and played whenever they wanted to, mostly because social game players typically did not spend enough time playing games on social networks to directly interact with their friends, who might not be online at the same time. Social games were typically free-to-play (F2P/FTP) and their business model will be discussed in further detail below. Due to the casual nature of social games, the scope of gaming naturally broadened beyond the core gaming audience (in the past, 15 to 30 year-old males) to encompass women, the elderly, and younger players.21

Hugh de Loayza, vice president of business development at Zynga, characterized social games and their players: “[Social] games are not destinations, social networks are not portals. Games are places that people go to spend time within social networks—and not a lot of time at that. You’re going to come in for 5 to 10 minutes to see what your friends are doing, play for a few minutes, and you’re off.”22 Tim Chang, principal at Norwest Ventures, called this phenomenon “snack gaming.” When asked, “Why social games?,” Mark Pincus, CEO of Zynga, said: “We are enabling consumers to have a fundamentally new gaming experience. For the first time ever,

20 “Video from Talk at SGS Social Gaming Industry Overview and Update, Inside Social Games, August 11, 2009, http://www.insidesocialgames.com/2009/08/11/video-from-talk-at-sgs-social-gaming-industry-overview-and- update/ (June 14, 2010). 21 Atul Bagga, “Online Gaming: Takeaways from Think Tomorrow Today Conference,” ThinkEquity, May 19, 2009, p. 2. 22Justin Smith, “Live Notes From GDC: Games That Connect People,” Inside Social Games, March 24, 2009, Dohttp://www.insidesocialgames.com/2009/03/24/live Not Copy-notes-from-gdc-games -thator-connect- people/Post (June 14, 2010).

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we’re letting them engage in games with their real friends in their real social networks…. Gaming is a fundamentally social experience, not a single-player experience, and not a technology experience. We are bringing gaming back to its roots.”23

In terms of game content and mechanics, social gamers have mostly stuck with tried-and-true games because of their proven success models, although this too had begun to change. Games like Playdom’s Sorority Life and Zynga’s Mafia Wars were different in subject matter, but gaming-wise, they were similar—both were role-playing games that allowed players to complete tasks for monetary rewards. If players recruited a larger group of friends, they could get to the best gaming content. Both games could garner millions of players because of the viral nature of social networks, where friends invited friends who, in turn, invited other friends to play, but Mafia Wars had roughly four times as many players as Sorority Life in December 2009. “Borrowing” from other games has, at times, caused problems for the social games industry. For example, early social game Scrabulous was shut down on Facebook by Hasbro for copyright law violations. Justin Smith of the Inside Social Games blog said: “Early on, the best practices have been to borrow elements from the most popular games, and that’s started to play out in the courts.”24

Beyond players, platform, game play, and game content, social games differed from traditional console and PC games in their development—social game companies had more flexibility and control. In the traditional PC and console-based gaming business, games could take years to develop (the World of Warcraft took four to five years to develop) and tens of millions of dollars to make. Social gaming expert Chang at Norwest characterized this as “Gaming 1.0”: “Gaming 1.0 has many parallels with the movie business. In Gaming 1.0, firms published packaged-goods games into the retail channel. Titles sold for $29.95-$59.95 and often required budgets of $20- $40 million or more, and multi-year development cycles to produce. Those basic facts made the risk-reward characteristics unattractive for venture investment: huge sums of money were needed to launch and promote a new product.”

Unlike Gaming 1.0, Gaming 2.0 (or social gaming companies) could build games in a matter of weeks, then launch the games in beta versions, and continue to build the games even after they went live, continuously adding to them as players gave them feedback. Success was about how a game made people want to recruit their friends to play, and developers designed and continued to modify games with that premise in mind. Max Skibinksy, CEO of social games company Hive7, said that the key to successful games was to develop those that were “easy to learn, hard to master.”25 He called the social games industry a “long-awaited creative rebirth of the gaming industry.” He said: “Until recently, the little secret of traditional game development was that it’s a boring place to work despite all the external glamour. Typical teams would be around 100 people working for two to three years on a big project with a massive budget. Given the money involved it was all about avoiding risk…. Social gaming just blew the doors wide open on that stagnant status quo…. Social gaming models decreased the costs so much, it’s not prohibitive

23 Atul Bagga, “Social Games: Interview with the CEO of Zynga,” ThinkEquity, February 24, 2009, p. 2. 24 Troy Goodfellow, “Social Games: The Industry’s New Wild West,” Tribune, 2009. 25 “Building Social MMOs For Facebook Q&A with Max Skibinsky, CEO of Hive7,” Inside Social Games, August 10, 2009, http://www.insidesocialgames.com/2009/08/10/building-social-mmos-for-facebook-qa-with-max- Doskibinsky-ceo -ofNot-hive7/ (June 14, 2010). Copy or Post

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anymore to experiment and try new ideas.”26 At companies like Hive7, it took three to four months to develop a new game since the goal was not to “overdesign” it.

Chang at Norwest did mention that one of the risks for social games was their reliance on social networking platforms, which could change in their popularity or change the rules for application developers. He also said that social games by nature were simple games, but the risk of that type of gaming was that they could be repetitive or unimaginative because they were easy to make.27 BusinessWeek writer Sarah Lacy agreed: “Building the bulk of your business on someone else’s platform is always dicey. And games that do well are restricted to poker and others…. Every big player has its own version of each, with little to set one apart from the others…. Whether they [social game developers] can continue to build a catalog of titles that resonates with gamers remains to be seen. And like all things Web 2.0, social gaming may turn out to be a passing fad that people drop as soon as the next new shiny diversion comes along.”28 (Exhibits 3 and 4.)

REVENUE MODELS

Traditionally, millions of hardcore gamers went to an offline retailer and paid $30-$60 per game title and sometimes $15 in monthly subscriptions for an MMORPG (massively multiplayer online role-playing game, which usually had its own site and existed outside of social networks) like World of Warcraft, for example. The popular World of Warcraft had more than 10 million paying subscribers in 2009, making the game the world’s most subscribed MMORPG.29 On the other hand, the basic social games business model was free games on top of social networks or free-to-play online gaming. The free games could be supported by various revenue streams such as advertising, microtransactions/virtual goods, application installs, and subscriptions. Compared to traditional video games, social games still paled in comparison in terms of revenue, but had future growth potential.

Chang described the social games business model as a “two-layer cake with icing.” The largest layer of the cake was microtransactions/virtual goods; a smaller layer was subscriptions; and the icing on top of the cake was advertising. Industry leaders like Pincus at Zynga believed that virtual goods and application installs [a category of advertising] were the two largest revenue opportunities for social gaming over the next five years.30 Howard Marks, CEO of Acclaim, said that a majority of the players (~90%) in the free-to-play model would not pay for the virtual goods and needed to be monetized via advertising; a smaller majority of the players spent about $10-20/month on virtual goods; and an even smaller majority would be willing to pay much higher amounts (~$1,000/month) for virtual goods.31 Chang agreed, stating that in the U.S. social games market, 98 percent of participants played for free, with 1 to 3 percent engaging in microtransactions (virtual goods and virtual currency).

