Facebook Buys Instagram: Why They Did It, and How It Could All Go South

By Rob Enderle April 09, 2012

One billion dollars seems like a lot of money for a company with fewer than 12 people, but that is because firms like this aren’t valued by headcount. That figure is what Facebook allegedly spent to buy Instagram. What is going on here is that Facebook is weeks away from having an IPO that is estimated to be in the $100B range, and it is working to assure that stratospheric valuation.  Against a $100B IPO, if this works, a $1B investment isn’t bad, but this could backfire badly, so let’s look at both what Zuckerberg is trying to do and at how it might go south.

Assuring a High Valuation

When you are trying for a stratospheric valuation, you want as much positive news as you can get going into the IPO. You want a feeding frenzy for shares and Facebook has been working to achieve that by limiting the number of shares available so there will be a far larger demand for shares than there will be shares on the market. This is a typical supply and demand mechanism, but it also hinges on buyers who are willing to pay sky-high prices for their shares.  

If there is a cloud over the company of any significance, investors may not be so eager, the valuation and initial public offering will collapse short of the financial goal and Facebook will emerge with much less cash and in much weaker financial shape.  

Google initially emerged as the major cloud on Facebook’s horizon with its Google + property. But Google + has since fallen on harder times and now seems unlikely to eclipse Facebook. The most recent challenger is Pinterest, a firm that has leapfrogged Facebook and now appears to be challenging the social networking giant. The biggest challenge, however, isn’t direct, it is indirect in that Pinterest appears to showcase a Facebook vulnerability to targeted attacks.  

Put in other words, a straight on feature-for-feature attack by Google + didn’t work, but by focusing on just a small part of the social landscape -- in this case, pictures -- Pinterest indicated that Facebook could be vulnerable in certain areas. This is often called “being nibbled to death by turkeys,” but the point holds.  

Now if Facebook was to respond to Pinterest directly with something it developed, there is good chance it would find itself in violation of one or more of Pinterest’s patents.   But if Facebook can use a pre-existing technology which is already established, it can both roll out a Pinterest-like product more quickly, and, more importantly, defend it with Instagram’s own intellectual property.  

How It Could All Go South

Buying a tiny company for $1B will likely not appear to be rational behavior to many investors tied to revenue, profit or size metrics for company valuations. In fact, this amount, without a background, could actually scare investors away from a company that appears to lack strong financial controls. Spending out of business was a common problem during the .com years and if someone influential connected those dots, this acquisition could cripple Facebook’s IPO.

In addition, both Yahoo and Google might be interested in painting Facebook in that less flattering light in order to cripple the company. Facebook hasn’t proven astute in marketing or image to date, and that weakness could be exploited during this acquisition attempt.   

Given the amount of this transaction, it might not even require that Google or Yahoo’s help for the perception of this deal to go south and, not only hasn’t Facebook put in place a strong PR mechanism to color efforts like this, disclosure rules that surround IPOs may prevent an adequate response even if they had such a mechanism.  

In short, if not handled carefully, the perceptions surrounding this deal could do the IPO additional damage not mitigate the damage already being done by Pinterest.  

Wrapping Up: Perception is Reality

It amazes me how few successful engineers understand that perceptions are reality for all of us and that it is as important to manage perceptions surrounding a company as it is to manage what the company does. New-wave companies like Google and Facebook have proven particularly inept at handling image and that will undoubtedly come back to bite them in the future. In this instance, it matters less why Facebook bought Instagram than it does how people perceive the acquisition. Facebook is strong on the reality but weak on the perceptions which suggest there is more risk to this move than necessary.  

Edited by Rich Steeves

President and Principal Analyst, Enderle Group

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