The messaging company WhatsApp was recently bought by Facebook for a whopping $19 billion. The owners of the start-up will receive $4 billion in cash, $12 billion in Facebook stock and the remaining $ 3 billion in the form of restricted stock units, which will vest over the next four years.
In rupee terms, Facebook paid close to Rs 1,18,000 crore (assuming one dollar is worth Rs 62.2) for Whats-App, a company with just 45 employees. This amount is greater than the individual budgets of most ministries of the Indian government for the next financial year, except the defence and the finance ministries.
So what is it that made Facebook pay so much money for WhatsApp?
Lets compare this with Instagram, a company that Facebook acquired in 2012 for a billion dollars. Interestingly, Instagram had just 13 employees, when it was acquired. Why did Facebook a billion dollars for a company with just 13 employees and 19 times more for another company with just 45 employees?
Computer scientist and philosopher has an explanation for it in his book Who Owns the Future? As he writes “When it was sold to Facebook for a billion dollars in 2012, Instagram employed only thirteen people…Instagram isn’t worth a billion dollars just because those thirteen employees are extraordinary. Instead, its value comes from the millions of users who contribute to their network without being paid for it. Networks need a great number of people to participate in them to generate significant value. But when they do, only a small number of people get paid.”
In the above paragraph replace Instagram with WhatsApp and the logic stays the same. As of the end of 2013, WhatsApp had around 400 million users worldwide. So Facebook was essentially paying to acquire the number of people who used the messaging service rather than the knowledge and the technological prowess of the people who ran it.
But wouldn’t it be cheaper for Facebook to just build a similar application? In fact, it wouldn’t take much effort on the part of Facebook to develop a similar and even a better application than WhatsApp. So why pay so much money for it?
In fact, WhatsApp like Facebook and Twitter before it is a classical example of what economists like to call a network externality. This is a situation where demand for a product creates more demand for the product.
As economist Paul Oyer writes in his new book “A product has a network externality if one added user makes the product valuable to other users…The rise of the internet has made network externalities more apparent and more important in many ways…Perhaps the best example of the idea is Facebook. Essentially, the only reason anyone uses Facebook is because other people use Facebook. Each person who signs up for Facebook makes Facebook a little more valuable for everybody else. That is the entire secret of Facebook’s success—it has a lot of subscribers.”
Again, replace Facebook with WhatsApp in the above paragraph and the logic stays the same. What made WhatsApp very valuable is the fact that it has close to 400 million users. Hence, even though Facebook can create a similar application at a much lower price, it can’t get 400 million people to use it.
Take the case of Google, which launched Google+ a few years back to take on Facebook. The experts felt that Google+ was a better product and some of them even went ahead and predicted that people would now move on from Facebook to Google+. But that did not happen.
As Niraj Dawar writes in Tilt – Shifting Your Strategy from Products to Customers “For those who want to be a part of a social network, it makes sense to congregate where everybody else is hanging out. There is only one village square on the Internet, and it is run by Facebook. Being on a different square from everyone else doesn’t get you anywhere—you just miss the party.”
This was the main reason why people did not move from Facebook to Google+, even though it may have been the better product. “Google + may offer features such as greater privacy or group video chat,” writes Dawar, but it fails to “create the positive feedback loop, because it makes sense for everybody to be where everybody else already is.”
So even though Google+ was believed to be superior to Facebook, the users continued to stay put with Facebook. As Oyer puts it “Google+ has signed up many users, but it has not put any real dent in Facebook’s dominance. Nobody is going to switch to Google+ from Facebook unless most of her friends do, too, and it seems very unlikely that whole groups of friends will act in a coordinated fashion to move from one social network to another.”
Given this, even though Facebook could have launched a better version of an application on its own, there was no guarantee that people would start using it. Chances were that they would have continued to use WhatsApp. And that explains why Facebook paid a bomb for it.
Also, in a way Facebook was just buying out prospective competition. Many youngsters have their parents and family, as friends on Facebook. This obviously limits the frankness of the conversation that they can have with their “real” friends.
This has led to teenagers preferring to use messaging services like WhatsApp rather than Facebook. In fact, in a recent earnings call Facebook admitted that teens were spending lesser time on its service and were fleeing to messaging applications like WhatsApp WeChat etc. Mark Zuckerberg, the chairman of Facebook, believes that kids are fleeing the format because parents spam their walls with inspirational quotes and tagging them in photographs which they really do not want their friends to see.
Another explanation on why teenagers are fleeing Facebook was offered to me by a friend who has worked extensively in the technology industry in the United States. When it comes to technology, Facebook is not a light app, like the chat sights. There is a newsfeed comprising of various kinds of data and there is always a chance that things get lost to your intended audience under large piles of such data. Also, it might need more memory, something that the lowest priced smartphones, which the kids are likely to use ave may not have.
Due to all these reasons Facebook paid $19 billion for WhatsApp.
The article originally appeared in the Mutual Fund Insight magazine dated April 2014
(Vivek Kaul is the author of Easy Money. He can be reached at [email protected]. He would like to thank Somnath Daripa for providing some excellent thoughts on the topic)