The Instagram – Facebook Deal: What was Zuckerberg Thinking?

Written by Saul Griffith in Featured, Stock Analysis, Stock Market News | 3 comments

Mark Zuckerberg forked over a billion dollars for a small photo-sharing outfit with no revenues and 13 employees. The deal was sewn up over three days, mostly at Zuckerberg’s mansion in Palo Alto, California, and Facebook’s board was informed of it at the last minute. Quite clearly, it was a solo decision by Zuckerberg.

What went on in his mind when he took this decision? How did he SWOT Instagram when its CEO, Kevin Systrom, named two billion dollars as the asking price for signing over his 18-month old creation?

Here’s an attempt at piecing together the puzzle.

[S]trengths – Instagram

Possibly the single biggest attraction of Instagram was its rapidly expanding user base. In a very short while it had amassed 30 million users on the iPhone. When it launched for Android, it captured a million downloads the first day, and hit the 5 million mark in just six days – contrast this with the iOS launch which reached this level only after six months! This surely must have made Mark Z. sit up and take notice.

And in all fairness, Instagram was not just a rank unknown tech outfit which struck out lucky on its product. It had already gone through Round 1 funding by reputed private equity investors and a few days earlier had sewn up $50 million in funding in round 2. This latest round valued the company at $500 million. Zuckerberg had the advantage of leveraging the diligence that had already been completed by the PE investors.

In his inner heart Zuckerberg probably also admitted that Instagram was quite easily the best photo app out there to use with mobiles. He knew the power of photos and what a significant role they had played in Facebook’s own meteoric growth. Not to ignore the fact that Instagram brought a whole new behavior pattern to digital, and particularly smartphone photography – visual curation. Users could now harness the application to modify, embellish, and add any number of special effects to seemingly humdrum and low quality photographs taken impulsively on their phones, and then send them out to share. This was social networking brought to photos in a way far superior to Facebook’s own somewhat clunky processes for uploading and sharing.

With such a big user base, no longer could anyone, and certainly not Mr. Zuckerberg, ignore the wealth of personal and location data that would come along with the application’s purchase.

The icing on the cake must have been Instagram’s battle-tested and talented team. Never forget that Zuckerberg’s previous acquisitions almost always focused on people. He was usually candid about the fact that he bought ‘teams’ not ‘products’.

With these strengths, it was probably easy to choose between Instagram as an expensive acquisition now, rather than as a potential competitor later.

[W]eaknesses – Instagram

There appeared to be only one. Instagram had no revenues to speak of.

[O]pportunities – Instagram

Acquiring Instagram could, at one stroke, achieve control of mobile photo sharing and its future. Photos had suddenly become easy to take, touch up and send – gone were the days of digital cameras, instead you shot with what you talked on. Photos were suddenly the new ‘cool’ ingredient in social networking, and impossible to ignore in their new, mobile avatar.

If all that sounds to us mortal folks like there’s money to be made, to Zuckerberg it would probably sound like the hum of presses printing money, billions more of it. Here was a route to monetizing the huge customer base that used mobile phones to click pictures. Anything was possible – advertising, data mining, mobile wallets…what have you!

Instagram could also prove to be complementary, more so if its photo sharing capabilities could be seamlessly integrated into Facebook. Besides, there was no getting away from the fact that in many ways Facebook was also everybody’s photo album, and in the future the source of many memories and nostalgia. Instagram would make these memories so much better to look at and do wonders to enhance Facebook’s own overall visual appeal.

Here’s a thought – Zuckerberg probably figured that Instagram was good for taking away 10 to 20 percent of Facebook’s user base in the coming years. Given that view it was a great opportunity to be had for a billion bucks. But as this is written, I hear that Instagram boosted its user base by 10 million after the acquisition was announced. How’s that for an almost instantaneous haircut in the effective price paid per user due to the Zuckerberg effect?

And lest we forget – a billion bucks spent a month or so before your IPO sure gives you a lot of publicity and hype for boosting bullish sentiment!

[T]hreats – Instagram

Looking at Instagram’s rapidly growing user base, and the thought of all that falling into the hands of competitors such as Twitter or Google+, may have given Zuckerberg sleepless nights.

He would have known that Twitter’s overtures to Instagram had been rebuffed by Systrom, so some comfort there. But Google may have been the real cause for worry. With Instagram’s super-hit Android launch, Google could be eyeing it with the intention of dovetailing it into its Google+ social networking service. This would be anathema to Zuckerberg, and could possibly explain the deal taking place so soon after the Android debut, the hush-hush manner of its consummation and the ‘can’t-take-no’ price. Google was likely taken unawares by the swift move.

But what is it with photos? Zuckerberg knew that Instagram’s photo app could be the launching pad, the so-called thin edge of the wedge that a competitor could use to prize open and call to question Facebook’s overwhelming supremacy in social networking media, built to a huge extent on photos users share with each other.

Zuckerberg is all for innovation, disruptive or otherwise, except he probably doesn’t like it eyeballing him across the ring. There really was no alternative to buying Instagram – the risks, otherwise, were too great.

And don’t forget the IPO and its $75 billion – $100 billion stake. A competitor with Instagram in its bag could go to town with an “I am Facebook’s comeuppance” message and maybe roil sentiments ahead of the issue. Far better to safeguard the IPO on the one hand and to bask in the glory and buzz of a billion dollar buyout on the other!

The last piece

As the pieces fall into place, we have one all-important piece left to fit: price.

Why would Systrom name a price of $2 billion and then walk with half that amount? He held the cards and could likely guess Zuckerberg’s concerns.

The deal is rumored to have been structured 30:70 as cash: stock. That’s $700 million worth of stock rumored to represent about 1% of Facebook’s capital. With 2,332 million shares in capital, we get a deal value of about $30.02 per share [on the basis of $700 million/23.32 million shares.]

Yet private exchange SharesPost reported transactions of Facebook shares traded between $44 – $45 through 30 Mar and 31 Mar 2012, a few days before the deal. This values Facebook at about $105 billion.

If indeed the IPO prices around $45 a share, the value of the stock component paid to Instagram’s owners would be 50% higher, i.e. $1.05 billion. Add the cash of $300 million and the total deal value becomes $1.35 billion.

Mr. Systrom, now we’re talking!

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