I’m just back from a week skiing and visiting relatives and the big news whilst I’ve been away is undoubtedly Facebook’s $1bn acquisition of Instagram. The question on everyone’s lips is, of course, ‘how come a two year old startup with no revenues is worth $1bn?’. I think the answer is pretty clear – it’s all about Facebook’s IPO price. Assuming they get out at Zuckerberg’s rumoured $100bn target then the Instagram deal only has to make a 1% difference to the FB share price for it to be worth $1bn. I think that high priced acquisitions of startups are often valued with half an eye to the acquirers share price. In this case Facebook’s pending IPO make it particularly easy to understand the logic.
Returning to Facebook, small improvements to their IPO share price will come from taking analysts concerns off the table and this deal helps with big concerns two:
- Instagram’s competitive threat to Facebook’s photo sharing dominance (particularly if acquired by Google)
- Revenues from mobile are an important part of Facebook’s growth going forward and photo sharing on their mobile app is mediocre at best
Other incidentals that help are:
- Instagram’s growth has been explosive up to 30m users, and with the release of an Android app last week that growth is widely expected to accelerate
- Instagram is an incredibly well run company – there are numerous small pieces of evidence for this, but my favourite is that they got to 4m users with only 4 employees
- Valuation has been increasing rapidly and the deal likely won’t get any cheaper (Sequoia and other VCs who invested last week at a $500m valuation would likely want more than 2x if they stayed in for any length of time)
- Instagram doesn’t rely on other social networks and transition to ownership by Facebook won’t create any difficulties with Google and other competitors changing their attitude to the business
- $1bn values Instagram at $33 per user, which compares with $118 on Facebook (assuming a $100bn IPO)
Alan Patrick makes some similar arguments about Facebook’s IPO driving the price here.
When I was interviewing to become a VC for the first time in 1999 I was asked to do an analysis of AOL’s valuation and I said then, as I am saying with Instagram now, that it only makes sense in the context of the valuation of other similar companies. If you try and make sense of it from a fundamentals perspective – i.e. from forecast cashflows or profits, it quickly becomes clear that the only way to get there is by making outrageous assumptions. The same isn’t true of Facebook though, where they have significant profits and cash flow already and whilst their forecasts are aggressive they aren’t ridiculous and are underpinned by logic and trading history. I think that is the difference between 1999 and today.