26 Ibid. 27 Ryan Kim, “Social Networking is the Next Big Thing for Gaming,” SFGate.com, August 3, 2009, http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2009/08/03/BUMN1926DU.DTL&type=printable (June 14, 2010). 28 Sarah Lacy, “Social Gaming Scores in the Recession,” BusinessWeek, May 1, 2009. 29 Gus Mastrapa, “Future Plans World of Warcraft Magazine,” Wired Game Life, August 20, 2009. 30 Atul Bagga, “Social Games: Interview with the CEO of Zynga,” ThinkEquity, February 24, 2009, p. 2. 31 Atul Bagga, “Online Gaming: Takeaways from Think Tomorrow Today Conference,” ThinkEquity, May 19, Do2009, p. 2. Not Copy or Post

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Advertising

Display Ads In the earlier days of social applications and games, advertising was the preferred monetization model. Advertisers paid for in-game/application advertising, paying on a CPM (cost per thousand views), CPC (cost per click), or CPA (cost per acquisition) basis. Social application developers like RockYou and Slide made money through display advertising.32 Such social app companies made “widgets” or applications like SuperPoke! (Facebook users, for example, could wink, hug, and even throw a sheep at another friend) that initially dominated Facebook and MySpace when the social networks had first opened up their platforms. Their social applications grew quickly and were designed to monetize by serving ads into the application flow. For example, in one of their social apps, RockYou or Slide would have a top banner ad and a bottom banner ad on the page. In addition, when users clicked on a button to take a certain action, the app would “roadblock” the user with an ad that the user would then have to click out of.

The revenue models of most Web 2.0 companies were largely based on advertising. It was difficult to attract big traditional advertisers like Ford, P&G, or Coca-Cola to advertise on most social applications because of their low CPMs (effective cost per thousand impressions). Thus, most developers of social applications were challenged on the revenue front. Many had difficulties monetizing and had low engagement and no “compulsion loop” or reason to return over and over. Many social applications grew users quickly but also decayed quickly. And, changing from an advertising-based company to a social game company was hard. Chang said: “The problem is that these companies don’t have the fundamental DNA or understanding of social games. They’re trying to latch onto virtual goods and making social games, but their apps are not well suited to that transition. These companies have a fundamental identity crisis.”

The difficulties of monetizing social applications created opportunities for the larger players. RockYou ran an advertising network that connected advertisers and game publishers. It placed ads into the social applications of its network participants and took a cut of the revenue. In addition, RockYou acted like an advertising agency, building social applications and ads for the brands of companies that did not have that type of expertise. It would then insert those apps and ads into its own applications like SuperPoke! or into the applications of its ad network participants. Chang called this line of business “Razorfish 2.0s”—instead of building websites, large social application companies were building apps and ads for brands. Such companies

Social gaming companies like Zynga and Playfish did not rely on an ad-only monetization model—ads were only the icing on the cake. Social game companies only lightly monetized the majority of their players through ads, but did not have high expectations of their monetization potential. Instead, they focused on other, more innovative advertising models like application installs and the sale of virtual goods.

32 RockYou had 130 million monthly users worldwide. Investors included Sequoia Capital, First Round Capital, Lightspeed Venture Partners, and Partech International. Lance Tokuda and Jia Shen founded RockYou in 2006. They had worked together on a photo slide show project for software developer Iconix. Slide was RockYou’s main competitor. PayPal cofounder Max Levchin founded the company in 2005. The company was funded by co- founder Levchin ($1 million dollars initially), the Founders Fund, Mayfield Fund, Khosla Ventures, BlueRun DoVentures, and others.Not Slide had 150 million Copy monthly users worldwide. or Post

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Application Installs Because social games sometimes had immense player bases, often in the millions, this translated theoretically into a significant number of eyeballs for potential advertisers to target. Most advertisers in the social game space were not branded companies like Coke, but were typically other social game developers who were on the hunt for new players of their games. Many of these smaller companies might not have the larger budget to purchase other types of ads so they went to Zynga, for example, and paid the company 50 cents every time a Zynga game player installed the advertiser’s applications, or Cost per Install (CPI)—the purest form of performance advertising. Zynga offered players incentives to install applications; for example, blackjack players could get extra chips by clicking on a link.

In early 2008, Zynga CEO Pincus said that players clicked on 50,000 links each day and that the company was breaking even.33 He also said: “We haven’t had a new business model on the Internet in eight years since Google Search…. Ours is a new way of web marketing, which is a scalable way for smart web marketers to acquire customers. There are a few of us that are in the business of using that channel, but within a couple of years, it’s going to become an industry unto itself, and become a normal marketing channel just like SEM [Search Engine Marketing] and SEO [Search Engine Optimization]. That’s the idea of CPI. It is the idea of using social networks and the open APIs34 as a customer acquisition channel.”35

More specifically, a social game developer could purchase 100,000 installs from Zynga for 50 cents per install ($50,000 total). An install was a “web instantiation,” according to Pincus. “It’s getting a somewhat permanent navigational instantiation of your application, right on a user’s inbound or outbound web top.”36 If an advertiser used that same $50,000 and went with traditional online marketing, they could buy 100,000 clicks on Google, with about 10,000 people registering with the advertiser, according to Pincus. “So we can give you 10 times the number of marketing impressions with app install than you will get with Google click. It’s a new marketing channel that I think will drive down the cost of customer acquisition in a lot of key e-commerce areas by 80 percent.”37

Beyond charging other social gaming companies for their players through installs, companies like Zynga had become a network of games and had begun to cross-promote their networks of games across their own players. “That’s the magic,” said Chang. “The install part is so incredible because you could charge other companies too to get your network of players. The old days of gaming were hit-based so if you succeeded, you did well, but if you didn’t with your one game, you were in trouble. What Zynga is showing is that they’re becoming a network of players and games, almost like a Comcast with their channels. Zynga wants to be the Comcast of games. They could bounce their players back and forth to play different games.”

Virtual Goods

33 Brad Stone, “More Than Games,” The New York Times, January 15, 2008. 34 API stands for “Application Programming Interface.” An API is the definition of how a programmer can access the functionality contained within a code library. 35 Atul Bagga, “Social Games: Interview with the CEO of Zynga,” ThinkEquity, February 24, 2009, p. 2. 36 Ibid. Do37 Ibid. Not Copy or Post

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What Are They? Virtual goods were digital objects that were purchased or exchanged on the Internet. Virtual goods included digital currency that could be used in a game or elsewhere on the Internet, weapons or tools that gave a gamer an advantage in the game, digital clothes that an avatar could wear, etc. Sometimes virtual goods were not necessarily “goods” but could be small impulse- driven purchases bought for saving time or moving up a level in a game. Virtual goods could also be digital gifts, such as a picture of roses sent by one person to another on Valentine’s Day through a social network like Facebook. More complex and expensive 3D goods and property could be exchanged in multiplayer online games within virtual economies.

