Facebook has just acquired the maker of the
iPhone application Instagram, which lets users do simple photo editing and
sharing with friends, including social-network functions such as “like” and
comments. The application itself is in no way complex enough to explain the $1
Billion price (even the valuation of the company on Feb 2., $30 million, would
be a rich price for such application). The earnings are not either: There are
no revenues at present because the firm has concentrated on building a user
base, and has not launched any revenue model, such as advertising or other
commercial tie-ins.
So what is driving the price? One, the user
count is increasing very rapidly, going from 15 million in early December to 27
million now. Well, it is probably more because I am writing 36 hours after the original
Wall Street Journal article. Two, the application has high engagement, meaning
that users spend a lot of time with it. There are probably some other reasons
as well, such as the speculation that Facebook felt a need to defensively grab
this firm before someone else did, but those two explanations sum up a lot of
the appeal. What we have is a valuation based on the network effect: users find
an application much more valuable because others (especially their friends)
also have it, and this network effect makes them reluctant to change to a
competing application that offers the same functions, or even a better one.
Once the network effect is established, Instagram may be able to reduce the user value, such as by devoting part of the screen to
advertising, and the users will still remain loyal.
Or will they? Under what conditions can the
network effect unravel? The answer is in theory surprisingly simple, but hard
to do in practice. A business based on the network effect can be taken apart
through knowledge of how diffusion processes work. First, make a better product.
(This could be a problem in the Instagram case: possibly the simple photo
editing and sharing is all its users need or want.) Next, generate adoption of
your new product by technologically curious "innovators". This is easy to do; a certain
proportion of the population like to try out new things to see if they are
better than what they currently have. Among these innovators you will find some
opinion leaders that others pay attention to: make sure to announce their
adoption if you can, and give them tools to invite their friends. Social network
sites do this through their “friend” or “link” contact requests, and any
application that tries to break into a network-effects market needs such a
function. If the business you are competing with is well established, find a
segment where it is weak and start there. If your service is really good, it
will naturally start eating into the next segments of the population from
there: The early adopters, who are influenced by the first innovators, the
early majority, who are the friends of the early adopters, and the late
majority, who come on board when something is so big that everyone is telling
them about it. Even if your service is not that much better you may be able to
find ways of rewarding users to stay (usually through neat product features) while waiting for the other to make some
misstep, like putting too much advertising on the screen.
Businesses built on
network effects have customer loyalty that makes them valuable beyond what a
simple examination of the product or the revenues would suggest. But they are
not isolated from competition and they are not licenses to print money. A
business built on network effects can be beaten by another business that also
uses network effects, plus good product design.
Raice, Shayndi & Spencer E. Ante. 2012.
Insta-Rich: $1 Billion for Instagram. Wall Street Journal, April 9 2012.
PS: Here is an interactive look at the numbers behind the acquisition:
PS: Here is an interactive look at the numbers behind the acquisition:
