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Why Did Facebook Pay $1 Billion for Instagram?


Compare the transaction to Google's $1.65 billion purchase of YouTube in 2006.


It's official: Facebook is paying $1 billion in cash and stock for the social-photo app Instagram.

Now you may be asking yourself, "Why is Facebook paying such a seemingly huge pile of dough for some measly old free app? Is there really something special about giving smartphone users the ability to share photos with cliché special effects?"

By the way, have you seen my teddy bear photo with the Brannan filter and tilt-shift effect?

So let's talk about what makes allowing me to cheesify said bear worth $1 billion.

First things first, Instagram is growing awfully quickly, going from nothing in 2010 to over 27 million users as of March. And now that Instagram has moved away from being Apple (AAPL) iPhone/iPad/iPod-only by adding a Google (GOOG) Android app, that 27 million user number could soon look tiny.

Now why is this important? Well, it's simple. Facebook is running out of bodies.

Facebook hit the 845 million user mark in late 2011, but its user growth rate has come down big time and the addition of Instagram users will boost it.

However, keep in mind that since Instagram has no revenues, it will hurt Facebook's growth in revenue per user, which is illustrated in this table:

Now, while there's no immediately identifiable financial boon to Facebook with this deal, the purchase of Instagram has significant strategic benefits.

In this regard, we can compare the transaction to Google's $1.65 billion purchase of YouTube in 2006. At that time, YouTube had no revenues and enormous expenses, but as the dominant force in online video, it was an incredibly attractive asset from a competitive standpoint.

Instagram is a highly social platform, and in that regard, it is technically a Facebook competitor, albeit a stripped-down, photo-focused one. Therefore, it makes a lot of sense to keep that competition in-house and under control.

Buying Instagram keeps it out of the hands of companies like Google or Microsoft (MSFT) that might seek to build it into a full-fledged social network, or expand it to devices like notebook and desktop PCs. That would dramatically expand Instagram's reach, and make it a much more viable threat to Facebook.

Remember, Facebook is hugely profitable, and has tons of cash and expensive stock (that could get more expensive after the IPO) to spend on deals. Therefore, the purchase price of $1 billion looks like cheap insurance against a potentially significant competitive threat. And believe you me, it won't be the last such deal Facebook makes this year.

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