zuckism

If there were any analysts that had doubts about Facebook’s mobile dominance plans, they have been put to rest. Last week, Facebook announced the $19 billion acquisition of the most popular mobile messaging app, WhatsApp. It is an exciting move by Facebook, which seems to be leaving no stones unturned to make sure it dominates the world’s social networking market.

WhatsApp’s offering

Santa Clara-based WhatsApp was founded in 2009 by ex-Yahoo engineers, Brian Acton and Jan Koum. The app delivers mobile messaging capabilities irrespective of a phone’s OS by using the phone’s mobile broadband subscription. It is available across multiple platforms including iOS, BlackBerry, Windows, Android, and Nokia. Users are able to exchange texts, images, audio, and video content through the app without paying anything to the wireless carrier. According to a research report by Deloitte, mobile messaging services are gaining popularity, accounting for twice as many messages sent over the mobile Internet compared with traditional texts.

The WhatsApp app is free to download and does not charge any fees for the first year of the subscription. A year later, WhatsApp charges $0.99 per year to let the user continue to use its services. WhatsApp does not disclose detailed financials, but reports suggest that it was operating at an annual revenue run rate of $20 million. Whatsapp had also mentioned that it was already operating a successful business model. In fact, it paid corporate taxes within a year of its product launch. Prior to the acquisition, Whatsapp had received venture funding of $60 million led by Sequoia Capital. Its last round of funding held in July last year, raised $52 million of this funding at a valuation of nearly $1.5 billion.

Whatsapp has seen rapid adoption so far. As of December last year, it had more than 400 million registered users and more than 200 million were monthly active users. Since then, at the time of the acquisition, it had increased its user base to 450 million users. It claims to be adding over a million users every day. The app sees more than 50 billion messages and 500 million images exchanged over its platform daily. WhatsApp’s goal is to be available on every single smartphone – that is an estimated 1 billion phones as of 2013.

The acquisition

WhatsApp cost Facebook $4 billion in cash and an additional $12 billion in stock. WhatsApp’s founders and employees will be eligible for another $3 billion in stock grants to be paid out, if they remain employed by Facebook for four years. This is the biggest acquisition so far by Facebook and the second largest tech space acquisition after HP paid $25 billion to acquire Compaq in 2001. Many are not pleased with the high price tag.

According to research by OnDevice, the global messaging app market is highly fragmented based on the region. Despite the strength of its messenger, Facebook has been scouting the market for potential acquisitions to increase its presence on the mobile usage front. The company had offered $3 billion to acquire Snapchat, but the deal fell through, because Snapchat did not want to sell. Finally, it was WhatsApp that gave in.

WhatsApp was rumored to have been courted last year by both Google and Facebook, but it refused to sell as well. Recent reports suggest that even now, this may not be an easy marriage. Both Facebook and WhatsApp are led by two strong willed CEO-founders who have very different beliefs. Facebook’s revenue source is advertisement powered by extraordinary levels of data analytics and WhatsApp’s guiding principle is “No Ads, No Games, No Gimmicks.” Where Facebook relies on collecting and leveraging user data, WhatsApp does not collect any other information besides the mobile phone number and the address book. In fact, WhatsApp does not even store the messages that are sent over their platform. Due to his communist country background, Ukrainian founder Jan Koum doesn’t believe in invading people’s privacy. For now, though, both CEOs have agreed to keep their differences aside.

There are several theories on why Facebook really bought WhatsApp. Surely mobile dominance will have a big part to play, and I also agree with Sarah Lacy’s argument in Pando Daily on photos being a core driver for the acquisition. Facebook earlier spent $1 billion to acquire photo app, Instagram. But Instagram processes 55 million photos a day. Facebook, with all its might, also processed 350 million photos a day. Compare that with WhatsApp, which claims to process 500 million photos a day. The acquisition will not only ensure that the online photo messaging space is now dominated by Facebook, but will also ensure that the market’s “attention” remains focused on Facebook instead of a competitor like WhatsApp or Google.

