An uncomfortably large number of people were aware of the fact that Facebook acquired Whatsapp for US $19 billion. I have spent a considerable amount of time trying to locate the reason for such widespread interest in the transaction and have realised that it wasn’t the money that had the people talking; it was the companies that were involved in the transaction. There is a simple test to locate which side of the interest table one falls on, you must ask yourself this one question: Did you know that the actual split of the transaction was 12 billion dollars in stock, 4 billion dollars in cash and another 3 billion dollars in restricted shares. If the answer to the question is no, then you are my target audience for this article, for I intend to exploit your familiarity with Facebook and Whatsapp to discuss some fundamental notions of valuation and at the same time observe the shift in priority of capital in the 21st century.
Let me begin with the fundamental notions bit, where I would like to talk about “cash flow”. Cash flow is the amount of money that goes in and comes out of a business in an accounting year. A net positive cash flow would mean that the cash that was earned by a business is more than the cash that was spent by the company. What does this have to do with valuation of companies?
Simply put, if you were to value a company today, you will have to base it on an estimate that the money that you were to pay today has at least be equivalent to the future cash flows that are likely to be earned by the business. However, it is also essential to understand that there is always a time value that is attached to money. It is only natural if you were to pay a man what he would earn in the course of 10 years it would be discounted to reflect the fact that a given amount of money today is worth more than the same amount in the future (this is to account for the fact that a person is getting the money ahead of the time). This concept is known as “discounted cash flow” and this is the method that is used for arriving at a value for any company.
Applying this same method to Facebook’s acquisition of Whatsapp, when Facebook valued Whatsapp, the company had insignificant revenues which were on the wrong side of $ 10 million. So why the US $19 billion acquisition? The founders were firm on the stand that they never wanted to monetise this platform using advertisements, which is where most of the networks get their revenue from. It is amusing that Whatsapp chooses to portray its disdain for advertisements by quoting Tyler Durden. The company’s explanation that can be found here begins with the following quote:
Advertising has us chasing cars and clothes, working jobs we hate so we can buy shit we don’t need.
The crux of their argument is that the entities that concentrate on advertisement revenue do not place enough emphasis on user experience. Personally, they believe that allowing advertisements is being dishonest to their product. However, what they had in abundance was users who were more than 450 million at the time of acquisition and the company was adding more than 1 million users daily. You would have noticed that our Whatsapp accounts come with a rider that Whatsapp is free only for a limited period of time and after that one is required to pay $0.99 per year. If implemented, this is $500 million in revenue. This is a conservative estimate that even when the company has a billion users (which it is likely to reach very soon), it would be in a position to generate revenue of 50 cents per user. What is concerning is that so far the company has not shown enough indication of achieving such revenue. In its latest earnings, Facebook reported that Whatsapp generated $ 10 million in revenue.
All the figures could seem underwhelming and rightly so, but Facebook does not see it that way. Zuckerberg in a recent interview said that they don’t think of monetisation until a product has a billion users. This statement provides wonderful insight into the modern day risk appetite and priority. It is systemic, here is a man who had his own idea valued in billions when there was no certain way to monetise it and he has gone ahead and passed that benefit to another idea that solved an inherent problem of global connectivity in a private sphere. This investment is recognition that the future of internet is mobile first and the fact that there is a market for communication on that medium that is more private than glorious displays of affection and humour that are shared with 500 “friends”. He would have preferred it if Facebook messenger had become the platform for the aforementioned requirement but this money is acknowledgement that Facebook was slow to act and realise what was going on.
The sum of the story is that if one were to view the investment from a traditional valuation perspective, one might say that Facebook had placed its cognitive ability in a box which was lying on a shelf which was too high for it to reach (even when it tried reaching it on its tiptoes with its tongue wagging in anticipation of wisdom) and hence could not bring it to the negotiating table. The other view is to acknowledge that modern day investor pays for effective monopolies that enjoy global acceptance. It is paying for potential that has precedent in the form of Google and Alibaba. The rationale is once you have everybody using it, monetisation will enjoy scale that would astound even the most unadventurous entrepreneur. What is to say that 5 years later, people would mind paying a dollar for using Whatsapp for a year? If a billion people pay a dollar a year to a company that incurs a minimal cost, the profit margin is mind boggling. So are the possibilities of synergies between various online platforms and conversion of Whatsapp from an application into a platform providing seamless communication and related options
One might make an argument that this picture does not account for competing applications which will be ready to offer free service thus hamper the market share of an application that charges for its services. However, it is essential to understand that envisaging migration of customers is like envisaging one’s New Year resolution in action. It makes for good thought, seems utterly doable but ends up falling slave to a puny five letter word called “Habit”. Habit is the very reason a company enjoys a high premium on “Goodwill” in any balance sheet. Think about it, Facebook isn’t a concept or a product anymore, it is a habit and the same thing applies to Google.
When Whatsapp was acquired it had almost transformed from a product to a habit and this is the priceless asset that Facebook put a number on. Facebook’s desire to dominate the communication, the possibilities offered by scale, familiarity and habit; these are products that can justify any price today. Of course, it could all end up a Shakespearean tragedy, where a man would remark on the futility of it all with the sort of wisdom that only retrospect could provide but even then it would end up a tale worth telling. If I was Facebook I would fancy my odds. What do you think?