October 30th, 2012 / Insight posted in

Is credit due to Facebook?

What the introduction of Facebook credits means for the small developer

Until recently, ‘gaming’ largely meant the console market, where the focus was predominantly on a standalone experience via a console attached to a TV, PC or portable games unit, such as the PSP. This has typically attracted a younger, male audience. Nintendo’s Wii console, on the other hand, has got all ages and both sexes involved in gaming and, arguably, has been the forerunner to what we have come to know as ‘social gaming’. However, it’s been Facebook, coupled with the increasing popularity of the smartphone, that is changing all this.

In the last year or so, social gaming has exploded in popularity around the world at a phenomenal rate. Through Facebook, we have seen the release of games such as FarmVille, Mafia Wars and PetVille, all developed by US firm Zynga. Until this month, and since August 2009, FarmVille has held the top spot by monthly active users, or MAU, reaching a peak of 80 million MAU earlier this year. Arguably, we are seeing a return to the days where community games, such as Monopoly and Cluedo, brought people together, albeit virtually.

There are four key players in this market – Playdom, Playfish, Zynga and Crowdstar – and a rapidly expanding list of others. Playfish is one company at the forefront of the revolution; its extraordinary success led to an acquisition by electronic gaming giant Electronic Arts for approximately US$300m in November 2009. Now, with the backing of an industry leader and its coveted licences, additional Playfish games have been released on Facebook, such as FIFA Superstars and Madden NFL. Zynga’s success through some of the titles mentioned above has led to a current valuation of a massive US$5.5 billion.

Facebook credits

In February this year, Facebook launched ‘Facebook credits’, a virtual currency that can be used to buy virtual goods within its social networking site. At present, this currency is still in beta test phase, with over 75 developers and 200 plus applications using it. It is planned to be integrated across all Facebook applications and games by the end of 2010.The latest big developer to sign up to Facebook credits is Electronic Arts. In November, it signed a five-year deal to accept Facebook credits as the exclusive payment method for it’s games on the social networking site.

Facebook credits are expected to become the sole currency accepted on the Facebook platform. This will have implications for the growing number of social gaming developers and businesses, firstly in understanding how it works, but also in terms of what it means for a successful strategy. One thing for sure is that by the time you read this article, there will be a new announcement or development that takes the Facebook credits story one step further along its journey.

So how do Facebook credits work for the user?

Users, or games players, obtain Facebook credits either by purchasing them from Facebook or they can earn them through game action, offers or other promotions. Users can use their credits to purchase digital or virtual items from the ever-expanding credits-enabled applications on Facebook, for example, a tractor for a user’s farm on the FarmVille game. If purchasing credits, payment can be made in a wide variety of ways, such as credit card, PayPal and now by Facebook credit vouchers of varying monetary values. The latter are now sold in Tesco and Game in the UK, with other retailers sure to follow. The user receives ten credits for every dollar equivalent spent – although the user never actually owns the credit. Instead, he or she gains what Facebook calls a “limited right to use” them. The user can then purchase virtual gifts; again the user never owns the gift, but is licensed it for play.

How the Facebook credits purchase process works

Within Facebook, a user places an order by clicking a ‘Pay with Facebook’ button. The order gets submitted to Facebook and it gets the item details being purchased from the application. If the user has sufficient credits or if the user has a stored credit card or other payment credentials on file, the order is fulfilled. If the user does not have payment credentials on file, the user may get redirected to a new page for entering credentials or may stay within the application, depending on the payment type.

When the user confirms his or her willingness to pay, Facebook calls the application back-end to let the application owner’s system settle the order, after which Facebook completes the transaction appropriately.

The following diagram roughly illustrates a simple order fulfilment process: 

 


Source: Facebook

Facebook credits versus PayPal as a means of payment for game play

PayPal has been reported to account for more than 50% of direct payments within social games, and it is Facebook that is the second largest driver of traffic to the PayPal website after eBay. It offers a secure and safe way of transacting on line. PayPal’s success linked to Facebook hasn’t gone unnoticed, so it’s not hard to see why Facebook credits are being positioned as a serious competitor to PayPal in the virtual payments market.

