Instagram is not worth $1 billion to Facebook

Sat, Apr 14, 2012 - 9:27am -- Isaac Sukin

This is based on a comment I wrote on the Mashable post Why Instagram Was Worth $1 Billion to Facebook which has absolutely no explanation of why Instagram was worth $1 billion to Facebook.

How can you have a whole post about how Instagram was worth $1 Billion and have absolutely zero numbers in it? Yet that's what we're seeing all over the internet in the wake of Facebook's billion-dollar acquisition. Many people have explained why Facebook bought Instagram, but few have explained the valuation. Explanations for the purchase generally break down into these points:

  1. Instagram was Facebook's biggest competitor in the mobile space. This is pretty ridiculous, though Facebook execs may not think so. Instagram had about 3.5% of Facebook's user-base at the time of purchase, and most Instagram users are also Facebook users. If you scour the internet from before the acquisition, you will not find anything about Instagram being considered a Facebook competitor. They're different services.
  2. Instagram is about photos. Facebook is about photos. Facebook wants a mobile presence. This is probably true.
  3. Facebook didn't want a competitor to acquire Instagram first. Likely true, although if Instagram wasn't a threat in the first place, this wouldn't matter.
  4. Facebook panicked, like when they bought Friendfeed. Probably true.
  5. Mobile location data helps sell ads. Also true, although neither Instagram nor Facebook currently have mobile revenue strategies, and ads are not as effective on mobile devices. Plus, users love Instagram, and they will not be happy if Big Brother comes in and "ruins" it with ads.

Even if true, none of these reasons actually matter when it comes to the valuation. In order to show that Instagram is worth $1B, you have to demonstrate one or more of the following:

  1. Instagram has the potential to make $1B in profit in real terms.
  2. Instagram had the potential to do $1B of damage to Facebook’s profits.
  3. Facebook collaborating with Instagram creates $1B of value to the combined entity.
  4. A valuation of $1B for Instagram somehow justifies a valuation of $100B for Facebook.

You also have to show that Facebook couldn't have bought Instagram more cheaply, which is probably not true. We know that Instagram had closed a $50 million round just days before at a $500 million valuation, and that price was probably overvalued. Clearly that investment was made with the expectation that Instagram would grow, so a purchase price of $500 million wouldn't have made sense. However, the price tag was so high in the first place because of inflated expectations, meaning an acquisition exit was built into that price. Facebook probably could have negotiated a lower price. At $1B, investors literally doubled their money overnight. At the size of that deal, even a less-than-2x return would have paid for a lot of bad investments, even in a VC industry that pushes for notoriously high returns on its few winners.

Instagram was also not in a position to make $1B in real profit. With no clear way to make money, the $1B price tag valued each Instagram user at over $33. (It's worth noting, however, that at a $100 billion valuation, Facebook users are valued at about $118 each... that's another story.) Its users love the service, but that means that any revenue plan would need to be based on a premium tier with new privileges, because putting existing features behind a paywall or degrading the experience with advertising will be a tough sell. That's not a revenue model that either Facebook or Instagram has experience implementing.

And there's no way Instagram could have done $1B of damage to Facebook's profits. Instagram is not a competitor to Facebook in user base, advertising, or in-app purchasing -- the three pillars of Facebook's profits. The area where Facebook has the most economic potential is social commerce, which is the reason anyone in their right mind could even think about Facebook being valued at $100B, and Instagram is clearly not a player in that space. In other words, Facebook’s greatest economic value could come from taking a cut of items sold via Facebook, whether through tariffs on in-app purchases or through Facebook credits. So even though over 80% of Facebook's revenue currently comes from ads, an Instagram ad service wouldn't really threaten Facebook's most valuable business model. Yes, Facebook is popular because of photos, but photos are not a driver of e-commerce. The percent of Facebook's revenue that comes from ads has been shrinking significantly every year, and ads don’t work as well on mobile devices anyway.

The biggest question in my mind is whether Facebook adds enough value to Instagram that it could boost its revenue potential to $1B. This is basically the driver behind other acquisitions to which people have compared this one, namely YouTube (over $1B by Google, now making over $1B in annual revenue) or Flickr ($35MM by Yahoo!, now one of the top 50 websites in the world) even though plenty of similar deals have failed miserably. Facebook's biggest advantage here is its user base of some 850 million people, and indeed thanks to the press around this deal Instagram has added 10 million users since the deal was announced a week ago. However, Instagram has no unique assets that Facebook couldn’t easily have replicated, and Facebook had been rumored to have been working on a similar application, so it's unclear why Facebook couldn't have simply launched its own service. Instagram will remain mostly independent, after all, and offers integration with a number of other services (which Facebook says it will maintain). But it's not as if the 12 or 13 Instagram developers had some incredible magic sauce that meant they were the only ones who could build an engaging photo application. With the weight of its users behind it, Facebook could probably have built a more-or-less identical app with a larger user base fairly quickly. On the other hand it has failed at similar ventures in the past (Facebook Deals and Facebook Places / the Gowalla acquisition come to mind) so perhaps it was scared to try again.

Even if you're not convinced about Instagram's revenue potential, let's be realistic. Instagram is not worth more than the New York Times. Instagram has not really generated over $1200 in economic value per *minute* since it was incorporated about 560 days ago. For Facebook, $1B is 25% of its working capital. Unless you cynically believe that Instagram's price tag justifies Facebook's IPO target, it's difficult to compare Instagram favorably to other things that have actual billion-dollar values.

We don't actually know what Instagram's balance sheet looks like, or what Facebook's plans for it are. But given what we know, $1B just doesn't make sense.