Zynga (ZNGZ: Nasdaq), the social gaming leader, went public on December 16, 2011, following months of hype and speculation. It followed several high-profile internet companies in the IPO class of 2011, including LinkedIn (LNKD: NYSE), Pandora (P: NYSE) and Groupon (GRPN: Nasdaq).
Turbulent market conditions made it difficult to get to that celebratory opening bell, let alone do so successfully. The internet sector, this year, made life harder for itself and Zynga exemplifies the trend.
For many companies, the path to IPO in 2011 was littered with rookie shareholder communication mistakes and flat-out corporate governance failures. We can look back on Andrew Mason, the CEO of Groupon, who viewed the SEC ‘quiet period’ as more a suggestion than a regulation. Or consider the abundance of companies with dual shareholder structures, which cements control in the hands of the few, rightly or otherwise.
Yet, with the many examples of flawed corporate governance available to us, Zynga stands out. The company saw its implied valuation plummet from $20 billion to $7 billion when its S-1 came out (Zynga’s IPO began trading at $7 per share). There are many reasons for this, but the corporate governance aspects can’t be ignored. Zynga’s approach to governance fell short in five specific areas:
1. Shareholder structure: despite the problems they’ve caused at companies like Dow Jones and Playboy, ‘super-shares’ are back, although under a new moniker. Now called ‘founders’ shares’, they provide disproportionate voting rights to certain key and early employees. Zynga isn’t alone in adopting this structure, but it developed a new class that is without precedent. Mark Pincus, CEO of Zynga, is the sole shareholder of a third class of equity that comes with 70 times the voting rights of common shares.
2. Revenue risk: Zynga is disproportionately dependent upon Facebook for access to its user base – and it pays a 30 per cent ‘tax’ on revenue generated through the platform. Although Zynga is trying to diversify through mobile, its efforts are still in their infancy. The current situation comes with an incredible amount of risk, especially if the mobile strategy takes too long to pay off, or fails to pay off at all.
Further, let’s not forget that Facebook is still a private company – and one that doesn’t like to reveal much. Investors in Zynga thus cannot get access to information that may impact their decisions on board votes and investment dollars. This situation is likely to change, with a Facebook S-1 rumoured to be coming in April, but the lack of transparency from such a substantial partner has salient implications for Zynga’s investors.
3. Track record: earlier this year, Pincus took cash off the table, at a healthy implied valuation and at Zynga’s expense. The CEO sold $109.5 million in stock back to Zynga in March 2011 at $13.96 per share. Only two months earlier, Zynga bought stock back from two employees at just $6.43 per share. Could a 100 per cent increase in value have been justified after only two months? It seems unlikely, given that the company’s second-quarter financials revealed (in an amended S-1) a year-over-year profit decline of more than 90 per cent.
The timing of the Pincus transaction raises questions about the CEO’s ability to understand the public perception of corporate actions, and about the strength of Zynga’s board and internal controls.
4. Lack of options: at pre-IPO companies like Zynga, stock options are like gold – sometimes even more valuable. They are offered instead of some cash compensation, as a way to attract top talent while keeping expenses down. So, when employees are asked to give back options, even those that haven’t vested yet, people notice. Pincus is reported to have pressured several employees into surrendering unvested stock options — or lose their jobs. He claims to run a ‘meritocracy’ and wants to make sure underperformers and those who have made only limited contributions to Zynga don’t benefit disproportionately, but the employees affected didn’t accept that reasoning well. One employee resigned, and the other stayed: both hired attorneys.
Even if, as Pincus contends, the employees didn’t deserve the large packages they received when they were hired, it was a bit late in the game to pull them back. Shouldn’t there have been controls in place to make sure early packages were appropriate?
5. Tone at the top: most governance issues come down to the tone at the top, which you may remember from the COSO framework. The board of directors appears comfortable approving measures that fly in the face of corporate governance best practices, and the CEO is running Zynga as if it’s his own CastleVille (a side effect of holding 38.5 per cent of the votes). Doubtless, this contributed to the flat IPO, which followed months of falling implied valuations and expectations.
Zynga has had some time to breathe, with the holidays just ending, and it has a bit of time remaining before the shorts can get their hands on the stock. Even showing an intention to improve the corporate governance situation would send a positive message, but time is running out.