Stephen Foley: Facebook's acquisition of Instagram is a hyper-defensive move against a potential rival

 

In 1994, the KLF, one of the more cerebral pop outfits of the Nineties, took the proceeds of their many No 1 hits, piled the cash high in an abandoned boathouse on a Scottish island, and set fire to it.

The event, “K Foundation Burn A Million Quid”, was high art of ambiguous meaning. Two decades from now, we will probably still be debating another event in a similar tradition. Call it, “Z Foundation Burns a Billion”.

The Z Foundation, of course, is Mark Zuckerberg's fiefdom, Facebook. The social networking giant's decision to lavish $1bn on a 13-person start-up called Instagram was apparently a “chief executive to chief executive deal”, hashed out in just a few days after Mr Zuckerberg called Instagram founder Kevin Systrom.

Instagram doesn't have any profits. It doesn't have any revenues. It doesn't have a business plan to generate any money in the near future, either, so there is nothing you can do to model its value. There is no point trying to discuss whether it is “worth” $1bn. It cannot possibly be, at the same time as it most definitely is.

Mr Zuckerberg decided it is worth paying Instagram's founders and backers $1bn-worth of Facebook stock and cash, just in case he was staring at the thing that would relegate his career to an online historical curiosity. If only MySpace had bought Facebook in 2006 (or Friendster had bought MySpace in 2004, or Yahoo had bought Google in 2005 for that matter).

Facebook doesn't have to work out a way to make a $1bn-plus return on Instagram. It is enough that Instagram cannot now go on to build a rival social network, built on smarphones, where Facebook is weak.

Only YouTube, sold to Google for $1.65bn 18 months after it launched, rivals Instagram for the speed with which it grew and the eye-dropping, jaw-popping price tag at which it sold. Google knew its Google Video project was failing; it was as terrified as Zuckerberg that a rival was sprouting up that would soon wreck its dominance of advertising on the internet.

These hyper-defensive acquisitions are rare, particularly by companies still in their growth phase, like Facebook. More often, the buyers are big companies that have run into the sand, such as Yahoo, will buy a fast-expanding start-up in the hope of adding some growth to their revenues. There are also scores of small deals in the tech industry every month, where talent-hungry giants like Google buy a software developer's not-that-hot startup just as part of the process of hiring him.

As for the hope-and-a-prayer valuation, no one in Silicon Valley is going to complain. A relatively small cabal of large venture capitalists are in the biggest or hottest deals, and they are as likely to be sitting on the boards of the acquirers as they are on the acquired. High valuations mean mark-ups all round for their portfolio of investments.

The Instagram sale is the stuff of start-up entrepreneur dreams, and the wildest kind. Start a company, develop some software, watch it become insanely popular and sell it for a vast sum. No one begrudges him his lottery win, but Mr Systrom and his backers didn't even have to go to the sweat of working out how to generate profits.

And profits - ultimately - are the only arbiter of whether an entrepreneur and his venture capital backers are adding some of value to our sluggish economy, or just taking money from a bigger sucker.

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