Is Instagram Really Worth $1 Billion? Yes—If You’re Facebook

Posted by Dylan C. Lathrop and Tim Fernholz

On Monday, two technology companies each spent a billion dollars on a collection of ideas. Microsoft bought hundreds of patents from AOL, a move that would have been the big tech news of the day had Facebook not announced its acquisition of Instagram, the mobile photo sharing app, for a clean billion in stock and cash.

True, Instagram is a company, not a collection of intellectual property, but when you look at the logic behind the decision, it’s clear that Facebook doesn’t think the code that underlies Instagram was worth the price. It’s the idea behind the app—and the community it spawned—that have made it one of the fastest-growing social networks out there.

The initial reaction to the news was shock. Many Instagram loyalists were saddened that Facebook wanted to horn in on their hip little playground. Investors were astonished at the price paid for a company with no revenues to speak of—roughly equivalent to trading the entire GDP of Djibouti for two years of work by about a dozen people. Silicon Valley was surprised: Couldn’t Facebook, already a leader in photo sharing, simply outcode and outspend its smaller rival?

Facebook founder and CEO Mark Zuckerberg’s post about the decision suggests he didn’t think Facebook had the tools to build an effective competitor for Instagram, and that Instagram seems to have captured some of the magic that social network platforms need to succeed. Forget the filters; it’s zeitgeist that makes the photo app a smart buy.

Zuckerberg presumably knows a thing or two about the social network business; particularly that product is not enough to succeed. Facebook’s past and present competitors—MySpace, Friendster, Google+—could all replicate its functionality, but none have been able to recreate the user engagement that has made Facebook so successful. With 27 million users less than two years after launch, Instagram showed every sign of being able to attract people and keep them involved.

As a Facebook competitor, Instagram threatened in two areas: One, sharing photos, is one of Facebook’s strengths and drove its growth. The second, mobile, is one of Facebook’s comparative weaknesses at a time when mobile is widely perceived as the future of the tech industry. To that equation, add Instagram’s brand as a hip social network at a time when Facebook is a practically ancient eight-year-old.

All that means that the community that formed around sharing photos on Instagram is more robust and interactive than what Facebook is currently offering. The company isn’t just adding value to its own business but also taking a competitor out of the market—and off the market: Rumors are flying that the high price was due in part to a bidding war with Google following the launch of Instagram on its Android mobile operating system.  The high price could be worth it if it prevents a Facebook competitor from acquiring a huge user base.

The price also reflects a premium for the new users added to the Facebook universe and the data that millions of people snapping geo-tagged photos on their phones can bring to a company that’s already data-driven.

Of course, for Facebook, price wasn’t necessarily the top concern. With its first public stock offering approaching, some have asked if the Instagram buy is a way to tweak Facebook’s own valuation. Given skepticism about the deal from Wall Street, that seems unlikely. More likely, the IPO helped with the purchase—no doubt much of the stock transferred in the deal was valued based on the expected IPO—and since the company had no particular plans for the $5 billion it hopes to raise on NASDAQ, some of that cash will help support this arrangement as well.

Facebook will have to be careful, though. Acquiring a popular company is easier than making it work in its new context, as Yahoo learned when it bought Flickr in 2005 and failed to maintain the site’s lead as a photo sharing community or a driver for its corporate parent. Facebook will have to tread carefully as it makes any changes to avoid angering Instagram’s fans.

Valuing a company is ultimately a very subjective process; it’s not just a matter of guessing at future revenues, but also at the state of an entire industry that’s rapidly changing. A billion dollars may seem like an insane amount of money to pay for something that was essentially built in eight weeks, but if you’re Facebook and you see another company has replicated your intangible social-ness while taking the lead in the two most important parts of your business, well, maybe the price is right.