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.

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