The biggest upward trend in virtual goods players were social gaming companies themselves and their games. Within games like Mafia Wars and FarmVille, users bought items to enhance their experiences. Even Facebook offered its users basic virtual goods that they could “gift” to a friend for a fee. Other friends could view the gift on the receiver’s profile page. Such gifts typically cost $1. Hi5, a social network popular in Latin America, had a similar type of offering for its users.

Payment Methods for Virtual Goods There were several possible ways for users to pay for their virtual goods. The latter two ways, mobile payments and prepaid cards, originated in Asia. Prepaid cards accounted for the huge growth of social games in China and Korea. Mobile payments and prepaid cards were just beginning to be adopted by U.S.-based social games companies, while U.S. companies added several other payment methods from its web heritage to the mix, such as lead generation through CPA offers (which did not exist in other countries), Paypal, and surveys.

1. Lead Generation through CPA Offers—When users bought a virtual good in a game or application, often they could opt to fill out an offer for Netflix service or StudentLoans.com, for example. Such companies were willing to pay for new customer leads. Such offers were powered by companies like SuperRewards and Offerpal, which took a cut of Netflix’s payment, giving the remainder to the application developer. Half of the virtual goods in the U.S. were paid for via lead generation through CPA offers. A risk of lead generation was the plethora of questionable offers that could taint the space and frustrate a company’s player base over time.

2. Credit Card, Direct Payment, and Paypal—With Paypal, users needed a bank account or credit card to set up an account that enabled money transfers through the Internet, thus avoiding traditional paper methods like checks or money orders. Younger users under the age of 18 preferred payment by lead generation because they often did not have credit cards or Paypal. Direct payment companies like Spare Change allowed users to fund their accounts with their credit card, Paypal, bank account or mobile phone, then they could use Spare Change instantly on their social network applications.

3. Surveys—Users could also fill out surveys in order to pay for virtual goods. San Francisco-based Peanut Labs collected surveys from online market research companies Dolike GMINot (Global Market Insite)Copy and reformatted them intoor social game Post-friendly formats.

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Companies paid GMI to conduct research for them and that money was split amongst Peanut Labs and social game or social application developers when users opted to fill out surveys for virtual goods instead of paying money.

4. Mobile Payments—Users could purchase virtual goods through their cellular phones using premium SMS (PSMS) services. The most common method of payment required the user to send a numerical message that allowed the user to receive the ring tone, coupon, code, virtual good, etc. that they purchased. Palo Alto-based Zong was the global mobile payment division of mobile monetization company, Echovox. San Francisco-based Boku offered similar services. Mobile payment in the U.S. was still relatively young, making up only 10 percent of services available to pay for virtual goods.38 The payment method tended to be popular with teens and tweens who did not have other payment options, but had cell phones and used them like ATM cards.

5. Prepaid Cards—Users could buy prepaid cards for specific virtual worlds or games at retail stores, kiosks, and other venues. Users within teen and tween-based virtual worlds, like Club Penguin39 and Habbo,40 tended to purchase currency through prepaid cards since they often had no bank accounts or credit cards. On the future of prepaid cards and U.S. social game companies like Zynga, Chang said: “What’s very likely to happen is that Zynga and other large social game companies will start cutting prepaid card deals and trying to get Zynga cards in Safeway and Target.”

6. —In February 2010, Facebook had launched its own native Facebook Credits, a virtual currency that people could use to buy gifts, and virtual goods in many games and applications on the Facebook platform. Facebook took a 30 percent revenue cut from applications (similar to the 30 percent cut Apple took in its App Store). Zynga had scoffed at Facebook’s 30 percent cut and the two were facing off and sorting through their issues.

The Potential of Virtual Goods Though already a multi-billion dollar market in Asia, virtual goods had just begun to grow as a viable monetization model in the United States. In terms of numbers, Piper Jaffray said that U.S. virtual goods revenue in 2008 in the U.S. was $265 million. They estimated that virtual goods revenue in the U.S. would increase 134 percent in 2009 to $621 million, and by 2013, that number would be at $2.5 billion.41 International figures will be discussed below.

The reason for Asian growth was the immaturity of online advertising, which required Asian companies to innovate and develop other revenue models such as mobile payments and prepaid cards. Companies in China and Korea developed the free-to-play model. In the United States, the model typically sold products or offered products/services for free, while monetizing through ads. Chang said: “The global recession has led to the collapse of retail and purchased products as well as the ad market. So we’re starting to copy and adapt these other models from Asia.”

38 Tim Chang, Norwest Venture Partners. 39 A virtual world where teens and tweens could waddle around as cartoon penguin avatars and play games, chat, and participate in other activities. 40 Habbo is a social networking site for teens which allow teens to chat, role play, and play games. Do41 “Play to Pay: PNotaid Internet Services,” PiperCopy Jaffray, July 13, 2009. or Post

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Jeremy Liew of Lightspeed Venture Partners agreed: “In Asia, people have been paying real money for virtual goods for years. It is the primary business model for games and Internet companies in China and Korea, far more important than advertising. We’re starting to see similar behavior in the U.S., also led here by online games and social networks…. 2009 will be the first real breakout year for this business model in the U.S.”42

Piper Jaffrey analysts said: “The bottom line is that social games are just starting to pick up recognition [of virtual goods] among social network users and we believe over the next five years, as the social games market matures, it will likely be the fastest-growing segment of virtual goods based offerings.”43 As an example, Sebastien de Halleux, COO of Playfish, said his company’s Pet Society game sold 20 million virtual Christmas trees and ornaments in 2008. Players paid up to $2 for each virtual item. Whereas real Christmas trees could only be viewed by a few people, virtual trees and ornaments could be viewed by hundreds of online friends.44 Similarly, Playdom’s Sorority Life game sold $100,000 worth of virtual Volkswagens over a two-day period.

Traditionally, a significant amount of virtual goods revenue came from people playing games in virtual worlds like Habbo, Second Life, and Stardoll.45 However, the open platform strategy embraced by Facebook and MySpace fueled significant consumer recognition, as well as adoption of virtual goods within social networks and within Western countries. In fact, Piper Jaffrey analysts believed that in 2008, the majority of the virtual goods-based revenue in the U.S. came from virtual worlds, but that trend was shifting more and more towards virtual goods revenue coming from social networks.46

Subscriptions/Memberships

Subscriptions were popular in online video games like World of Warcraft. They were also popular in tween-and-younger virtual worlds like Club Penguin, where users purchased virtual goods through subscriptions rather than microtransactions. Because parents were uncomfortable with price-tagged items within virtual worlds, Club Penguin and similar games tended to follow subscription-based models.

