Wade Armstrong

Another Reason I Like Google's YouTube Purchase, But Not Yahoo's Rumored Facebook Acquisition

Posted Monday October 23, 2006 in Business

Now, I’m obviously not a big fan of Yahoo buying Facebook, while I love Google buying YouTube, but the fact remains that a mediocre purchase at a good price is still a pretty good business move, while a good purchase at too high a price is usually a mistake. Yahoo could make a good thing out of Facebook if it can get the company for the right amount of money, and YouTube could be an albatross around Google’s neck if the search leader pays too much for the video sharing site. Unfortunately for Yahoo, it looks like it’ll have to pay too much for its bad buy, while Google gets a good price for its strong strategic fit.

Notes on Valuation

The first question is: how do you value companies like these? It’s, of course, hard to value companies that aren’t making money, and hard to value companies that are young, but the fact is that most companies start out by not making money and all companies are young sometime. Business leaders have an obligation to put their companies in position to buy the next Microsoft, and that means figuring out how to value a money-losing company that just might be able to sell its OS to IBM, if IBM and Gary Kildall are silly enough.

Generally, large, successful companies are valued based upon their hard assets and their income streams. For companies like YouTube and Facebook, however, we’re best off to look at comparables — similar businesses that have been involved in transactions and which, ideally, have longer track records, so that we can look into our valuation targets’ futures. Both YouTube and Facebook attempt to monetize individual users, so we want to look at similar companies and see how much money they got per user or per registered member. (This isn’t a particularly strange way to value a company; catalog retailers have long been valued in this manner, because they, similarly, try to monetize every single name on their mailing list.)

Good comparables have similar business models and practices. For YouTube, we want to look at Web applications that are primarily tools, but which also have some community features. For Facebook, we want to look at community sites with some tools built in. Two good comparables for YouTube are the photo-sharing site Flickr and social bookmarking pioneer del.icio.us, both bought by Yahoo; for Facebook, we of course look at Myspace, bought by News Corp., and, again at Flickr.

(A note on sources: I’ve tried to get the best data possible off of the Web, but I’m restricted to mostly free sources, and the companies here were all bought as private companies, so they didn’t have to make any public disclosures; thus, much of the information below is based on conjecture or on what is generally accepted.)

YouTube Valuation

YouTube currently is rumored to have about 35 million unique US users (while this number seems ridiculously high — do you really think 12% of the US population uses YouTube? — it’s all we’ve got to go on). This puts Google’s purchase price at about $32/user. Compared to Flickr, at $130/user, and del.icio.us, at $66/user, this seems to represent a spectacular discount (another fun comparable is Mark Cuban’s Broadcast.com, bought by Yahoo for the unbelievable sum of $710/user in 1999; go ahead, click on the link and see how successful that business now is).

So, what might account for this discount? Well, there are clearly outstanding concerns about YouTube’s liability for videos it hosts that infringe on copyrights. At this price, Google could afford to pay an extra $2 billion in copyright settlements while still coming in at a lower per-user price than was paid for Flickr (with more than $10 billion in cash according to its latest 10-Q, Google can afford these payouts too). It’s also the case that Flickr, in particular, had a very strong community, and that del.icio.us was highly-syndicated, so there might be some rationale to value one of these services’ users more highly than a YouTube user.

YouTube was also not making money, while both of these services were, I believe, more or less profitable, so YouTube may have been prepared to accept a lower valuation based on a lower actual revenue per user. All of these figures are hidden, of course, because the companies in question were private at the time. It’s worth noting that Google’s purchase price is only $0.04 per video stream; Google probably thinks that, as the king of online ads, it can find some way to make at least $0.05 per video stream — even at that low premium, we’re talking $1 million cash a day, and on ad inventory to which Google doesn’t have access currently, making this acquisition entirely accretive to the bottom line.

