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Zynga’s IPO hiccup: why they got it right in the end

We tend to assume the worst when we hear the words “material weakness,” and for public companies required to comply with the Sarbanes-Oxley Act, it’s certainly not good news. But in terms of Zynga’s hiccup last week, in which the social media company restated revenues during its IPO filing process, it’s not as bad as it might seem. What did Zynga do, and why it was right in the end? We can draw a lesson from this tale.

First, full disclaimer: RoseRyan has had the honor of working with Zynga on discrete projects, and we respect the work of our colleagues there. We weren’t involved in the work leading up to their IPO (but would have loved that).

Zynga’s situation: they are not alone
Last week, Zynga filed an amendment to its S-1 registration statement, which included restating revenue for the quarter ended March 2011. Here’s why they had to restate:

A portion of Zynga’s revenue is derived from the sale of virtual goods. In accordance with today’s accounting literature, the up-front customer payments for these virtual goods are to be recognized as revenue over the estimated customer relationship period, and the company recognizes this revenue over the average playing period of paying players.

So far so good, right? Not quite. Unfortunately, Zynga did not update its estimates for playing periods associated with two of its games. The result: too little revenue was recognized, and for the March 2011 quarter, the difference was material enough to require that they restate their financial results.

Zynga is not alone in the challenges it faces in pre-IPO finance and accounting work. With innovative business models popping up every day and a continually changing accounting landscape, many companies find themselves in similar situations. The difference is that most of them resolve issues like these before their initial S-1. For Zynga, identifying the issue in the middle of its SEC filing process put them under a huge public microscope.

Material weakness: yes or no?
Zynga’s amended S-1 filing disclosed the restatement snafu as a “material weakness” in its internal control structure in the context of its risk factors. In other words, they highlighted the issue as an example of one way in which the accuracy of their financial statements could be at risk. As with most companies, this risk factor is just one of a laundry list of risk disclosures provided to investors.

Technically speaking, Zynga is not yet required to comply with the reporting requirements relating to internal controls. And once they go public, they’ll have until their second annual report to tackle this reporting requirement. In the meantime, however, they are still required to maintain effective internal controls to ensure accuracy in their financial statements.

Having said all that, I believe calling out their material weakness was the right thing to do. Putting their cards on the table shows that Zynga takes this mistake seriously, and transparent financial disclosure certainly builds credibility and trust with investors and analysts.

Moral of the story
If you’re planning an IPO, start early and give yourself enough time to sweep under the bed and take care of those dust bunnies before you’re under the microscope. Investing in preparation will pay dividends … we promise.

At RoseRyan we live and breathe these issues every day. We know most companies aren’t there—and I mean the vast majority. But we keep talking about it, pushing our clients in this direction and helping with their housecleaning.

And we give kudos to companies like Zynga that provide transparency to the issues they face.

To learn more about what we advise for pre-IPO companies, check out our recent intelligence reports, IPO in Your Future? and Ace Your IPO Filing.