Social game companies too could adopt the subscription-based revenue model in order to develop a recurring revenue stream. Chang said: “Zynga and other social games companies want to be a network of players and a next-generation publisher and operator of many social games, all using a common currency system, point system, where they are able to cross-promote their own games across all of their players. The logical next step is that if you’re going to sell a Zynga prepaid card, then eventually you might turn on a Zynga VIP club, where for $5 or $10 a month, a VIP member could get 15 bucks’ worth of points. That way, Zynga could retain

42 Jeremy Liew, “Consumer Internet Predictions for 2009,” Lightspeed Venture Partners, December 11, 2009, http://lsvp.wordpress.com/2008/12/11/consumer-internet-predictions-for-2009/ (June 14, 2010). 43 “Pay to Play: Paid Internet Services,” Piper Jaffray, July 2009, pp. 14-15. 44 ”Social Gaming Turns 2!”. op. cit. 45 Stardoll is a site where people create a MeDoll avatar and go shopping, dress the doll, and socialize with each other. Second Life is a 3D virtual world where users can socialize, customize an avatar, connect, and create using free voice and text chat. Do46 “Pay to Play: PaidNot Internet Services,” PiperCopy Jaffray, July 2009, p. 16. or Post

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recurring revenue. This is a model that will probably start kicking in at the end of the year. Some Asian companies do have this; that’s why I think the U.S. will also copy and adapt this too. Only 1-2 percent of a social game company’s players will actually do this, but those will be your power players and this will give you juicy recurring revenue.”

SOCIAL GAME COSTS

Typical costs related to social games were for development of the game itself. Other costs were typical overhead expenses related to employees and administration (usually minimal for smaller social games companies, but sizable for leaders like Zynga who had over 400 employees), as well as customer acquisition and what Chang called “gaming as a service.”

Customer Acquisition: “Social Ad Arbitrage”

Social game companies could acquire players through installs, as discussed under “Revenue Models” above. Obviously, all social game companies could acquire new players virally by friends inviting friends to play. Another way social game companies could acquire players was through “social ad arbitrage,” as Chang coined it. People logged into social networks like Facebook to check e-mail, messages, photos, and conduct other social transactions. Thus social networks like Facebook and MySpace had billions of impressions when compared to a media page view such as an article on Yahoo!. Traditional advertisers like Ford or P&G might pay $5 to $15 to show a targeted ad on Yahoo!, if the user was reading an article on a specific subject, for example. But Ford might not pay Facebook that amount, or anything at all, to try to capture the attention of a social network user who was looking at a friend’s photo or sending a message to a friend. Social network eyeballs resembled Hotmail and Yahoo! Mail’s eyeballs, where users were not there to read, click, or research. They were simply there to send messages; thus those places were not strong places to advertise, only garnering low eCPMs such as 5 cents up to $1.47 Representatives from companies like P&G even explicitly stated that they avoided buying ads on Facebook.48 The highest-performing eCPM in social networking was the login page, since all users were guaranteed to see that page.

The outcome of such low-performing advertising space on social networks was a plethora of outstanding inventory. Thus companies like Zynga and other social games used advertising on social networks as a cheap way to acquire new players or a way to conduct social ad arbitrage. In fact, Zynga was the biggest buyer of ads on Facebook and other social networks.49 If social game companies could buy Facebook ads at 10 cents CPM (meaning you could show Mafia Wars to a thousand people for 10 cents), assuming 100 people clicked on such ads and 10 people ended up installing the game with $1-2 average ad revenue per user per month, then social game companies would have generated $10-20 while only spending 10 cents. “You could do this all day long,” said Chang. “This really works well for social games and is the chapter 2 of social apps.”

47 Interview with Tim Chang. 48 Nicholas Carlson, “P&G Ad Man : ‘I Don’t Want to Buy Any More Banners on Facebook.’” Business Insider SAI, November 17, 2008, http://www.businessinsider.com/2008/11/p-g-ad-man-i-don-t-want-to-buy-any-more- banners-on-facebook- (June 14, 2010). 49 Adam Ostrow, “Bing to Add Facebook “Like†Data to Search?” Facebooking101.com, 2010, Dohttp://www.facebooking101.com/modules/facebookbloggers/index.php?sort=time&start=20 Not Copy or Post.

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Ongoing Operating Costs: “Gaming as a Service”

Initially, the development costs for social games were low, perhaps around $5,000. But as the industry evolved, games became increasingly sophisticated and thus costs increased, too. Chang said that to build a full-scale social game could cost hundreds of thousands of dollars, and to maintain the games could cost millions of dollars: “To get a game out, it doesn’t cost a lot. But if you’re trying to maintain a healthy virtual economy, that means you have to constantly update and refresh the virtual goods catalog, moderate the community to make sure players are not cheating or abusing each other, etc. Social games are no longer something you just publish and sell. They are ‘gaming as a service.’ It’s an ongoing service and your operating expenses to maintain[ing] that service are actually far more than the cost of developing the game.” As an example, of the 400 Zynga employees, “probably 300 or more are just engineers dealing with break fixes, server issues, fraud issues, etc.”

MAJOR SOCIAL GAMES PLAYERS

The top three social games players were Zynga, Playdom, and Playfish, attracting the largest revenue and monthly active users. Other smaller players were Serious Business, with games like , Rock Legends!, and Happy Hour; Popcap Games with games like Zuma and Blitz; and Metrogames with games like Biotronic, Word Island, and Waka-Waka.

Zynga

Zynga offered the broadest array of games to and iPhone platforms with almost 40 games on Facebook alone. The company’s top social network games on Facebook included FarmVille, Café World, Mafia Wars, FishVille, Texas Hold’em, and YoVille!. Mafia Wars, , YoVille! and Vampires were the top games on MySpace. iPhone games included Live Poker, Mafia Wars, and Vampires Bloodlust. Zynga had about 100 million monthly unique visitors, many playing multiple games. By late 2009, Zynga had revenues that were estimated north of $200 million.50 Serious Business CEO, Siqi Chen said: “I respect Zynga just for their sheer willpower to dump as many resources as they have into an idea—both in terms of acquisitions and developing original IP. They bet on this space hard and are a big winner.”51 Chang added: “Zynga’s play is to be a publisher 2.0 in social gaming. If you have a whole network of players and you can publish games into that network, you are the next EA.”

Pincus launched Zynga in July of 2007. Pincus was a well-known Silicon Valley entrepreneur who had started the early social networking site Tribe and enterprise software company SupportSoft Inc. In early February 2009, Pincus discussed the company’s strategy: ‘We’re trying to have the most scalable approach to the market…. We invest heavily in metrics. We’ve learned and watched companies like Slide and RockYou, who have been the best at being metric- driven in measuring. We have recruited heavily from the game industry. We brought people

50 Eric Eldon, op. cit. 51 “Industry Perspectives: Q&A with Siqi Chen, CEO of Serious Business,” Inside Social Games, July 8, 2009, http://www.insidesocialgames.com/2009/07/08/industry-perspectives-qa-with-siqi-chen-ceo-of-serious-business/ Do(June 14, 2010). Not Copy or Post

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who understand real game development…. And then, we have people who have deep understanding of social networks and web marketing. We watch a lot of things; we test a lot of things. And our goal has been to be the largest in social gaming.”52

Zynga attracted financial backing from investors like Kleiner Perkins Caufield & Byers. In January 2008, the company raised $10 million from Union Square Ventures, LinkedIn’s , , and others. Zynga raised another $29 million second round of funding in July 2008, which included Kleiner and other investors such as Institutional Venture Partners, and previous investors Union Square Ventures, Foundry Group, and Avalon Ventures. In November 2009, it raised a follow-on round of about $15 million. John Doerr, a Kleiner partner, said that Zynga had “cracked the code” on how to develop engaging and viral games fast.53 In July 2008, the company also announced that , a Kleiner Perkins partner and former cofounder and CEO of Electronic Arts, would join Zynga’s board of directors.