Google also appears to be getting some great technology, as I’ve said before. YouTube movies stream with better quality than do Google Video movies, and the site has been remarkably stable despite its popularity. I’m not in a position to say if YouTube has cutting-edge technology, but they’ve certainly done a solid job. It’s difficult to value their technology, although the number is probably in the very small millions. To get good tech at a discount like this is a great bonus, especially in comparison with del.icio.us and Flickr, which, since they were bought at much smaller total prices, must have had their technology account for a higher percentage of the purchase price. Flickr, at least, was built in PHP, one of Yahoo’s favorite technology; del.icio.us was built in perl, not one of Yahoo’s main tools from what I can gather.

Put all of this together, and YouTube is a great buy for Google, at the right price. YouTube’s founders are taking the risky approach of accepting an all-stock offer, but that does keep down their taxes while exposing them to Google’s substantial upside — potentially extraordinarily profitable (some people think that, if Friendster founder Jonathan Abrams had taken $30 million in Google stock in 2002, he would’ve been worth more than $1 billion today).

Friendster Valuation

So do the numbers look as good for Friendster? If you’ve read this far, you probably know the answer is no. Friendster has nine million members, and its co-founder, Mark Zuckerberg, has been pretty clear that he wants $2 billion for the site — that’d be $111/member. Now, that’s within the kinds of valuations Yahoo’s been throwing out there — they’re the ones who bought Flickr and del.icio.us — but it’s high compared to YouTube or, especially, to MySpace, which is the most obvious comparable, and was bought for about $26/user. Yahoo has reportedly offered $900 million; at that price, we’re talking about $55/member, which at least gets into the Myspace ballpark.

(Of course, it’s now clear that Myspace was sold much cheaper than it should have been; I can’t imagine how angry its heavily-diluted founders must be to have received what is rumored to be only a few dozen million for their shares, when they could probably have gotten twice that number if their VCs hadn’t, reportedly, pressured them to sell.)

Is there a reason Friendster gets this premium? Well, there are no potential legal liabilities, as with YouTube, so that helps; Friendster is also growing well. But Friendster’s in the midst of a strategic shift, which actually suggests they should be selling at a discount, since the buyer absorbs the risk that the new strategy won’t work. Friendster is written partially in PHP, which might suggest that they’re a good match, technologically, for Yahoo’s systems, and command a premium, although it’s hard to imagine there’s any shortage of good PHP programmers out there.

One possibility is that Yahoo is paying extra for Zuckerberg and co-founders Dustin Moskovitz and Chris Hughes; Zuckerberg is very high-profile and outspoken. Old-media exec Terry Semel has been competently running Yahoo for several years, giving good returns to investors, but it’s clear that the company lacks Google’s vision. Perhaps a brash new figurehead would help? Of course, being young and inexperienced, Zuckerberg could be just as much a liability, and some investors would want a discount for an unproven leadership team.

Even if Yahoo isn’t paying more for Zuckerberg, it’s possible that they’re paying more just because they’re Yahoo. Yahoo’s simply not as cool as Google, and people may be more excited to work at the hipper company that’s always trying new things. On top of that, Yahoo’s stock has dropped nearly 1/3 in the last year, while GOOG is up 150%; that mandates a more-cash, less-stock deal for Facebook, and also a higher-priced deal, because there’s less upside to holding equity in Yahoo (Google can, effectively, deliver a higher price than they initially pay thanks to their stock’s appreciation — if GOOG performs this year as it did last, the YouTube founders will end up with about $3 billion).

So Yahoo ends up making a strategically weak purchase at a high price. The only way this acquisition makes sense is if Yahoo can take advantage of synergies with an integrated Facebook that are non-obvious, or if Facebook co-founder Zuckerberg turns out to be another Steve Jobs. Both seem risky. In contrast, the YouTube buy is good for both parties if things just continue as they are. That’s a much better risk/return profile, and, if Google can keep making acquisitions like this, it’ll stay well ahead.