Monetization

Facebook maintains that WhatsApp will continue to operate independently and autonomously even after the acquisition. But I have my concerns with that statement, as I am sure that Facebook will want to recover the huge investment by monetizing WhatsApp. Assuming that WhatsApp reaches its goal of being on every smartphone and is able to monetize 10 percent of this base, that would be revenues of nearly $100 million a year (at current subscription rate, assuming a high conversion rate of 10 percent). If Facebook were to increase the subscription fee to $1 per month instead of per year, that would help it earn revenues of $1.2 billion per year, which is well within the realm of possibilities.

I strongly believe that very soon, the model of free apps will fade as people developing them won’t be able to sustain them. App developers will either have to charge subscription fee or show ads and it will become acceptable for WhatsApp to do the same. WhatsApp may prefer the subscription model, but some of their users who choose not to subscribe will have to be willing to be see advertisements as well. Let’s say, 10 percent will subscribe, and 90 percent will choose to watch ads. The service provides very high levels of value and stickiness. Even $1 a month is quite cheap for most users to pay, to keep using it. So at least a billion dollars a year worth of revenue is well within the realm of possibilities.

I know WhatsApp is in principle against advertising, but now Facebook owns the product and they have not bought this product as a charity. They intend to leverage it, just as Yahoo will eventually have to monetize Tumblr. And it is not just Facebook’s management. Given that the deal is structured so that WhatsApp founders now have stock in Facebook, it is in their interest to ensure that Facebook’s stock rises. It is easy to understand why WhatsApp will need to give in a little to embrace Facebook’s advertising-based revenue model. This could generate another billion or two in revenues quite easily.

I agree with Om Malik in Gigaom, that the acquisition price is “jaw dropping and seemingly insane”, but I don’t see how Facebook won’t come out the winner in this one.

While the consensus is that the deal is driven to a large extent by fear and panic, I do think that Mark Zuckerberg is emerging as a very shrewd CEO. He has invited Jan Koum to join the board of Facebook. This will expose Koum to the concerns of shareholders, and inevitably, these concerns will be around monetization, revenue growth, and profitability. The solution of charging subscription and showing ads are going to be so obvious to everyone, that Jan Koum will not be able to resist yielding. Very cool psychological move!

Industry implications 

Communication, messaging, and photo apps are a dime a dozen on all the major smart phones. Of these, some have come to dominate their markets (Example: Kakao in Korea), some have created significant niche user bases (example: TextMe), and there are numerous ‘also rans’ that will simply go out of business in due course. We can certainly expect more acquisitions in the category by major tech companies, especially the social networks, and perhaps even the mobile platform vendors. We can also expect some acquisitions by the carriers and handset vendors who will try to differentiate with proprietary apps.

But eventually, I do not see the current party of free apps funded by gobs of venture capital continuing forever.

And that, in the end, will make the likes of Facebook win.

They will monetize.

The market will play ball.

I don’t believe in ‘free’. It’s against the basic value of capitalism, which I happen to still believe in.

The market will, in time, come to appreciate the wisdom of this simple model: offer value, get paid for it.

Also, startups going crazy over the valuation should remember that 99% of the entrepreneurs who go out to seek financing get rejected. WhatsApp had Sequoia and other VCs bankrolling their growth with $60 million. This is a low probability scenario, and for most entrepreneurs, keeping your feet on the ground would be an excellent idea. That being said, expect to see confused and highly speculative behavior both from entrepreneurs and investors for a while, as the tech industry reels through this shock.

More broadly, Robert Reich says WhatsApp is everything that is wrong with the US Economy. Well, yes, WhatsApp is not just valuation without revenue, it is also valuation (and wealth) without job creation. And yes, this trend is pervasive. In case study after case study, we’re seeing wealth creation without job creation, and that trend is not going to change anytime soon.

[This post was originally published here on One Million by One Million.]

[Illustration by Niv Bavarsky for Pandodaily]