Playdom

Playdom created games like Mobsters, Bloodlines, and Sorority Life, with Mobsters as the number one game on MySpace. The company focused on games for the major social networks, such as MySpace and Facebook, garnering 20 million monthly active users. John Pleasants, former Electronic Arts COO, served as CEO. Dan Yue, Chris Wang, Ling Xiao, and Silicon Valley veteran Rick Thompson founded Playdom in February 2008. Playdom’s tagline was: “Where players rule,” outlining Playdom’s focus on providing its players with the best possible player experience. Cofounder Yue said: “What makes Playdom unique is our top-to-bottom commitment to players. We introduce new features and improvements into our games and closely watch player response to decide what stays and goes. In a very literal sense, our players are shaping our games.”54

The company collected various data and knew that its games engaged players for an average of 11 minutes per session, with longer session times for role-playing games. Playdom also said that more than 5 percent of the people who played their games spent money on virtual goods. Playdom was estimated to have 2009 revenues of over $40 million from selling virtual goods.55 In November 2009, the company announced a large round of funding ($70 million), at up to a $300 million valuation from venture firms such as New Enterprise Associates, Lightspeed Venture Partners, and Norwest Venture Partners, making the company the second highest funded social game startup behind Zynga.

52 Atul Bagga, “Social Games: Interview with the CEO of Zynga,” ThinkEquity, February 24, 2009, p. 3. 53 Jessica E. Vascellaro, “Gambling on Facebook Games, Zynga Cashes In,” The Wall Street Journal, July 23, 2008, p. B6. 54 “Playdom: Until Now, the Best-Kept Secret in Social Gaming,” Playdom, BusinessWire Press Release, March 11, 2009, http://www.playdom.com/uploads/news/pdfs/20090507130156_Playdom_PressRelease.pdf (June 14, 2010). 55 Eric Eldon, “Playdom: Another social gaming company playing it smart with virtual goods,” Social Beat, April 8, 2009, http://digital.venturebeat.com/2009/04/08/playdom-another-social-gaming-company-playing-it-smart-with- Dovirtual-goods/ (JuneNot 14, 2010). Copy or Post

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Playfish

Playfish was another start-up in the social gaming field, founded in 2007. The company had a variety of games on MySpace, Facebook, Bebo, and Yahoo!. Games included Pet Society and Restaurant City and the company drew 22 million monthly players. Siqi Chen of Serious Games said that Playfish “brought extensive game design and high polish games to Facebook, and they’ve done extremely well. They haven’t exactly been dumb on the metrics side either— they’re extremely sophisticated.”56 Playfish was rapidly expanding, and offered games on iPhone and Android mobile platforms. The company had also raised several rounds of funding. In October 2008, it raised $17 million from Accel Parters and Index Ventures. Playfish’s players spent an average of 35 minutes per day playing the company’s games.57

Traditional Game Publishers

Although traditional game developers had in general taken a wait-and-watch approach to social gaming, some such as Electronic Arts (EA) were moving in. In 2008, EA acquired a small social gaming site called ThreeSF. EA was also collaborating with talent agency CAA, to launch games for social networks.58 In August 2009, EA acquired a social gaming and distribution company called J2Play, and in November 2009, it acquired PlayFish.

In April 2009, when EA launched its mainstream MMOG BattleForge, it began testing a virtual goods model. Although the game was initially sold for $49.99, unlike other mainstream MMOG titles, the company did not charge a monthly fee to its players, but instead hoped to fund its post- production costs (and updates) through the sale of virtual goods.59 In June, 2009, EA announced that it would launch BattleForge for free as a “freemium” product (after dropping the price to $29.99) because the game had sold less than 100,000 copies. The virtual goods component had saved the game, as gamers spent money on virtual cards and booster packs with new troops.

French video game publisher Ubisoft launched its first trivia game, TickTock, on Facebook in 2009. TickTock players could not yet buy any virtual goods, upgrades, etc., because the company wanted first and foremost to create fun and high-quality games, and look at monetization opportunities later.60

As traditional gaming companies like EA and Ubisoft began to enter the world of social games, industry insiders like James Currier, CEO of wholesome social gaming company Wonderhill, commented: “My money is on the web people [versus the console game developers] to take the

56 “Industry Perspectives: Q&A with Siqi Chen, CEO of Serious Business,” op. cit. 57 Kristian Segerstrale, “All 3 Playfish Titles in Facebook Games Top 10!” Playfish, http://playfish.wordpress.com/2008/06/09/all-three-playfish-titles-in-facebook-games-top-10/ (June 14, 2010). 58 “The Video Gaming Market Outlook,” Business Insights, August 2009, p. 15. 59 Christopher Mack, “EA Experimenting with Mainstream Virtual Goods in BattleForge,” Inside Social Games, April 23, 2009, http://www.insidesocialgames.com/2009/04/23/ea-experimenting-with-mainstream-virtual-goods- in-battleforge/ (June 14, 2010). 60 Christopher Mack, “Building a Social Gaming Studio Within Ubisoft: Q&A with Omar Abdelwahed,” Inside Social Games, August 5, 2009, http://www.insidesocialgames.com/2009/08/05/building-a-social-gaming-studio- within-ubisoft-qa-with-omar-abdelwahed/ (June 14, 2010). Do Not Copy or Post

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lion’s share of the gaming world by 2013, because I think it’s easier for us to learn the philosophies of game creation than it is for the gamers to learn the philosophies that make you successful on the web.”61 Zynga’s Pincus commented: “This is a new kind of gaming business, and it’s not build and publish; it’s build and serve and then have recursive loops around tweaking and serving. So this business feels more like eBay, or Amazon, or Google. It’s an always-on business, where you have to have a massively scalable backend. And you also have to have people watching servers all the time…. So I don’t think anything stops EA and Activision from getting into this. But first, I don’t think there is enough money in it for them to carry it out. Even if they own the entire market today it’s not a right fit for their business model. And secondly, it’s the wrong business for them right now, because it requires a very large investment and has very little payoff today.”62

Others, like Chang at Norwest, believed that both traditional game publishers and social game companies could learn from each other. He argued that social game companies could learn how to raise the quality of their titles while existing game companies could understand better how to incorporate social features and new business models into their games.63 Andrew Mayer, a social games consultant agreed, stating that the PC gaming market was not “dead,” per se, but rather invigorated by social games as a new generation of PC games had given players a genuine reason to pay for things like virtual goods (Exhibit 5).64

