Why Facebook Paid $1 billion for Instagram

Aquihiring is a new age term that describes acquiring an entire company for its talent and synchronicity. Facebook masters the art.

the new tech billionaires

13 developers, 18 months, $1 billion! The American Dream?

Didn’t have time earlier this week to express my initial surprise on the news that Facebook was paying $1 billion dollars for a 18 months old start up with 13 people on the payroll called Instagram. When I heard the news I thought: What makes this company worth $1 billion to Facebook, and my initial reaction was : NOTHING. At least not in terms of traditional valuation models. But then we already have accepted that traditional ways of valuing a company by its cash flow, or the sum of its parts, is entirely ineffective in a technology world where companies make only one product and give it away for free, as is the case with Instagram.

And when the Wall Street Journal reported that Facebook’s Board of Directors was all but out of the picture when Mark Zuckerberg struck the $1 billion deal to purchase Instagram, things became a bit murkier, to be discarded as the actions of egocentric maniac.

The WSJ article said: ‘It was a remarkably speedy three-day path to a deal for Facebook—a young company taking pains to portray itself as blue-chip ahead of its initial public offering of stock in a few weeks that could value it at up to $100 billion. Companies generally prefer to bring in ranks of lawyers and bankers to scrutinize a deal before proceeding, a process that can eat up days or weeks. Mr. Zuckerberg ditched all that. By the time Facebook’s board was brought in, the deal was all but done. The board, according to one person familiar with the matter, ‘Was told, not consulted.”
Mr. Zuckerberg’s handling of the Instagram acquisition could be seen as a reminder that Facebook is still in some respects a one-man show in spite of the fact that the company is on the verge of going public.
But even though foregoing on the surface seems to explains a lot, it does not explain everything.

The Numbers

First there is the product; an application for smartphones that can take square, Polaroid-style throwback images, run them through a few cool filters to make them look snazzy and share them with other users on social media sites. Truth is that the app is not rocket science or a cutting edge fighter jet simulator and could have been developed by any solid mobile App developer.

Could it be the user base that Zuckerberg was interested in? Hardly in my opinion since FB already was touting 850 million users versus a “paltry” 35 million on Instagram. Sure the growth curve was spectacular from a start in October 2010, but this was not a matter of adding market share for Facebook.

Nor did the two-year-old Instagram bring much in the way of revenue to the table. In fact, the company has no revenue stream at all; it was living off of $7 million in venture capital funds it managed to raise on the back of its early success, having garnered 1.75 million downloads just four months after its launch. (The product, by the way, was built on just $500,000 in seed funding pre-launch.)

So here is the traditional valuation picture: No revenue, little money in the bank… you might think a company like that would come cheap. That instead, Facebook believed it justified a $1-billion price tag tells us that Facebook values the company for something more than Instagram’s application, audience, or earnings.

The War for Talent

I wrote about it a little while back when I said that traditional websites will not be in existence anymore 3-4 years from now as the mobile world takes communication by storm. The mobile-application economy is so strong right now that the war for talent in this space is as hot as the surface of the sun. And the small set of developers with the mettle and skills to develop for these still somewhat-difficult-to-build-for platforms (at least when compared to Web development) can virtually write their own ticket with several options, provided they are located in the greater San Francisco area. (More on that later).

Talent can decide to emerge in their own start up or settle for a well paid position in an established company. In the first case they may hit gold and have the shares to prove it, while in the second instance they just toil for a good paycheck with profit sharing, as all the valuable founder’s shares have already been issued.

And Facebook is struggling on mobile devices and as we are going mobile at warp speed and Facebook is lagging behind while also struggling with high talent turnover.

So, to pick up a startup with a proven, talented development and distribution team for mobile is nearly priceless… especially if you can do so with an “earn out” that virtually guarantees employee loyalty for a few years after the initial deal is struck. Of course $80 million per developer in the Instagram team, may seem a bit wacko, even for Facebook. Yet as a society we don’t seem to mind that Sports Superstars make a million dollars per game or a movie star catches $20 for a movie!

It’s all about content

With somewhere around 35 million users, Instagram represents a major source of content for Facebook. When you snap a photo with the application, it is posted to your Facebook profile and displayed to your friends. Comments follow, and users are engaged.

The secret to Facebook’s runaway success lies in its flat out simple business model. In essence Facebook is an entertainment company that doesn’t have to produce or license any content. Users, developers and brands do it for them. No need for licensing from film studios or major record labels required, as users provide the content. On SearchAmelia’s Facebook page we provide links to the articles we think you might find interesting, incuding YouTube videos, or new songs – after all, who knows better what will make you laugh, or tap your feet, or scream out loud than your friends?
On top of that, it lets you socialize while you are at it, all the while consuming and providing highly customized content that’s much surer to fit your desires than the average cable-TV lineup.

