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Wednesday, April 18, 2012

Instragram purchase could give Facebook investors pause

Scott Flegal

In case you missed it, last week Facebook agreed to pay $1 billion for a small, online mobile photography application company known as Instagram.

Instagram had developed a popular application that allowed users to store, edit and share photographs online. While Instagram had great success in attracting users, it was less successful when it came to money. It never turned a profit.

But undeterred, Facebook owner Mark Zuckerberg forked over $1 billion for the 2-year-old company. It was indeed a good day for Instagram’s two founders and 11 employees. But with Facebook’s initial public offering looming, it will be interesting to see how this decision plays in the marketplace. Zuckerberg has insisted on a post-offering structure that guarantees him control of Facebook for life, so potential investors will be marrying him, for better or worse. The Instagram purchase could give investors pause.

So why did Zuckerberg want this deal so badly? There are several rationales supporting the acquisition. First, Facebook has no photo application comparable to the Instagram application. Instagram gave 35 million amateur photographers a place to store, edit and share those photos. The Instagram application is well-designed and it really works. One can certainly see the attraction for Facebook on that level. No doubt Zuckerberg hopes to keep Instagram’s users and bring on many more.

But Instagram had something else that Zuckerberg coveted that has proven elusive for Facebook. Instagram users shared a sense of community and loyalty to the company.

Zuckerberg desperately wants Facebook to be loved. But while Facebook will soon have over 1 billion users worldwide, very few get all warm and fuzzy about the company. Many are put off by its user privacy policies and its ever-present ads. People view Facebook as a bully. For Zuckerberg, who badly wants Facebook to be a force for good in the world, this is a problem that needs to be addressed. But did he need to spend $1 billion to scratch that itch?

The acquisition was also driven by the bizarre relationship between Facebook, Google and Twitter. These three companies are the biggest fish swimming in the consumer online tank, and they keep a close eye on each other. There are rumors that Google may have been kicking the tires at Instagram. That provided another incentive for Zuckerberg to make the deal happen once he determined he wanted the company. Again though, $1 billion seems like a lot of cabbage to fork over to keep a photo application out of the competition’s hands.

As for Instagram, it played its hand brilliantly. It was textbook negotiating. Only a few days prior to the Facebook deal, Instagram closed on a round of venture capital funding where it sold 10 percent of Instagram for $50 million. I am no math whiz, but if 10 percent is worth $50 million, then that means a sophisticated venture capital firm valued Instagram at $500 million within days of the time that Zuckerberg forked over $1 billion for the same company. Based on that valuation, Facebook paid a 100 percent premium for the company.

In the language of negotiation, Instagram improved its BATNA – its Best Alternative to a Negotiated Agreement – by closing on the $50 million funding round. By doing so, it ensured that it could continue to operate and grow in the future whether or not it took Facebook’s offer.

From there, the company looked Zuckerberg in the eye and told him it would take $1 billion to get the deal done. Zuckerberg blinked. At some level, it must have infuriated him that this tiny company with no profits was charging such a premium. But he bought Instagram anyway.

It was a great day for Instagram. The two founders made a fortune. The remaining 11 employees reportedly split an amount in the vicinity of $110 million. The venture capital firm doubled its $50 million investment in a matter of days. If you are a young person considering graduate school, might I suggest computer engineering?

That is not meant, by the way, to disrespect the talented individuals on the Instagram team. Kevin Systrom and Mike Krieger, the founders, have amazing stories that reflect the requisite blend of smarts, talent, hard work and sheer gumption that it takes to make a fortune in the online world. Their story is fodder for another article. But the deal understandably left a lot of people wondering whether Zuckerberg is ready to assume the enormous post-initial public offering role in which he has cast himself.

Personally, I very much admire Zuckerberg’s personal commitment to making Facebook something more than a company that just maximizes shareholder returns. He means it when he says he wants Facebook to change the world. But to make Facebook what he wants it to be, he needs to make good decisions. Given the degree of control that he will continue to exercise over the company after it has gone public, the pressure on him will be extraordinary. He will have to convince his shareholders and the market that he is up to the task.

The Persian conqueror Cyrus the Great described his own decision-making process as follows: “Diversity in counsel; unity in command.”

Zuckerberg should heed that advice. His decision-making processes need to ensure that while he has the final say, those around him feel safe to express strong and divergent opinions. Otherwise, he may find that being a one-man show is not all it is cracked up to be.

Scott Flegal is a business lawyer and mediator. Visit him online at www.flegal.com or www.negotiationworks.org. Follow him on Twitter at www.twitter.com/hscottflegal and read his blog at scottflegal.com.