How Ads Could Ruin Zynga and Why They (Probably) Won’t

Post IPO, does the gaming giant need to see the advertising light?

Players can spend a lot of time chopping trees, quarrying rocks and planting grapes in CastleVille, all in the name of helping a princess build her home. When they run out of the energy needed for such tasks (given out as energy points, which are tracked on an on-screen bar), they have lots of ways of getting more juice—ways that, usually, will cost them more money, or, in some cases, test their friends’ patience. (Players can ask Facebook users for help in gaining more energy.)

But despite the time users invest in CastleVille, Zynga’s latest runaway hit game, participants can play for a while without seeing much in the way of advertising. To date, Zynga’s ads mostly have been limited to virtual in-game product placements (e.g., a virtual McDonald’s), direct response-oriented banners and offers to receive energy boosts in exchange for cash (“Get 32 Crowns and 10 Facebook Credits for only $1!”).

That’s been fine, since Zynga’s been making a killing on selling virtual goods to a small slice of its most engaged players. But with the growth of that business slowing down, Zynga, in some ways an industry holdout in the realm of advertising, is about to get serious about ads by scaling its business through incentivized advertising.

“My perspective is, if you look at the early days of casual game advertising, it was bad,” says Zynga CEO Mark Pincus. “Bad for gamers, bad for advertisers. You saw people trying to squeeze the pay-per-click model into games. You want to play the game, not buy a hotel room.

“We built our entire business model around engagement,” he continues. “Now advertising is the fastest growing part of our business. At the end of the day, we’re in the middle of really an amazing, magical secular shift to free gaming. We think it very quickly surpasses TV as the next major worldwide free consumer medium. And we want this to be free, free as possible. We want to scale this as a mass-market free medium, and engagement ads are just a great way to fill that massive void.”

The risk for Zynga is clear: Known for its emphasis on user experience, can the lure of brands offering, say, free energy, keep players from turning their backs on the games they love? Equally important: Is Zynga going far enough?

“We’re at a tipping point,” says Zynga chief marketing and revenue officer Jeff Karp. “We have a huge opportunity. We’ve done solid numbers, but there’s a ton of potential” to do more.

According to its recent earnings report, last year the newly public Zynga earned $75 million in ad revenue, up 225 percent versus 2010—numbers that were far more solid than some expected. But Zynga’s revenue projections for 2012 have already disappointed Wall Street. Also, for years industry experts have estimated that just 1 to 5 percent of Zynga’s players actually pay for virtual goods—those special shovels that help players complete tasks faster on Treasure Isle, or super-powered hoes that hasten the tending of crops in FarmVille. Most Zynga gamers are cheapskates, meaning that the company hardly monetizes them, despite their huge numbers (240 million active players).

Add in the news that social game growth is slowing down, and it’s not hard to see why the (overheated) headlines predicting Zynga’s demise have already begun. “Why Zynga Will Never Be Great Again,” wrote The Motley Fool last month. Similarly, GigaOm asked the question, “Is the honeymoon over for Facebook gaming?”

“The age of just blasting social games is over,” says Tim Chang, managing director, Mayfield Fund, which invests in mobile and ad technology. “Monetizing just 1 percent of the general audience is burned out. The entire is shifting toward the mid-core.”

Clearly, Zynga, whose Facebook hits include FarmVille, CityVille, Zynga Poker and Mafia Wars, has never made advertising its top priority. Until recently, the company has had only one sales executive, Manny Anekal, who just jumped ship to join the mobile ad startup Kiip. In fact, Zynga has long outsourced much of its ad sales operations and technology, previously working with the likes of appssavvy (the ties have since been severed), SocialVibe and Burstly, as well as supply-side platform companies like PubMatic and The Rubicon Project.

And while Pincus is a regular at Silicon Valley events like Web 2.0, you don’t see him and his team blanketing Advertising Week or Interactive Advertising Bureau events. It’s safe to say that Zynga doesn’t have the top digital media agencies on speed dial like Yahoo, or even Facebook, does.

“Right now they are just scratching the surface,” says Brandon Berger, chief digital officer at Ogilvy & Mather.

Adam Shlachter, managing director, digital, MEC, says that Zynga is still not a big consideration for many of his clients. “Since they have a diversified revenue stream, with much of it coming through credits and commerce, advertising [still] doesn’t seem as critical to their business today,” he notes. “I think part of that is due to how they are, or are not, selling. … And the price tag is steeper and opportunities more complex than your average digital ad buy.”

To date, advertising on Zynga has mostly been about big hits, i.e., brand integrations like that virtual McDonald’s or a virtual Best Buy. Matt Story, vp, director of Publicis’ Denuo, says such properties are very attractive to marketers. “You can’t argue about the size of the audience,” he says. “And consumers don’t seem opposed to their ads.”

