A Sneak Peek at Zynga’s IPO: How to Turn Virtual Goods Into Real Money

With Zynga’s IPO filing likely to hit any day now, the question is: What will it tell us?

When it goes public, the Facebook game developer will be the first major U.S. company supported primarily by the sale of virtual goods to do so.

To get an idea of what such an animal might look like, I talked to a handful of accountants, lawyers and game companies to get a sense of what we might find under the hood.

What’s immediately clear is that there are no obvious answers.

The Securities and Exchange Commission and other governing bodies have not yet come up with a legally prescribed method for taking into account the sale of virtual goods.

That leaves companies to come up with their own best guesses.

“There are no rules about this stuff,” said Bob Komin, the CFO and COO at Linden Lab, which operates Second Life, the four-year-old online virtual world. “I haven’t heard anything about a standard, but it’s probably the number one thing we talk about before we get audited every year.”

Revenue recognition on the sale of virtual goods is not exactly a sexy topic (unless we’re talking about an avatar’s undergarments!). But as more companies shift to a free-to-play model, where games are monetized through microtransactions and virtual goods, the subject will become more commonplace.

Zynga may be the first out of the gate, but many others are waiting in the wings — Facebook being the most prominent. Zynga declined to comment for this story.

Here’s what is known about Zynga

Four of its titles dominate the most popular applications on Facebook: CityVille (No. 1); FarmVille (No. 2); its newest title, Empires & Allies (No. 3); and Zynga Poker (No. 4).

All of those games are free and monetized through the sale of virtual goods, such as purple cows, energy boosts, clothing or premium buildings.

In-game items like these are either purchased directly on Facebook or through gift cards purchased in the store. Zynga also makes money from advertising and mobile games, but revenues from those are presumed to be far less.

In total, Zynga reportedly generated about $400 million in profit last year on about $850 million in revenue, although subsequent sources told AllThingsD’s Kara Swisher that the filing will reveal much more robust numbers.

But it’s not the sheer magnitude of Zynga’s business that has created problems for bean-counters. It’s the details on how to account for every last penny.

In a white paper, accounting firm Ernst & Young writes that there are three typical models being used today.

Here’s how they break it down:

• Game-based model: The company recognizes revenue over the life of the game.
• User-based model: Revenue is recognized over the estimated life a user plays the game.
• Item-based: Revenue is recognized based on the implied or explicit life span of the item — in other words, how long it would last in the real world. Examples of more durable goods are virtual vehicles, furniture or weapons. Revenue from these would be recognized for as long as the player stays active in the game. Revenues from a more consumable item, like a virtual cup of coffee or a jolt of energy, would be recognized almost immediately.

And there are still other factors to take into consideration, such as whether the goods were paid for with virtual currency or real cash, and how much information a company has for establishing the averages.

Lack of rules won’t stop companies from filing to go public

It can get really confusing really fast.

Kirk Soderquist and J. Dax Hansen, attorneys at Perkins Coie in Seattle, are looking at the legal ramifications of virtual goods.

“You have a bunch of alternative financial services companies that have sprung up on the Internet around social networks and gaming because there’s a need to deal with money in an innovative way. But the laws aren’t clear on how they apply to the Internet and the gaming space,” Hansen said.

Despite the lack of clear regulations, they said, they don’t believe that’s keeping any companies from filing for a public offering.

The one major aspect for a company to consider is unclaimed property laws. If a user purchases credits or coins but doesn’t use them, a company can’t necessarily set an expiration date and count them as revenue. In many states, it is considered “unclaimed property” — like an unused gift card — and the government can collect the revenue.

“Investors and acquirers will be interested in how you deal with that,” Hansen said. “If they are dependent on breakage for their business model, then they have another think coming.”

Linden Lab recognizes revenue over three years

Linden Lab’s approach for Second Life most closely resembles user-based accounting, which recognizes revenue over the average lifespan of a player, which is three years.

That time frame was picked, Komin said, because players tend to stick around for two to four years. “So, three years is not a bad estimate,” he said.

Komin prefers the long timeline because it evens out the revenues, making the company look like it has a very predictable and recurring business model. “If you have recurring and repeatable revenues over three years, it means that even if you are growing really fast, your reported numbers would be growing less quickly, but it would be more predictable. The other far extreme would be to report everything in the current period, and you’d see the growth as it was happening — but it would be more volatile.”

In other words, if Zynga does the same thing and reports FarmVille revenues over more than the two-year period it has been popular and revenues from Poker over three-plus years, revenues will be very consistent and not reveal much in terms of how well its games are currently performing.

Likewise, sales won’t spike when they release a new title, like Empires & Allies — which has jumped from the seventh most popular game to the No. 3 spot in the past week, according to AppData.com.

The iPhone is an example of the two accounting models

A good example for this is how Apple originally accounted for its iPhone.

When the first iPhone came out, Apple used subscription-based rules to account for the revenue. That meant that sales from the iPhone were spread out over many months, rather than right after a customer bought the phone. Wall Street analysts found the practice annoying because the company’s revenues barely budged despite selling two million devices in one quarter.

Apple was forced to report it this way because it technically wasn’t selling a finished product. Over the life of the product, Apple planned to push down free updates to the device. (This is also why Apple once charged for iOS updates for the iPod touch, so it could recognize all revenue immediately.)

The laws have since changed.

“Apple is a great analogy,” Komin said. And just as Apple figured it out over time, “I think there will be some adjustment as people figure [virtual goods] out.”

To be sure, Komin has his preferences for how he wants to do it, as the company considers an IPO.

“Generally speaking, investors don’t reward you for volatility,” he said. “Recognizing revenue that matches [a user’s] life cycle feels better than recording it immediately. But whichever way we go, and whichever we choose to do, we have to make sure investors understand the business.”

Whatever Zynga decides, investors (and journalists!) will thank it for being transparent.