By introducing Facebook credits and making these the exclusive method of purchasing virtual goods within Facebook, this would leave PayPal’s role as simply enabling users to top up their Facebook credits account. Couple this with a recent Inside Facebook Gold survey, where it was revealed that whilst 70% of users knew they could buy credits through PayPal, only 22% of them chose to do so, PayPal has taken note.

Consequently, PayPal has recently announced improvements to its interface to make it less cumbersome. According to the head of social media at PayPal, this will make transactions very fast, like putting money into a slot machine in a pub. Whilst PayPal may be able to use its enhancements to increase the number of paying users for developers, it may all come to nothing if Facebook makes its platform credits exclusive, leaving PayPal’s role simply to top up credits for its competitor.

So what are the benefits to the developer of Facebook credits?

The main advantage of Facebook credits is the installed user base. First, that a single, cross-application currency can be used on some 550,000 active applications is a major selling point. Second, Facebook credits arguably has the edge over PayPal in terms of convenience and distribution; it is easy for anyone to buy vouchers from the likes of Walmart and Best Buy in the US, and Tesco and Game in the UK. Third, with tight security and simplified user interfaces, Facebook credits can be topped up in 16 international currencies and through a variety of methods such as PayPal itself, American Express, MasterCard, Visa and mobile (for example, AT&T in the US is trialling Zong, Bohu and BilltoMobile). However, an October 2010 Inside Facebook Gold survey highlighted that users still prefer to pay with familiar names like PayPal and Visa over mobile payment start-ups like Zong, but will change as this payment method becomes more common place.

This is a proven revenue model; many of the original social networks succeeded with similar schemes. By 2006, for example, South Korean social networking site Cyworld was bringing in 80% of its revenue by charging for virtual items (homepage wallpapers, background music). 92% of South Koreans in their 20s were using the site, resulting in 22 billion page impressions a month. Mobile services alone earned US$15,000 a day or 10% of revenue.

That the developer has to forego 30% of its revenue, Facebook’s response is that the use of a common transactional currency across the platform will lead to higher conversion rates, more paying users and greater net revenue. Developers have been drawn in by the promise, and to this end, Crowdstar (Facebook’s first official credits test partner) saw sales of its virtual goods double after its games went credit exclusive. Arkadium told the Wall Street Journal that Facebook credit users are three times more likely to buy goods than those using other options. Arkadium is considered a ‘casual gaming’ company and their biggest hit to date is Mahjongg Dimensions, which peaked with 1.5 million gamers.

Finally, there is scope for user education and marketing, which could spur repeat business. Facebook is open to discussions on innovative ideas, bulk discounting and seeding credits, for example, donations to good causes through links to Just Giving. Ultimately, the company believes its credits will boost developer revenue by pushing the number of users buying goods during social games from 1-3% to 20%.

Credits aren’t without their disadvantages for developers

Virtual goods are expected to bring in US$835 million in the US in 2010, while sales of virtual gifts and games are set to top US$6 billion by 2013.

But how much of this income will third-party developers see? Some within the industry expect Facebook’s flat 30% fee to translate to 50% of developers’ revenue after accounting for all potential costs. Cost is a major issue and PayPal is already the industry’s low-cost provider. This is because it is less reliant on credit cards and the associated expenses (credit card interchange fees), which are minimised.

Difficulties will arise if and when Facebook decides to integrate its credits with the sale of physical goods. Sellers with already smaller margins will be more price sensitive on every transaction than those with higher margins. The latter characterises the virtual goods market (e.g. social gaming sites and apps), which would gladly pay more for extra conversions. Additionally, PayPal incentivises balances (money-market interest rates, ATM/debit card liquidity) whereas Facebook has high funding fees and so will charge a premium.

All of the big developers have agreed to make their applications credits exclusive and there are plans to make other developers follow suit by the end of the year. This allows users to buy credits through PayPal but only pay for games using Facebook credits. The current set-up supports PayPal also at the game-payment stage, i.e. you can also use PayPal to acquire a virtual good from an application itself. The implication is a loss of control for third-party developers to Facebook. A single currency, Facebook credits, makes it harder for developers to implement their own sales promotions, e.g. bulk discounts and special incentives.

