It seems I can’t have any discussions with entrepreneurs without the topic of Instagram coming up. They all think that now is their time to strike the iron since the valuations are going to the stratosphere.
I want to be very specific and clear on this point. Facebook bought Instagram. Instagram was not sold to Facebook. That’s an important distinction, and lends well to the conclusion of this discussion.
Before we get there, for all the entrepreneurs out there, I wanted to share some experience on the topic of road shows. The very first road show in which I participated was Cymer, way back when I was a summer associate at Morgan Stanley. It was extremely exciting for a young guy, and unbelievably grueling for the management team.
The essence of the road show is that a company wishing to go public works with their investment bank to travel around the world meeting with institutional investors to convince them that they should buy stock in the coming offering. The process is a real slog, riddled with questions about the business and why the investors should invest. Those questions can make the difference in the price of the offering to the public market.
It’s critical to understand a few things here. Companies, when they go public, book the cash from the sale of the shares based on the first price. When a deal sets its price range, as Facebook did today of $28-$35, the company will receive their cash based on where that price lands. The employees and shareholders who continue to hold through the offering benefit from the price appreciation which comes in the months and years following.
The person who stands to benefit the most from future price appreciation is none other than Zuck. He wants the price to go up. More to the point, he wants to limit the possibility of the road show landing on the price at the bottom of the range, and potentially impacting the day 1 pop, future excitement, etc. Based on the S1 capitalization table, the valuation implied by this price range is between $75B and $94B.
Now, back to Instagram. People seem to be universally of the opinion that Instagram was not worth $1B. They are wrong. A thing is worth what someone will pay for it. Zuck was willing to pay $1B. Apparently without the consent of his board (since he controls voting).
If Zuck was worried about protecting the value of the stock, and maximizing his upside, it would behoove him to remove from the table any questions he might get from investors about “this Instagram thing” or “what are you going to do about Instagram and your mobile users” or “isn’t your engagement model based on traffic, and you are not the leading photo solution for mobile, which you have identified as critically important since mobile users are 2x more engaged?” You see where I am going with this?
So Zuck uses some stock to increase the likelihood that the price lands at the top end of the range. Doing some quick math reveals that the $1B price was really only worth about $0.37 per share of Facebook stock (based on the pricing range). Remember, this money he’s getting from other people when the stock prices. So Zuck spent $0.37 per share to protect his personal downside. $0.37 per share to maximize the likelihood that the price of the offering lands at $35 and not $28. It’s a very smart move.
The counter argument would be that investors would not have ascribed so much value to Instagram. They may not have…directly anyway. Investor sentiment is fickle and needs to be nurtured. The job of Zuck, the management team, and the bankers is to remove doubt. Doubt can cause the price to land at $28. Still a great day for employees, but the company loses $2.3B in cash from the sale of the stock. Further, the value of the company would be $19B less if it priced at the low end of the range versus the high.
In the case of a pricing of $28 versus $35, Zuck would lose $211M on the shares he is offering, and $3.5B of post offering share value. Is the $1B payment for Instagram starting to make a bit more sense?