The Billion Dollar Start Up

The Billion Dollar Start Up

Chances are if you’re on the internet you’ve probably heard of Facebook. With 840 million active users, the Big Daddy of Social media has a user base that rivals a large portion of the rest of the world combined. At the head of this organisation that just 8 years ago was starting out of a dorm room, the leader Mark Zuckerberg is now the head of an organisation worth more than the GDP of two thirds of the world’s countries. All of this is built on the idea that the social networks between people have a value that isn’t captured by how much cash the company is actually generating.

Wherever there is a good idea, there are bound to be imitators. Various start-ups over the past few years have each tried to pitch themselves as either an alternative social network that makes up for Facebook’s shortcomings (Google+’s being the ability to define different types of connections), or focusing on a specific segment of users (Linked In for professionals, Twitter for those who find the pace of Facebook too slow) and tailoring the service to match their needs. None however, have so far even come close to being a credible threat to Facebook’s monopoly in the social media scene: Facebook is easily larger than all of its competitors combined.

And Facebook intends for it to stay that way: earlier this April, Mark Zuckerberg decided to spend US$1 billion on a start-up of 13 people. The product? A smartphone camera app called Instagram that lets users snap a photo, quickly add some post-processing effects and share it right away on Facebook. Known for running the company on his own authority, it was reported that Zuckerberg spent 3 days in talks with the founder of Instagram before announcing his decision to buy the start-up outright to Facebook’s board, who weren’t made aware of this deal which is now Facebook’s biggest acquisition to date.

The official stance is that photo sharing has been a core part of why people use Facebook, and together the Facebook and Instagram experience can be enhanced, the justification being that Instagram has built a core user base of 40 million users thus far and is growing. Some speculate that the reason why Facebook acted so swiftly with the acquisition was to prevent an attractive product from potentially ending up in the hands of their rivals over at Google, seeing as the purchase came just days after the launch of the app on the Google powered Android smartphones (it was previously an Apple exclusive app).

It may be shocking for some that Instagram has yet to make a single dollar for its investors, nor does it seem likely to be generating any significant soon with its current business model. The fact that Facebook can afford to throw down a Billion dollars is a testament to the market appetite for anything social media related as some of the payment was made through Facebook stock. What’s also interesting to note is that this is the first time Facebook has bought a start-up for their product: usually the goal behind Facebook’s acquisitions is to acquire talented programmers to work on core services, but perhaps due to the hot market environment for social media they can simply buy out what they need, regardless of the cost.

Has the cost that was paid been too high? At the beginning of the year, Instagram was valued at $500 million by venture capital firms, which was already an impressive amount given that in February last year, Instagram was deemed to be worth $20 million by its investors. Over the span of  less than two years it has managed to achieve almost 50 times the return on capital, something unheard of for a company of its size, the sharp contrast being between how small the company is physically and how much it’s worth. History has shown that when the price of an asset rapidly inflates in a short time, where the underlying fundamentals are not very solid, there’s a good chance of an economic bubble forming around the asset. Various psychological factors with clever names like ‘The Greater Fool Theory’ may influence market participants to continually jump on board due to greed and herd mentality. If everyone continually buys in and no one leaves, then price can continue to increase at astronomical rates.

One of the earlier examples of an asset bubble forming around a commodity with no intrinsic value was the Dutch ‘Tulip Mania’ in the 17th century. Over the course of a decade speculators and an unassuming public drove the prices of ‘mosaic’ tulips, tulip flowers with patterned petals, to crazy heights. The most often quoted comparison is that one tulip could sell for the salary a highly paid craftsman would earn over ten years. The crash came just as quickly: in the span of a week when someone realised they wanted to cash out, suddenly there were no buyers in the market and sellers were left with tulips which could only be sold for 1/100 of the price they were going for earlier. The impact that a crash may have on the global economy is difficult to ascertain at this stage, but unlikely to be as bad as the previous bubble. It is only a handful of companies which society has yet to depend on, unlike the GFC which was caused by the banking sector.

As for whether buying Instagram will produce any tangible benefits for Facebook, only time will tell. In the mean time, investors are eagerly awaiting the long promised Facebook IPO, the initial round auctions of Facebook stock on the NASDAQ exchange. The expected valuation of $100 Billion will create a number of new millionaires and make Facebook one of the largest publicly traded companies in the world. However looking back at the meteoric rises in value of assets in the past, a fair conclusion would be caveat emptor – buyer beware.
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