Thursday, 12 April 2012

Why is Instagram Worth 1 Billion?

There are many reasons why Facebook would pay a lot of money for Instagram.  Reasons such as: to improve its mobile revenues (of which it had none), to eat Twitter’s lunch, to eliminate a potential future competitor, and basically to maintain its growth and market value momentum.  Remember, Facebook is the internet's largest photo sharing site and it knows the power of photos very well but what I really want to tackle here is why 1 billion as opposed $500 million?
The simple answer is it was a privately negotiated transaction and Instagram had just recently raised money from Sequoia Capital at a reported $500 million valuation, so they weren’t going to sell for less.  Well done to get to 1 billion.  This means that Sequoia Capital and other firms that contributed money were essentially able to double their money in a very short timeframe.
Prior financing round valuations and existing investors’ requirements are value pegs but here is some theory around what price is possible.  In cases like this companies are paying a scarcity premium.  The argument being that, either by way of market position (i.e. if all your friends are on Facebook there is no point being on Orkut) or by way of proprietary technology, these targets have something the acquirer can only attain by buying them.
At this point a buyer is paying a price beyond the notional value of the target and encroaching on the value to the buyer.  The notional value is a company’s value independent of the potential strategic benefits to a particular buyer.  The value to the buyer is that amount of value the acquirer can produce with the target.  Not something they typically pay for unless forced to in a competitive situation.
To consider this by way of a generic example, let’s assume a billion dollar revenue company is paying 10 times revenue for an early stage company generating $1 million in revenues.  The target company’s technology will allow the billion dollar revenue company to increase its market share by 10%; a value of $100 million in revenues.  You can understand why the acquirer might pay $10 million for this company.
The conclusion is that a buyer paying a price below the value to the buyer is something that makes economic sense, even though the price may sound astronomical…. and if you are being approached by Facebook (estimated value of $100 billion) then there is a lot of room to pay a lot of money.  In my next post I will examine what Facebook could have paid.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.

Wednesday, 11 April 2012

VTI Profit Margins Underwhelm

In the Spring issue of the Veracap Technology Quarterly we took a closer look at technology sector profitability.  While valuations have improved substantially, many mid-market technology companies still struggle with profitability.
On average only 55% of the technology companies included in the Veracap Technology Index (the “VTI” includes all technology sector companies trading on the TSX and TSX-V with a market capitalization between $10 million and $500 million) were EBITDA positive and, of those companies, the average margin was 12.1%.  The subsector with the most profitable companies was the IT Consulting & Services sector and the sector generating the highest margins was the Internet Software & Services sector with an average EBITDA margin of 15.3%.   In looking for an explanation of these results we believe the answer lies in the average size of the companies.  The average market cap of the VTI is only $81 million.  Of the companies not generating a positive EBITDA, 84% had a market cap of less than $100 million.  Canadian technology companies go public at a relatively small size and need to grow larger to achieve scale and improve efficiency.
The most profitable companies in the VTI were Mediagrif Interactive Technologies with an EBITDA margin of 33.6%, Enghouse Systems with an EBITDA margin of 27.2% and C-Com Satellite Systems with an EBITDA margin of 23.9%.  While nowhere near world leaders like Google and Microsoft which have generated EBITDA margins in the 40% range for years, these are nevertheless our strongest performers in the quarter. 
So do high margins translate to the best valued companies in the VTI?  In general yes, the above noted companies are in the top quartile in terms of an EBITDA multiple but there are exceptions as well such as C-Com Satellite Systems which ranks 3rd in profitability but was valued at less than four times LTM EBITDA.

Derek van der Plaat, CFA has worked in private market M&A for more than 20 years and is a Managing Director with Veracap Corporate Finance in Toronto.