And in that line up, arguably most valuable of all are the posted photos. The most engaging content on Facebook, in terms of what items in the newsfeed and timeline draw the most clicks, comments, likes, etc. is photographs. You only have to attend a party of any kind and witness the absurd amount of pictures that get uploaded to Facebook in real time.

Increasingly, those photos come from the ubiquitous, camera-equipped cellphone. And with tens of millions of users and its strong mobile focus, Instagram is now responsible for providing millions of new pieces of content to the social network each month, with Facebook by far the preferred target for users of its app.
That exclusive access to content is partly what Facebook bought. But it bought something else, too: protection.

Instagram could have struck out on its own. As it turns out, the company had actually raised $50 million just days before the buyout was announced. With that kind of money in the bank, Instagram could have set its sights on erecting its own social network on top of that installed base of users. Even if it failed, it would have choked off an important source of content for Facebook. If successful, there’s no telling what kind of impact it might have had on Facebook’s all-important traffic.

Or… imagine what would have happened had another social network seized Facebook’s spot as the top dog in Instagram’s application.

Fending Off the Competition

According to news reports that surfaced in the weeks since the acquisition’s announcement, Facebook was not the first to the deal-making table with Instagram. Rival Twitter had been in discussion with it as well. Just how far along the two companies got in talks may never be known outside the room, but given the price tag now attached to Instagram, one can only imagine it was enough to put a scare into Facebook.

Had Twitter bought the popular photo-sharing company, Facebook would have been at risk of seeing all of Instagram’s users migrate to a competitive social network, bringing many of their friends and the associated pageviews with them.

With an IPO in the works, this risk is especially acute. A drop now in engaged users, in average visits per month, or any other major metric for the social powerhouse could shake market confidence in the company’s already rich, twelve-figure valuation.

Even if the dip never materialized – Instagram is but a drop in the bucket of Facebook’s overall volume of user-generated content, even with its tens of millions of users – you can be sure the press would have a field day with a major app going to one of its competitors. And that press itself could potentially feed back into reduced traffic for Facebook as it advertised a Twitter/Instagram combo far and wide.

Facebook’s ever present risk to become uncool

The threat for Facebook is simple: How do you keep the majority of the world’s Internet users on your site? Once any company becomes as large as Facebook, it needs to worry, as the saying goes, about having “jumped the shark,” i.e., passed its time of relevance. In other words, Facebook is continually at risk of becoming uncool – a kiss of death that could cause it to bleed users, just like predecessors Friendster and MySpace. The latter of those two companies went from a $640-million price tag when purchased by Fox to being sold off for a mere $35 million when its user base and revenue shrank by more than 75%. The former just went flat-out bust in a matter of months from its peak.

Facebook has to be concerned that the shift of computing to the mobile phone – for much of the world the only computer a person has, and for the developed countries the one we use the most when not working – could consign it to the same fate as its early competitors. Buying Instagram put one of Facebook’s most abundant resources – money – to use protecting market share, not adding to it, while guarding its position at the top of the social heap.

When You’ve Got It, Flaunt It

For all of its shortcomings and looming threats, the one thing Facebook has going for it – other than a massive large-screen user base – is cash… and lots of it. The company’s pre-IPO financials peg its annual revenue at more than $3.7 billion. On top of that, despite its rapid growth, it is already quite profitable, raking in more than $900 million in net earnings in 2011. According to inside sources, Facebook ended the year with more than $3.5 billion in the bank.

And the IPO will only add to that. Even though most of the equity in the company post-IPO will still be held by insiders, if they get their asking price on the market, the company will raise more than $10 billion in additional cash. With all of that money flooding in, why not put some of it to good use?

Thus this megadeal, surely overvalued by any traditional measure, will help maintain Facebook’s valuation and keep IPO investor interest high. That’s a small price to pay, even at a billion dollars. The extra billions current investors stand to make as a result will more than make up for one frothy acquisition, and likely made the board vote on the acquisition that much easier.

We’ll probably never know how the exact timeline of acquisition went, but to know that financial powerhouse tech investor Marc Andreesen, seed investor in Instagram and boardmember of Facebook, was waiting in one room in Zuckerberg’s house in Palo Alto, while the deal he was unaware of, was being brokered in another room, puts founder Zuckerberg in a different perspective. He just may be much more of a visionary than previously given credit for.

Facebook has typically made “aquihires” in the past, meaning that it buys other companies for the talent, not the product. In Instagram’s case, it was a strategic, bold move that Zuckerberg wants to secure Facebook’s position as the dominant photo sharing player in mobile and web. We can only hope that Facebook doesn’t turn Instagram into something that drives its user base away.

Two twenty something CEOs spending a weekend together hammering out the biggest mobile app acquisition in history (so far). That’s the new world we live in and it’s capital is firmly established in Silicon Valley and Palo Alto California. If you want to be recognized as top talent in technology development, be prepared to move there.

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