DreamWorks has discovered the same thing, teaming up with Zynga in 2010 on a custom execution for the animated movie Megamind in FarmVille that led 10 million players to visit the film’s farm and enticed 6 million to share the content. Last year, the two companies partnered on Kung Fu Panda 2 with a branded movie drive-in on CityVille that attracted 45 million gamers.

But such properties are both complicated and time-consuming to create. “It does provide certain creative challenges,” says Jason Alex, head of online marketing, DreamWorks Animation. “But we really created that ‘aha’ factor.”

“The question I have is, do they have the bandwidth to do a lot of these programs?” Story asks. “If they had five to 10 brands looking to execute big programs, they’d probably have to space them out.”

Seemingly in acknowledgement of such problems, Zynga’s push toward more scalable ad options has already begun. Last year, the company brought on an ex-Google exec, Aaron Rova, who is now vp of ad sales and partnerships. CMO Karp says he’s adding several more top executives in key markets in the U.S.

“They’ve gotten a lot more serious about advertising in the past six months,” says Chris Cunningham, CEO and co-founder of appssavvy. “They’ve been a one-trick pony and that wasn’t going to satisfy the market.”

Zynga, for instance, recently announced a promotion with three of its games—FarmVille, CityVille and CastleVille—and Frito-Lay, wherein consumers who buy certain snacks through March and part of April can also receive exclusive in-game items. There’s also an accompanying website.

The company is planning other ways to provide rewards for users engaging with advertisers. That CastleVille player waiting for more energy to help the princess? He’ll soon be able to view a trailer for a movie or answer a question posed by a packaged-goods brand, and get a boost. Zynga has gradually begun testing ads-for-energy exchanges with brands including Coca-Cola and 20th Century Fox.

Is Zynga worried about its new ads pissing off users? Some of its games have daily audiences that rival the likes of NCIS or even American Idol. In the past, Zynga has refused to blanket them with interruptive ads despite the TV-sized audiences (55 million players daily).

“If we interrupt them, we break the partnership we have, and our relationship,” says Karp. “Every day we have to earn that. So it’s about finding that balance. … This is about social rewards advertising.”

Some, however, have doubts about Zynga’s sincerity when it comes to this newfound passion for brand advertising.

“These guys are ARPU guys,” says one gaming executive, referring to the abbreviation for average revenue per user. “They think about maximizing yield on each player. They don’t think about ads.”

In its early years, the executive adds, Zynga was making a killing on virtual goods. It soared to $500 million in revenue in 2010. Last year, it pulled in $1.14 billion. So why, he asks, would you throw out a good thing, instead of fixing it?

Another social gaming insider asks, “Would you pull a developer off of a game that is generating $10 million in virtual goods to work on a million dollar ad deal?”

And there’s another question: Is Zynga going far enough? Sure, brands love engagement. But they also favor reach. Zynga could easily put a video ad between every level of FarmVille and probably pull in millions from advertising right away.

But that doesn’t seem to be the Zynga way. “From what I understand, they’re very particular about the brands they want to work with, as they should be, [so as] to not clutter the experience,” says Shlachter.

That’s fine with some advertisers. “I’m a purist when it comes to protecting game play,” says Ogilvy’s Berger. “This is a very different demo with a much deeper engagement level. Zynga let’s you do things you can’t even do in a huge game like Madden.”

There’s another big reason why Zynga needs to exercise ad restraint. As Mayfield’s Chang notes, “You can’t screw up your core business.” Zynga, he says, needs to segment its audience—showing lots more ads to the non-payers while never disincentivizing the big-paying customers. “Never give anything free to your whales,” Chang adds. In my mind, [Zynga is] are more of a data and analytics company than a gaming company,” so it might be able, he feels, to pull this off.

And, of course, because most marketers would love to have the wow factor of a virtual movie theater or elaborate store, a challenge for Zynga will be to still regularly create something completely original, something that will result in an “aha” factor. That likely requires more than handing out an energy boost.

Pincus believes it can—and that the company can move faster than some in the space might think. “We’re also a technology company,” he says. “This is a part of our platform and software. We can turn things around without involving an engineer. That’s why you started seeing our ad business get real by the end of last year. That is what we’re working on, making [these campaigns] easily repeatable, where it’s more a matter of just changing out creative.”

Of course, he adds, “right now, we’re still looking at larger ad deals. Joe’s Cleaners can’t come in and build a local Joe’s Cleaners in CityVille yet. But really any brand advertiser can do this with us. At a fraction of the cost of TV. … I believe there is going to be a new consumer deal that grows up [on Zynga]. You can buy [an item], or you can let McDonald’s buy it for you. And if McDonald’s buys something for me, I’m kind of liking McDonald’s right now.”