VIRTUAL GOODS IN ASIA

As discussed above, companies in the U.S. had lagged behind Asia in the sale of virtual goods and the monetization of social games and the social medium in general. In April 2009, the Asian market for virtual goods was estimated to be around $5 billion, 25 times larger than the approximate $200 million in the United States.65 In China alone, Pearl Research estimated that online gaming revenues were around $2.8 billion, of which virtual goods were 70 percent.66

Tencent was the largest Asian player. Smaller players included Korea-based social network, Cyworld, as well as Mobile Game Town, and GREE. Each of these players varied in their services and offerings—ranging from social networks to messaging, to games. Chang said: “In Asia, you have to be super innovative about business models because they don’t have advertising. For too long, the U.S. has had this panacea of advertising as the cure-all business model. And I blame that on laziness in the face of a weak business model. Asian companies built new models based on necessity—no ads, no credit cards, no subscriptions, etc. They just

61 Christopher Mack, “Virtual Currency Monetization Comes to Twitter with 140 Mafia and Super Rewards,” Inside Social Games, June 24, 2009, http://www.insidesocialgames.com/2009/06/page/2/ (June 14, 2010). 62 Atul Bagga, “Social Games: Interview with the CEO of Zynga,” ThinkEquity, February 24, 2009, p. 3. 63 Ryan Kim, op. cit. 64 Andrew Meyer, “How Social Games Saved the PC Gaming Market,” Inside Social Games, February, 12, 2009, http://www.insidesocialgames.com/2009/02/12/how-social-games-saved-the-pc-gaming-market/ (June 14, 2010). 65 “Virtual Goods Booming in Asia,” Inside Social Games, April 20, 2009, http://www.insidesocialgames.com/2009/04/20/virtual-goods-booming-in-asia-25x-bigger-than-american-market/ (June 14, 2010). 66 “Virtual Goods In Chinese Gaming Worth $2 Billion,” Virtual Goods News, April 8, 2009, http://www.virtualgoodsnews.com/2009/04/virtual-goods-in-chinese-gaming-worth-2-billion.html (June 14, 2010). Other Chinese companies generating virtual goods revenues included Changyou, The9, Netease, Shanda, and DoGiant. Not Copy or Post

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said, ‘Let’s just sell virtual goods and people will pay for them via cell phones or prepaid cards,’ and it was a business model born out of necessity that turned out to be brilliant.”

Companies in Korea and China were the most innovative first, creating the free-to-play category in online gaming. Such games were usually multiplayer games designed to be played at Internet cafes and other venues. They were free to start but were designed in a way that made the free player a “de facto poor citizen,” according to Chang. “You’re seeing everyone else with cool equipment and items and you’re just a little chump. That’s when human nature kicks in and eventually you get pride, envy, lust, wrath, greed, fear, and you want to be a player too. That’s when companies start converting 10-15 percent of these players who start buying virtual goods for any of those seven deadly sins. Those seven deadly sins fuel the virtual good and the microtransaction purchase engine.”

A brief discussion of the leading Asian players follows (Exhibit 6).

China

Chinese companies were some of the biggest innovators in the field of gaming. Companies like The9, Perfect World, Giant, and Shanda were all online multiplayer companies that had gone public based on the free-to-play business model with virtual goods (versus retail and monthly subscription models, like World of Warcraft). What this meant for players was that they did not need to buy a game in a box from a retailer and pay a monthly subscription, which led to a more frictionless experience for them.

Beyond MMORPG style games, the emergence of social games in China was led by Tencent, which was the major player in China, Asia and beyond, offering diverse services including instant messaging, social networks, portal websites, e-commerce, and games. Tencent was founded in 1998, had 355 million users, US$1.2 billion in annual revenues in 2008 (mostly coming from virtual goods), and a US$37 billion market capitalization in December 2009 (larger than Yahoo! and Electronic Arts combined). The company ran one of the largest web portals in China called QQ.com. Tencent was also the owner of the leading instant messaging franchise in China, a product called “QQ.” Tencent was not exactly a social gaming company or a social network; but rather a distribution engine and a leader in microtransactions. It was like a chat client which had become the perfect way to distribute games or sell virtual goods.

The two major revenue components for Tencent were digital items and packages and upgrades. Advertising made up a smaller percentage of Tencent’s revenue, representing only 12 percent of total revenues. In 2008, Tencent generated $720 million in revenue from virtual goods. Tencent’s virtual goods were inexpensive, with prices ranging from 10 cents to $1.

Tencent sold virtual goods for use across its different platforms. Its online currency, “Q Coins,” could be used to purchase virtual goods such as flirts, gifts, virtual pets, clothing for avatars, jewelry and cosmetics needed to customize avatars, and more plain vanilla items like more storage space, wallpapers, bigger photo albums, and ring tones. Users could purchase Q Coins Dowith RMB (the Not Chinese currency). Copy or Post

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Because Q Coins were so popular among younger Chinese people, they had become increasingly accepted in online stores and gaming sites in exchange for “real” merchandise such as small gifts, causing the People’s Bank of China (China’s central bank) to begin investigating the Q Coin and whether it deflated China’s regular real currency. In July 2009, China’s Ministry of Culture and Ministry of Commerce stated that virtual currency (as well as prepaid cards and cybergames) could no longer be legally traded for real goods or services. The official statement from the Ministries said: “The virtual currency, which is converted into real money at a certain exchange rate, will only be allowed to trade in virtual goods and services provided by its issuer, not real goods and services.”67

Tencent invested in U.S. game companies, offering its massive distribution network in China through its instant messaging channel. Tencent offered to enable U.S. game companies to acquire players, and agreed to operate U.S. companies’ games in China. Tencent offered revenue splits or paid U.S. companies upfront and licensed the game.

Beyond Tencent, Chinese social networking companies such as 51, Kaixin, and Xiaonei had recently emerged as players. Such companies made their own games, but had also begun to open up their platforms for third-party developers to develop social games and other social applications, similar to Facebook and MySpace in the U.S. Thus companies like Rehoo and XPD had begun to emerge, trying to become the Zyngas of China.

Korea

Korean companies were innovators in the virtual goods space, and many of them had begun to expand into the United States. NCsoft was a South Korean-based online computer game company which focused on online MMORPGs. It was the first company to adopt online role playing games with subscription models.

Beyond NCsoft, Korean companies were also the inventors of free-to-play MMORPGs. Instead of a subscription-based model like NCsoft, companies like NHN and Nexon had games that were free-to-play with microtransaction components. The NHN Corporation was like the Yahoo! of Korea, operating Naver portal, the most popular Internet portal and search engine in South Korea, and Hangame, the country’s number one online game portal. Like NHN, Nexon was also a pioneer of the free-to-play model using virtual goods sales to generate revenue. As early as 2005, NHN had $230 million in revenue, of which 85 percent came from virtual goods.68 Nexon also owned the successful game, MapleStory (originally developed by a company called Wizet). MapleStory was a free MMORPG where over 50 million worldwide players (over 3 million in North America) travelled the Maple World and defeated monsters. Players could interact with others by chatting, trading, or banding together to hunt monsters. Prepaid cards available in

67 Thomas Claburn, “China Limits Use Of Virtual Currency,” Information Week, June 29, 2009, http://www.informationweek.com/news/internet/ebusiness/showArticle.jhtml?articleID=218101859 (June 14, 2010). 68 Adrian Crook, “Virtual Goods Summit – 2007 Videos, Top 10 Notes, Raw Notes,” Freetoplay.biz, August 7, 2007, http://freetoplay.biz/2007/08/06/virtual-goods-summit-2007-videos-top-10-notes-raw-notes/ (June 14, Do2010). Not Copy or Post

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Walmart and Target enabled Nexon to enter the U.S. market and grow MapleStory to $50 million in revenue in three years.

