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The Facebook Hamster Wheel

With a $1 billion price tag for Instagram, a $1.1 billion valuation for Tumblr, and a rumored $3 billion bid for Snapchat, many observers are probably scratching their heads, wondering: why are companies like Facebook and Yahoo willing to shell out this kind of cash for barely-in-revenue-if-at-all consumer startups?

hamster-wheelWhile I can’t pretend that all these valuations are “rational” in a traditional sense, I can say that it becomes more understandable if you think about Facebook’s business model. Plain and simple, Facebook’s business model revolves around taking the total amount of time users spend on Facebook and making money against it, whether its through ads or charging a “tax” on virtual goods (think Farmville items) or gifts bought on the platform.

As a result, for Facebook to grow its core business, it really has two options:

  1. Increase the total amount of time users are spending on Facebook
  2. Increase how effectively you are monetizing existing time spent on Facebook

The challenge with #2 is that there really is an upper limit to how much money you can make on a minute of user eyeball-time before you start annoying the user base (either because there are too many ads or because the ads get kind of creepy). So, what most internet media companies strive for is #1 – increase the total amount of time users spend on their websites/apps.

The challenge with #1, though, is that every additional user-minute a company gets is an incremental minute of some other activity that the user needs to give up. And, since we all only have 24 hours a day (and need to sleep), that’s a limited number of minutes to go around, especially for a company like Facebook, where its users are already pretty addicted.

This means that Facebook (and other digital media companies like Yahoo and Twitter) is in a horrifying never-ending race not only to get more precious user-minutes but just to hold on to what they already have. Any time a shiny new startup takes off which seems to suck up user-time — especially if its amongst teens/adolescents who, because they don’t have tons of friends on Facebook already, don’t have any strong reason to be on Facebook — Facebook needs to find a way to grab that time back just to stay even. It’s a hamster wheel that Facebook can never get off of short of changing its underlying business model.

It’s this attention economy that drives digital media companies to pay up for startups like Instagram or Tumblr or Snapchat — they’re new threats to Facebook’s growth and business model, as well as new opportunities to get new user-minutes. That’s why these companies are so prized – for digital media companies in the attention economy, it’s the user-minutes, stupid.

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  • Jeff L

    I’ve been thinking of it like an insurance model. Facebook bought Instagram for about 1% of Facebook’s net worth at the time. The nominal excuse was gaining mobile proficiency, but if there was a more than 1% chance that Facebook could have been replaced in the mobile space and therefore every-space by Instagram, this was worth it. They turned out to be right. I hear people think Instagram as it is now would have been worth it at 4 or 5 billion dollars, so Facebook decision makers behind the last deal look smart.

    Now they offered 2.5% of their equity market valuation for Snapchat. That seems like overpriced insurance, but if it also comes with a plan to monetize existing users it isn’t too overpriced. In this situation I can only imagine that the user-minute metric is more relevant since I don’t recall hearing about Snapchat having functionality that really rivals Facebook at all.

    Yahoo buying Tumblr – that confuses me more. They already had tons of users that they have been unable to effectively monetize, so they decided to go out and buy younger, hipper viewers…

  • Ben

    That’s an interesting way of thinking about things — and not mutually exclusive at all

    Re: Snapchat — I’ll probably write more on this in a future blog post, but I think you underestimate the disruptive potential of these new mobile messaging platforms (i.e. WhatsApp in the US, WeChat in China, LINE in Japan, Kakao in Korea, Snapchat, etc.) They are becoming a key way that consumers communicate with one another — off of Facebook — and assuming that what comes next in social platforms will be mostly functionally equivalent falls trap to the Innovator’s Dilemma. The winners in mobile do not have to be the winners in the web-version of the world (i.e. PayPal vs Square, EA vs Rovio, Android vs Windows) — so I think the insurance model can work here just as well as the user-minute one

    Re: Tumblr — haha, exactly — what’s confusing about it? 🙂

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  • ao

    (i) why is Instagram now worth 4-5b?
    (ii) if a company needs to continuously buy insurance against things that have meaningful probabilities of completely disrupting it, i think it’s fair to argue that should lead to a diminution in one’s estimate of its intrinsic value. 1-2.5% of a company’s market cap may not seem like much, but with FB at 40-50x earnings, each of those acquisitions is basically a year’s worth of net income. keep doing this, and your shareholders ultimately get no return, which suggests that either Snapchat / Instagram are worth what FB is paying, or in which case FB isn’t worth very much, or they aren’t worth what FB is paying, in which case FB is destroying value.

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