Andy Baio provided an excellent perspective on Facebook’s acquisition of Instagram by analyzing the price per active user. This analysis shows that at about $30 per user this deal is far below many previous acquisitions. It also indicates that Yahoo’s acquisition of Broadcast.com continues to stand as the most outlandish deal at more than $10,000 per active user. At USV we have tracked a meaningful number of investment rounds across our portfolio and the data from this suggests that $30 per user falls well within the observed range of valuations (even when looking at registered instead of active users, assuming that a meaningful percentage of registered users are active).
But there are two important questions that this analysis does not consider. First, how should the dollars per active user change as a company’s user base grows larger. Many of the comps had smaller users bases and hence arguably more growth ahead of them (that was of course also the argument for the crazy Broadcast.com valuation but that growth never materialized). On the other hand for companies with network effects there is an argument to be made that the per user value should go up as the company grows larger: end users are getting more value from a larger network, making the service stickier, thus increasing lifetime value. Since Instagram is a network this argues in support of the valuation. That argument is particularly strong for a service such as Skype which has very strong network effects and is well reflected in the per user value.
Second, what is the steady state realistic value of each enduser? This is where things get a lot more difficult. It is unclear what the right business model for a service such as Instagram is. Charge for special filters? Charge for storage? Run advertising? To get to to $30 per active user if you assume a 10 year average user retention you have to get of around $4 per year per user (assuming an 8% discount rate). That has proven easy for social games companies such as Zynga (which can achieve as much as $2 per active use per month) but the precedents in photo sharing seem less compelling. For instance if you look at typical conversion rates to a paid account in the low single digit percentages, then those who do pay would have to pay annually around $80 - $100 which suddenly seems like a lot.
As with any of these discounted cash flow valuation exercises there are a lot of dials to turn here, such as the discount rate or how long users are retained (obviously 20 years would make a big difference over 10 years) and I am sure one can come up with theoretical constellations that justify the $30 per user. But it would appear that as a practical matter photo sharing services to date have not monetized that well. It would be great to get some data here from people who operate other services but I don’t believe that Yahoo ever broke out the economics of Flickr, but Fotolog was acquired for only $90 million at pretty large scale.
So did Facebook overpay for Instagram? Probably not. Photo sharing is an important core activity on Facebook and there was a meaningful threat of Instagram “unbundling” that activity from the rest of Facebook. If acquired by someone else such as Google that could provide the engine for a broader effort and potentially hollow out Facebook. As a defensive move spending 1% of its presumed market cap makes eminent sense in the near term. But that does not imply that similar services that don’t achieve critical mass should count on valuations even remotely close. It also raises an interesting question whether Facebook will have to make similar acquisitions repeatedly in the future to protect its core network.
Conversely, did Instagram sell too early? The above analysis suggests not. The deal removes all operational and monetization risk. It is all the sweeter considering how much equity the founders were holding and how small the team was. If they had wanted to double down from there they would have had to commit to building something much larger (not in terms of number of users where growth was strong, but in terms of potential for per user revenues).