Beyond these companies, telecommunication companies like SK Telecom (the AT&T of Korea) were also entering the social space. The company had the first hit social network in Korea called Cyworld, which was similar to Facebook or MySpace. Cyworld was the first to demonstrate the viability of the microtransaction revenue model in the context of social networks. The company was reported to have US$300,000 of virtual goods sales per day.69 The site sold virtual goods to users who could place mini-rooms, houses, and avatars directly onto their pages as decorations.

Japan

Virtual goods revenues in Japan were much smaller than those in China or Korea. Japan was the oldest country when it came to games, but they were “so fixated on consoles like PlayStation 3, Nintendo DS, or the Nintendo Wii (which were all declining 20 percent year on year), that it was slowing them down in terms of online and virtual goods,” said Chang. He added: “In Japan, they don’t have a lot of strong online social networks. Interestingly, some of their best performers are mobile social networks because many Japanese tend to use cell phones more than the PC. No one in the world has this category. They have nothing on social games and nothing on online social networking, though.”

Japan’s three public social network players were DENA (Mobage-town), GREE, and Mixi. These players each made more than $100 million per year on virtual goods, largely on the mobile platform. Their 2008 market capitalizations were US$1.5 billion, $1.1 billion, and $511 million respectively, and all three were profitable companies. DENA and GREE, like Tencent, had invested heavily in casual games and digital items as part of their revenue models. All of these companies had revenues per user that dwarfed those of Facebook and MySpace. By 2009, these companies were opening up their platforms for an open API, like Facebook and MySpace, in the hope of getting new applications.

Bill Gurley, Benchmark venture capitalist, argued that Mixi’s focus on advertising led to its lower revenue, comparing DENA and GREE’s revenue model to Tencent’s: “Here is the punch line: Mixi is the actual leader in the market in terms of users, is the clear leader on the PC, is the company that most resembles U.S.-based social networks, and has remained focused on advertising as its core revenue stream. Not surprisingly, their revenues per user are a fraction of DENA and GREE[’s], as is their market capitalization.”70

MOBILE SOCIAL GAMES

By 2009, most major social game companies and developers were in the process of bringing their games to new platforms such as mobile. The Apple iPhone was considered to be one of the big

69 Erick Schonfeld, “Cyworld ready to attack MySpace,” CNNMoney.com, July 27, 2006, http://money.cnn.com/2006/07/27/technology/cyworld0727.biz2/index.htm (June 14, 2010). 70 Bill Gurley, “How To Monetize a Social Network: MySpace and Facebook Should Follow TenCent,” Abovethecrowd.com, March 9, 2009, http://abovethecrowd.com/2009/03/09/how-to-monetize-a-social-network- Domyspace-and -facebookNot-should-follow -tencent/Copy (June 14, 2010). or Post

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future growth areas. Apple had developed its “App Store,” where iPhone users could download free applications, as well as purchase applications, add-ons, and virtual goods on Apple’s In-App Purchase platform, which billed users through their iTunes account. Apple took a cut of all applications sold through its store, allowing application developers to keep 70 percent of the purchase price. Many of the games available on the iPhone were still based on the Facebook Connect API, which allowed developers to access elements of Facebook’s application platform outside of Facebook on a diverse array of devices, meaning users could take their Facebook friends with them to other sites and devices, ranging from websites to desktop applications, mobile applications, etc.71

Ngmoco was a forerunner in the iPhone mobile social gaming space in terms of “cracking the code” on monetization, according to Chang, leveraging the same free-to-play plus microtransactions model that Zynga and other online social game companies had leveraged. Making the games free to download increased trial adoption by consumers and in-game microtransactions drove revenues over the long-run, well after the company’s games fell off their high download chart positions on Apple’s App Store.

Zynga was the first online social game company to launch a social game on iPhone in November 2008, with the release of Live Poker, the first truly live game on the iPhone. This game was a mobile version of Zynga’s popular Texas Hold’Em game. Live Poker allowed iPhone users to compete with 1.4 million daily players in the web’s largest free poker game. Users could play with their real friends from Facebook, MySpace, Bebo, and Hi5, or make new poker friends. Players could see which of their friends were online and click to join them. iPhone users could also access social information such as real player photos. Playdom, in July 2009, brought its popular game Mobsters to the iPhone. Users could connect their iPhone Mobsters game to their MySpace Mobsters game so they did not need to start all over on iPhone if they had already been playing on MySpace.

As the iPhone platform grew, however, monetization was an issue that some social gaming companies like Zynga worried about. CEO Pincus said: “We’re super excited about the platform for its ability to get a whole group of consumers who we might not get to through the web and social networks. But the part that’s below my expectations so far is that monetizing the platform effectively is still elusive.”72 Pincus felt that on iPhone, people did not find games in the same way that they did on social networks (through their friends). iPhone’s “directory model” did not scale to millions of people with different interests. He said: “You have the 25 most popular apps, but popular to whom? If you want to know what your friends are playing, the Facebook distribution model scales a lot better.”73

THE FUTURE OF SOCIAL GAMING

By the middle of 2010, the social gaming space had come a long way from its early days. Three major social game companies had emerged, and had begun to innovate in terms of monetization

71 ”Social Gaming Turns 2!” op. cit. 72 Stuart Dredge, “Zynga: 'Apple should bake Facebook Connect into iPhone,'” Pocketgamer.biz, June 15, 2009, http://www.pocketgamer.biz/r/PG.Biz/Zynga+news/news.asp?c=13858 (June 14, 2010). Do73 Ibid. Not Copy or Post

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models, as well as to adopt some elements of the already proven monetization models in Asia. What lay ahead for the industry was exciting for those in the industry as well as to those monitoring the space. According to Norwest’s Chang, the three major growth vectors in social gaming were international expansion, production innovation, and the mobile platform. “International basically means China,” he said. “U.S. social game companies basically want to get onto all of the social networks in China.” How to get international penetration was going to be top of mind for all of the major social game companies.

