Facebook Winners’ Curse

Back on April 9, Mark Zuckerberg announced that Facebook had agreed to acquire Instagram for a jaw dropping $1b.

What is Instagram? It is an iPhone app that allows people to swap photos with friends. The one and a half year old company has about 16 employees and its revenue is a cool zero.

Most commentators said that Zuck was either trying to pre-empt a potential competitor or to expand in the mobile market where Facebook is weak. There is nothing Instagram does that Facebook cannot replicate, make available to its 900 million users, and instantly kill Instagram. Why pay $1b for something that is essentially worthless?

Let me tell you why. It was to create a media frenzy for Facebook’s IPO, which was slated to happen 40 days later. If a company that has zero revenue and no prospect of profit is worth $1b, how much more would Facebook, which has $10b in revenue and $1b in profit, be worth?

The move was brilliant! The media couldn’t stop talking about Instagram and using it to infer the unlimited potential of social networking.  All the dumb investors came out of the woodwork to demand a piece of Facebook at any price. The rest is history.

There is an economic theory called the winner’s curse. It essentially says that when a bunch of uninformed people bid on an object, the winning bid is almost surely higher than the true value of the object, rendering the winner an actual loser. With his Instagram acquisition, Zuck set the stage for many investors to experience winner’s curse first hand.

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