Time to Rage

Mark Zuckerburg announced that Facebook was acquiring Instagram for $1 billion yesterday, which set off a firestorm of blog posts, tweets, and news articles debating whether this was a sign of a bubble or if Instagram sold out too soon. I think Facebook needed to pay $1 billion to make the deal happen, so I thought I would offer my 2 cents on how Facebook could try to justify the $1 billion figure. 

I’ve never really valued a company without any revenues before. Since I’m a restructuring banker, I have valued several companies that are massively cash flow negative, but they (or at least their management teams) all generally have rosy projections that increase their revenues higher than their costs within 3 to 5 years which give me something to work with when performing valuation analyses. 

I’m sure Kevin and Mike, the brilliant co-founders of the delightful photo-sharing app Instagram, have a plan for generating revenue for their company at some point in the future. 

3 Traditional Methods to Value a Company Don’t Justify $1 Billion Price

However, the fact remains that the 3 traditional ways to value a company (DCF, Precedent Transactions, and Market Multiples) won’t help us justify the $1 billion sale price. 

1. DCF - Since Instagram has no significant revenue at the moment and is unlikely to be cash flow positive in the near term (despite extremely low overhead with less than 15 employees!), there is no way a DCF could support a $1 billion valuation.
2. Precedent Transactions - The only relevant precedent transaction might be Yahoo’s 2005 acquisition of Flickr for $35 million, but there isn’t much publicly available information on that transaction for us to use as a comparison. I know Instagram has 30 million users, but the ~$33 Sale Price / User multiple is meaningless without something to compare it to. I guess I could compare it  to OMGPOP’s ~$210 Million Sale to Zynga, which implied a ~6 Sale Price / User multiple, but games and a photo-sharing app really aren’t that comparable. 
3. Market Multiples - Unfortunately, there aren’t really any of comparable public companies available for Instagram.

Great. So, if I’m trying to use traditional valuation methods to quickly value Instagram, I can’t really make any significant conclusions due to the lack of available information. 

Since Early-stage, high-growth start-ups often have little to no revenue, they routinely need to raise funding to support operations. These fundraising rounds come with a negotiated valuation of the company at the time of the financing so that the company (i.e. founders) can issue shares to the investors at a set price they both agree on.

Instagram Raised $50 Million at a $500 Million Valuation Last Week

In a surprising move, Instagram reportedly raised $50 million of additional funding late last week at a $500 million valuation from a group of several top venture capital firms. So, it should be simple, right? If Instagram was worth $500 million on April 5th, shouldn’t it probably also be worth $500 million on April 9th, just 4 days later?

Well, it depends (shocker!). There is a major difference between financial investors (a VC fund, hedge fund, Private equity firm, etc) and strategic acquirers (other companies, usually in a similar industry). The subject company is more valuable to the strategic acquirer for 2 key reasons:

1. Control - The strategic acquirer generally purchases a majority (>50.1%) of the company, which allows them to control alll operations of the company. On the other hand, financial investors generally have a minority stake in the company, which does provide some control through Board Seats but is not sufficient to make unilateral decisions. Even if a financial firm acquires a majority of the company, the company will still be more valuable to the strategic because of #2.
2. Synergies - Ahh…probably the favorite word for M&A bankers, synergies are the rationale for all corporate acquisitions. Synergies are the benefits that can increase overall value through a merger of the two companies. These benefits always come down either to increased revenue opportunities by aligning the products or (more likely for traditional M&A) a chance to cut costs by reducing redundant operations/headcount.

• Facebook Now “Owns” Photo-Sharing (Online and Mobile) - At its core Facebook is a photo-sharing service. People spend hours each week on the website looking at photos, often in a creepy, voyeuristic ways. But Instagram is a fast-growing mobile app with 30+ million users, a number that will undoubtedly grow rapidly now that it is available on Android and due to the publicity of the Facebook sale. Instagram allows Facebook to own the photo-sharing space both on the web and on mobile.

• Facebook Took Out its Biggest Rival - Taking a picture on Facebook on your phone sucks. It takes 6 screens on the mobile Facebook app before you can take a picture vs. just 1 screen for Instagram. Instagram is ridiculously easy to use and most of its users love it. As more customers adopt smart phones over the next few years, Instagram is poised for fantastic growth and now Facebook can capture that upside potential. If Instagram remained a private company, Facebook would have many reasons to be concerned about Instagram’s dominance on mobile phones. As angel investor Chris Dixon said in this tweet:

Giving up 1% of your market cap to take out biggest threat is a savvy move.

• Keeping Instagram Away from Google - Google has seen Facebook’s strength at all things social and has desperately tried to come up with ways to compete (see tying bonuses to success with “social”) but seems to be striking out with each new product launch - Wave, Play, and Google+ either have failed or haven’t really taken off. Instagram would have been a fantastic opportunity for Google to hit Facebook hard at its core competency of photos, and Facebook made a great strategic move to beat them to the punch in acquiring Instagram.

• Strong Existing Ties to Facebook - Instagram is already hugely tied to Facebook’s Open Graph (I mean check your your News Feed - I feel like 50% of it is Instagram photos, whether I want to see them or not). Most people have their Instagram pictures set to seamlessly integrate with Facebook, so there is a natural fit between the two products. Also,it should be relatively easy for Facebook to utilize its additional sales staff to begin to generate revenues from Instagram.

• Good Timing - Facebook is set to IPO next month. The $1 billion sale price is a combination of cash and stock, but the majority is likely to be in pre-IPO stock. Facebook doesn’t have to deal with any public company hassles of buying another company such as being worried about the effect of the acquisition on its stock price.  

Okay, So Why $1 Billion?

Instagram had all the leverage. They just raised a massive round of funding and the founders were perfectly willing to use the money to build a bigger business that could challenge Facebook. I’m sure Google has expressed interest over the past few months and Apple may be sniffing around to get a hit in something social, so there were likely no shortage of suitors. Anything less than a massive premium to the $500 million valuation and the co-founders would have said “Hell No” and gotten back to grinding to build a multi-billion dollar business.

Also, Facebook didn’t want to make the mistake that Yahoo repeatedly made in failing to close deals with Google (in 2002) and Facebook (in 2006).

While the $1 billion may seem excessive, it was the price needed to get a crucial deal done and I believe Facebook made the right decision in making this acquisition. 

(Note: Thanks to Hamza for pointing out a typo in an earlier version)