The second growth vector in social gaming, according to Chang, was production innovation. He said: “Within six months, the whole X Wars phenomena (Mafia Wars, Ninja Wars, etc.) will play out and players will be looking for what’s next. And the people to actually watch are Playfish. These guys are actual game guys. They understand social. They have games like Pet Society and Restaurant and are done in 2.5-D Flash. They are super innovative and the games are top-notch production value. Everyone is watching them as the next evolution because they have the best innovation and production value[s]. Today’s budgets are tiny, but eventually they will rise and could someday be millions of dollars to produce. But if that happens, companies better have really good monetization for that to pay off or a network of players to market to. And they can’t be too fancy because they might scare off non-gamers.”

The third future growth vector was mobile. By late 2009, the average price point of an application on the iPhone had dropped from $2.49 to around $1 or free, challenging the market size on that platform. If a company sold 1 million apps on the iPhone at $1 each, they only earned $1 million in revenue, of which $300,000 went to Apple. If the application cost anywhere north of $500,000 to develop, companies were not going to make much money. Chang commented on the future of mobile: “What is likely to happen in mobile is that the model will go to free-to-play plus microtransactions. I’ a firm believer that all markets should naturally become free-to-play with microtransactions. This is the business model that will win in any consumer market, whether it’s gaming or media or mobile content.”

Beyond the three main growth vectors were many other big opportunities such as the introduction of branded intellectual property into the online and mobile social gaming markets. Content houses and studios such as Marvel Comics, LucasFilms, and Dreamworks, were wondering how to enter the social gaming market and to date, companies such as Zynga and Playdom had not yet partnered with such companies to bring branded intellectual property into their games, which could lead to other opportunities for other startups in the space. Moreover, social gaming companies had begun to seek growth opportunities, whether being expansion into other social networks beyond Facebook, launching their own destinations sites (e.g. Zynga.com), going international into other social networks that already existed around the world, or expansion into other platforms such as mobile.

Whether that happened or not, the rapidly evolving social games industry would keep everyone watching.

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Exhibit 1 Zynga’s FarmVille and Mafia Wars

Source: Reproduced by permission from Facebook. Do Not Copy or Post

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Exhibit 2 U.S. and Worldwide Virtual Goods Revenue Estimates

Source: Gene Munster, Michael Olson, Douglas Clinton, Andrew Murphy, and Nicholas Gallus, “Pay to Play: Paid Internet Services,” Piper Jaffray, July 2009, pp. 18-19. Reproduced with permission.

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Exhibit 3 Sampled Leading Facebook Games

FarmVille by Zynga

Howdy Ya'll! Come on down to the Farm today and play with your friends. We got plenty of land for everyone. Come and see what everyone is hootin' and hollerin' about. 34,146,686 monthly active users

Mafia Wars by Zynga

Start a Mafia Family with your friends, do Crime Jobs for cash, buy Powerful Weapons, and Fight!!! 19,305,731 monthly active users

Farm Town by SlashKey

In the world of Farm Town you and your friends can have a great time! You can play games, design, grow and maintain your own farm and even send gifts to your friends. Play now and share the fun with everyone! 18,382,575 monthly active users

Pet Society by Playfish

In the world of Pet Society you and your pet can have a great time! You can play games, decorate your house and even bring gifts for your friends when you visit them. Play now and share the fun with everyone! 16,206,188 monthly active users

Texas HoldEm Poker by Zynga

Play Texas Hold'Em Poker with your Facebook friends. Get FREE Zynga chips every day that you play! 15,749,037 monthly active users

Source: “All Applications,” Facebook, http://www.facebook.com/apps/directory.php#/apps/directory.php?app_type=0&category=0&order=2&seeall=true (June 14, 2010).

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Exhibit 4 Sampled Leading MySpace Games and Social Apps

Mobsters by Playdom Start a Mob with your friends. Rise from a petty thief to Mafia Don. Rule MySpace! 13894684 Users

Mafia Wars by Zynga Start a Mafia family with your friends, Run crime ops for cash, Buy powerful weapons, and Fight!!!

Own Your Friends! by Playdom How much are you worth? 10128120 Users

Texas Holdem Poker by Zynga Compete in the biggest free Texas Holdem Poker game on the net with over 7 million players! 6229909 Users

SuperPoke Pets by Slide Adopt the CUTEST virtual pets on Myspace. Raise it and watch it grow! 5933338 Users

Source: “All Apps,” MySpace, http://apps.myspace.com/Modules/AppGallery/Pages/index.aspx?st=totalinstalls (June 14, 2010).

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Exhibit 5 U.S. Social Application Developers

MAJOR SOCIAL GAME PLAYERS

Zynga: Offers the broadest array of games to the social network and iPhone platforms. The company’s top social network games include Mafia Wars, Texas Hold’em, FarmVille, and YoVille!. iPhone games include Live Poker, Mafia Wars, and Vampire.

Playdom: Creators of games, including Mobsters, Bloodlines, and Sorority Life. The company focuses on games for the major social networks: MySpace and Facebook, garnering 20 million monthly active users. Recently announced former Electronic Arts COO as CEO.

Playfish: Offers games targeted toward younger users on MySpace, Facebook, Bebo, and Yahoo!. Games include Pet Society and Restaurant City and draw 22 million monthly players. Company is expanding to offer games on iPhone and Android mobile platforms.

MOSTLY IPHONE

Social Gaming Network: A leading developer of games for the iPhone as well as social networks. Popular iPhone offerings include F.A.S.T. and Vampires vs. Werewolves; Warbook, a social combat game for Facebook, was the company’s first product. iPhone games like F.A.S.T. enable friends to play each other head to head. The company has totaled over 10 million application downloads on the iPhone and generates over 1 million unique players per day through its social network games.

MOSTLY SOCIAL APPS

RockYou: Focus primarily on applications including Superwall and Pieces of Flair on Facebook and Superhug and Slideshow on MySpace. The company also develops applications for other social networks including Bebo, Hi5, , and Orkut. The company’s various offerings see a total of 130 million monthly users worldwide.

Slide: Focus primarily on applications including Slideshow, Superpoke!, Superpoke! Pets, and Top Friends. The company develops applications for Facebook, MySpace, Bebo, Hi5, Friendster, and Orkut. The company offers a unique advertising feature where companies can integrate their brands into Slide’s popular applications that reach over 150 million monthly users worldwide.

Source: Gene Munster, Michael Olson, Douglas Clinton, Andrew Murphy, and Nicholas Gallus, “Pay to Play: Paid DoInternet Services,” Not Piper Jaffray, July 2009, Copy p. 14 and case writers’ analysis. or Post

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Exhibit 6 Asian Players

JAPAN KOREA CHINA

Mobile Social Networks (+Web) MMO F2P MMO (+MTX)

• GREE • NCsoft • The9 • Mobage-town • Perfect World • Mixi F2P MMO (+MTX) • Giant • Shanda • NHN • Nexon—Kartrider and Social Games/Messaging/Network Maplestory (Distribution and MTX)

Telecom Carriers • Tencent

• SK Telecom—Cyworld Social Networks (in-house games), (microtransactions) Open API

• 51 • Kaixin • Xiaonei • Baidu

Social Game Developers

• Rehoo • XPD

MTX=microtransactions

Source: Casewriters’ analysis. Tim Chang, Norwest Venture Partners.

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