The revenue model has had its share of casualties too; Amazon and Google experimented with comparable payment schemes with little success. However, this time with the user base, it’s more likely to work.

What the next 12 months will look like for the developer

With FarmVille having just been knocked off its top spot, partly due to its age, but also due to the viral channels being turned off by Facebook, this signals a cooling off and maturing of the market which has until now seen explosive growth. It is no good launching another FarmVille type game today.

For the smaller developer, it is harder than it was a year ago, without the funding, the network and now the lack of viral channels. It’s not all doom though, funding is still available to the right businesses.This is still available at the seed/small venture capitalist (VC) end, as well as the top end; it’s the middle area where it’s hard at present to attract funding.

To be successful, user interfaces will certainly become more sophisticated. The next 12 months will see developers making their applications a richer and more immersive experience for the user, and doing something different, while still maintaining simplicity. Focusing on new markets, such as mobile and international, will be a key part of a developer’s strategy. For example, Zynga has just launched CityVille, a Sims-like game in five languages.

It also means understanding and integrating Facebook credits into applications for those smaller developers that have to start using them for the first time – if indeed these are made the sole currency across the platform.

So what do Facebook credits mean for a developer’s business plan and reported results?

Any small developer has an eye on raising initial or additional funding at some stage, be it seed capital, or from a VC, which is sometimes tied in with an Enterprise Investment Scheme (EIS) scheme.One of the key requirements is for management to have a robust business plan, with financial projections for at least five years.

An essential part of a business plan is to demonstrate the business can operate profitably and with adequate working capital and cash flow, which itself may be sought by a funding process. It is therefore worth highlighting some of Facebook’s terms and conditions, which should be considered when developing the business plan, the monthly management accounts and the year-end financial statements.

When a developer registers to accept Facebook credits, an account is opened and it is through this account that all transactions flow. The terms and conditions state that when a developer redeems Facebook credits that have been accepted for a transaction, Facebook will redeem them approximately 30 days following the end of the month in which the transaction occurred. These can only be redeemed in US dollars.

This raises two points: First, there will be a delay of between 30 and 60 days before the receipt of cash due to the terms of payment. This should be factored into account in a business plan and cash flow forecasts. Second, the developer will need to have the facility to receive US dollars, which means a developer is subject to foreign exchange movements upon translating balances to local currency. Whilst this does not have much impact with a stable dollar/sterling exchange rate, it does mean cash receipts can fluctuate if foreign exchange rates vary.

When a business is preparing its results, either at a month end or a year end, it will be important to recognise revenue appropriately. Under UK Generally Accepted Accounting Principles and International Accounting Standards (IAS18), revenue can only be recognised when earned. This means that once a virtual good has been purchased by a user, it can be recognised as revenue, even though the cash has not been received by Facebook. This will require a month-end adjustment to the accounts to recognise accrued revenue – which should, of course, also be reflected in the business plan. So for example, for virtual goods sales in November which would not be physically paid for until the end of December, these would be accrued in the November month-end accounts.

The commission that is payable to Facebook, namely the 30 cents in every dollar, should be recognised in the month-end and year-end accounts as commissions payable, within costs of sale. As with revenues, these costs should be appropriately accounted for at a month and year end.

Conclusion

Facebook credits are still in Beta phase, with the big developers having all signed up to use them. It was announced in January that Credits will become the exclusive payments method within the platform from the middle of 2011, later than expected. Most developers are preparing for the practicalities of this already, although not everyone has taken the time to think through some of the financial or legal aspects fully. That should also be put on the table for discussion.

The social gaming market has developed at an extraordinary rate over the past 18 months. With the market starting to mature, developers will be looking to differentiate themselves in 2011, looking to new markets, such as mobile and international markets. 2011 will be exciting in the social gaming sector; who knows where Facebook will stand this time next year vis a vis social games, who knows what new platform, hardware or operating system might take off or gain an edge.