Will Facebook Acquire Zynga?

The Wall Street Journal has a good article describing the co-dependency that has evolved between Facebook and Zynga.  The paper reports the following statistics about the two firms:

"Facebook, based in Menlo Park, Calif., derived 12% of last year's $3.71 billion in revenue from Zynga, according to the social network's IPO prospectus released Wednesday.  Meanwhile, Zynga, the San Francisco-based social gaming company that makes many games that are played on Facebook, received 93% of its revenue last year from virtual goods it sells on the social network."

Economic theory suggests that the two firms may be headed for a merger.  Why?  Oliver Williamson, the Nobel-prizing winning economist, has argued that companies consider transaction costs when determining how to organize themselves.  Put simply, firms compare the efficacy of using the market to organize economic activity to the efficacy of organizing such activity within the firm.  Often, companies establish contracts, strategic partnerships, or formal alliances with other firms if the arrangement provides value to both parties.  However, these market-based transactions sometimes become problematic.  Why? One reason is that the potential for opportunism and hold-up occurs.  That is, the firms may try to take advantage of each other.  Such holdup tends to occur in situations of co-dependency. 

Let's take a classic example from Williamson's work.  Imagine an oil refinery adjacent to a pipeline, each owned by separate parties.  What if the refinery and the pipeline each had no alternative uses.  That is, the only way to ship the oil from the refinery was from the pipeline, and the only use of the pipeline was to ship that refinery's output.  In that situation, each party would be beholden to the other, and they might find it hard to work together amicably via contract or alliance.  Merger tends to be an outcome in such circumstances.

We had a similar situation in the entertainment business recently.  Disney and Pixar had worked together through a contractual relationship for many years.  Then, Disney and Pixar entered into contract renewal negotiations in 2005, and the relationship became strained.   Why?   I would argue that the two firms had become co-dependent over time.  Disney needed Pixar, because its own animation studios had fallen on hard times.  Meanwhile, Pixar needed Disney because the original contract had given Disney certain rights even if Pixar terminated their relationship.  Disney could continue using the characters from the early Pixar movies, and they could make sequels to those movies, even if Pixar partnered with someone else in 2006.  Pixar really didn't want to see that happen to their beloved characters.  Not surprisingly, Disney acquired Pixar in 2006, thereby choosing horizontal integration over a market-based relationship - just as Williamson's theory would predict.

Now, we could have a similar co-dependency emerging between Facebook and Zynga.  Could a merger be in the cards?  It's certainly something to watch.  On the other hand, Zynga has been working to diversify its revenue base lately.  That may lessen the co-dependency over time.

The Facebook - Zynga Relationship

As the Wall Street Journal notes today, Zynga has embarked on a strategy to become less dependent on Facebook. To date, the firm has ridden the coattails of Facebook, with its social games doing incredibly well on the social network's site.   However, as the firm approaches an IPO, investors expressed concern with the dependency on Facebook.  Zynga now has begun to pursue a strategy of offering games directly to consumers through its own site as well as through mobile platforms. 

The issue of dependency raises an interesting question.   To what extent is Facebook dependent on Zynga?  To date, the dependency has been mostly one-directional.   However, if Zynga does succeed in developing its own route to market, then we may see a bit more of a co-dependent relationship.  Why?  Well, Zynga certainly helps Facebook a great deal, not only through the direct revenue that Facebook generates from the relationship... but also because heavy Zynga users tend to spend a great deal of time on Facebook.  As a result, Facebook has an opportunity to sell more ads.   If we end up with a situation of co-dependency, then I would look for rumors to begin to swirl regarding a Facebook acquisition of Zynga.  That's what tends to happen when two firms become dependent upon one another.   Each side worries about being "held up" by the other, and therefore, a merger often resolves the conflict and enables the two parties to cooperate more effectively.   We are far from that point, but we may be headed in that direction with the latest Zynga strategy moves.