Facebook Snaps a $1-Billion Photo

By Alex Daley, Chief Technology Investment Strategist

"What made Instagram worth $1 billion to Facebook?"

When asked this question recently, I responded with an immediate, "Nothing."

I’m not usually so terse or emphatic with my answers, as any longtime reader knows. But in this case, there really was nothing inherently valuable inside Instagram that made them worth the unbelievable sum Facebook agreed to pay. Yet they did it anyway. Clearly, there’s something missing from a traditional valuation analysis here.

That missing piece is what Instagram could have become in the hands of a competitor or even on its own, had Facebook not gone ahead with the marriage. Nearing its IPO, Facebook was willing to overpay in order to quash any potential risks that Instagram posed, both to the company’s reputation and its content stream.

Instagram by the Numbers

On the surface, Instagram might look like small potatoes. It has only one 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. Even though it has some sharing capability built into its own app, the overwhelming majority of photos are instead posted to Facebook (or Twitter or Posterous or other social network) with the app’s simple integration.

There is no magical computer science involved. The app – minus some intricacies that allowed it to scale to millions of users without buckling under its own weight – is simple enough that most any solid mobile developer could have thrown it together. This is not to dismiss the hard work the twelve-person company put into it – I am sure many late nights were spent on the finer details, squashing bugs, and the like – but it’s not exactly a fighter-jet simulator or climatology model. Facebook obviously didn’t want the company for its cutting-edge patents, code, or other intellectual property.

So maybe it had to do with the user base? True, the application is insanely popular, having been downloaded more than 30 million times according to the App Store statistics from Apple, and another 5 million on Android. (Of course, Apple and Google have it in their best interests to overcount those users, by including updates, reinstalls, upgraded phones, etc. But it is the best proxy we have, and we can reasonably assume Instagram still had tens of millions of users.) Plus, it was named "application of the year" by Apple for 2011, which was bound to further boost its appeal and draw in new users.

But Facebook already counts 850 million registered users, according to its most recent press releases. Even adding 30 million to that number would cause barely a ripple. And given that the most popular use of the application is to upload to your existing Facebook account, we doubt that it will bring many, if any, new users to Facebook. This was not about adding instant market share.

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.)

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 Need for Talent

First and foremost, for all of its accomplishments, Facebook has struggled on mobile devices. Its applications for iPhone and Android are must haves, sure. But that’s because of the power of the platform on the large screen. Those same apps, though at the top of download stats everywhere, have been largely derided as slow, buggy, and difficult to use. And that has left the door ajar for countless other social applications – everything from its biggest competitor, Twitter, to upstarts like the worrisome new mobile-centric application from a former Facebook executive: Path. The application troubles are chicken to the egg of not being able to attract and retain a strong mobile development team. The mobile-application economy is so strong right now that the war for talent in this space is white hot. 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 pick th eir spots.

On the one hand, they could join a company now considered quite large (which has already given all the really valuable founders’ shares away) and just toil for a salary alone. Alternatively, they could get the same money (maybe even more), plus real equity at a startup mobile game or app developer – a developer like Instagram. That’s a far more compelling proposition in many cases. After all, if the company goes public or gets bought out – by, well, it was once Microsoft or Google inserted here, but it seems now it’s Facebook too – for a handsome sum, then the upside is much higher.

No question, Facebook has attracted great talent. But we’re going mobile at warp speed, and in that space even the king of social media is grappling with the negative effects of high turnover. 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.

(Editor’s note: The war for top talent is raging in every corner of the technology sector – not just mobile and computer application development, but in biotech, robotics, network security… you name it. All this competition is creating profit opportunities that have the potential to be life-changing.)

Still, to pay nearly $100,000,000 per employee of the target company does not make a smart "acquihire" – the popular tech-industry term for an acquisition based almost solely on the team of people being acquired and not its businesses or customers. No matter how good the team is, no one is worth that much, not even to Facebook. Zuckerberg had to justify the purchase to his board, and the mere addition of a few smart developers would not have passed that test.

There had to be another factor in play. And there was.

The Value of the Photo

It’s about content. And with somewhere around 30 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 radically simple business model. It is basically an entertainment company that doesn’t have to make or license any content. Users (and to an extent application developers and brands) do it for them. So, no licensing from Hollywood studios or major record labels required. Instead, users themselves provide the content, such as links to news articles they think their friends will find interesting, or 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.

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.

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 Competitive Suitors

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.

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.