12 April 2012

Instagram, AOL … Are We Headed for an Intangible Meltdown?

‘Those who cannot remember the past are condemned to repeat it’ – George Santayana, Reason in Common Sense (1905)

Bubble burstingIn March 2000, Facebook co-founder Mark Zuckerberg was 15.  Instagram founders Keven Systrom and Mike Krieger were 16 and 14 respectively.  In the past week these three people – all still under 30 – have done a deal in which Zuckerberg’s company has acquired Systrom and Krieger’s for a cool US$1 billion.

At almost the same time, Microsoft has acquired 800 patents from AOL for just over US$1 billion.

These deals follow hot on the heels of last year’s acquisition of Motorola Mobility by Google for US$9.8 billion, and the purchase of 6000 former Nortel patents by the Rockstar Bidco consortium (Apple, Microsoft, RIM, EMC, Ericsson and Sony) for US$4.5 billion.

All of these deals have in common the fact that the entire valuation is based on intangible assets.  How do you put a price on a bundle of patents?  On a team of great employees?  On a loved brand?  Or on the future potential of a technology?

Are the recent valuations justified, or are we heading for another industry meltdown similar to the ‘dot-com’ bust of March 2000?  After all, the Zuckerbergs, Systroms and Kriegers of the world could be excused for failing to learn the lessons of history – they were little more than kids at the time!

VALUATION OF INTANGIBLE ASSETS

Ideally, of course, you would value intangible assets by looking at their potential contribution to future business, either through growing revenues, or withstanding competition.  In practice, this is such a speculative exercise that we suspect there is little or no rational analysis behind many IP valuations.  At one extreme, there are individual patents which are able to generate huge revenues, such as that held by NTP which brought a US$612 million dollar settlement from Blackberry maker Research in Motion.  At the other, there are entire portfolios that are virtually worthless because nobody needs to use the the technology they monopolise.  If anything, greater difficulties in valuation apply to other types of intangible asset.
Instagram
What is weird about the Instagram deal – or at least it should be – is that most people seem to have taken the price tag in their stride.  Of course Instagram is worth a billion dollars.  Isn’t it obvious?

Well, no.  Objectively speaking, the facts hardly seem to support such a high valuation.  Here are a few of Instagram’s vital statistics:
  1. Launched: 6 October 2010;
  2. Employees: 13 (plus two founders);
  3. Profit: not yet;
  4. Revenue: none to speak of;
  5. Users: over 30 million.
So where is the billion dollars worth of value in this?  Eighteen months is hardly enough time to have developed anything with proven staying power, and Facebook could easily hire 15 really smart people for far less than $1 billion.  And while 30 million users sounds like a lot, it is nothing compared to the over 800 million that Facebook already has (presumably including the vast majority of Instagram users), which is already predicted to grow beyond a billion before the end of 2012.

Clearly Instagram has value to Facebook as a partner rather than a competitor.  But how long is it going to take for the marginal benefits of ownership to accrue US$1 billion?  For all practical purposes, probably forever!
AOL
Microsoft’s AOL patent acquisition looks a little better.  At least Microsoft is getting 800 patents, and for a company with an active licensing program which is generating significant revenues, that must be worth something.  But if 800 AOL patents are worth 1 billion dollars, 6000 Nortel patents 4.5 billion, and 17,000 Motorola patents worth a sizeable part of 9.8 billion, it appears that the per-patent value is pretty consistent, regardless of the strengths or weaknesses of the portfolios in question.

Of course, with Motorola Mobility, Google is also getting an operating business.  But with a price-to-earnings [P/E] ratio of about 32 years, it is safe to say that Google is not expecting to get its money back through product sales!

THE INTANGIBLE MARKET

It appears that there are now accepted ‘going rates’ in the market, and that for the major players these generally sit in the 1-10 billion dollar range for anything worth acquiring.

This is fast starting to look like a market in which a combination of rapidly increasing valuations, confidence that intangible assets (especially patents) will translate into competitive advantage, speculation in IP (including by non-practising entities), and readily available venture capital, are creating an environment in which investors are willing to overlook traditional metrics such as P/E ratio in favour of confidence in IP monetisation.

In the dot-com boom and bust of the late 1990’s, IP was important.  Investors were generally looking for some form of protection to be in place as part of their due diligence of a prospective investee.  But technology, and fast growth, were of greater importance.  A typical business model involved operating at a sustained loss – burning the early investors’ money – while building market share by offering products or services for free in the hope of capturing enough customers to charge profitable rates at a later time. 

Now, intangible assets appear to be the main focus.  This is not, in fact, a bad thing.  A company that is focussed on identifying, capturing and protecting its IP is at least locking in the value created by burning its investors’ funds.  In 2000, the idea of selling a patent portfolio to generate some return to investors when a company failed as a going concern would have seemed reasonably radical.  But much has changed in the intervening years, and the idea that there are a variety of ways in which intangible assets may be monetised, other than simply using them as the basis for a company’s own products and services, is now uncontroversial.

But when IP speculation becomes rife, and valuations are plucked from the air (or based directly or indirectly on earlier valuations which were plucked from the air), there is a very real risk of losing touch with any realistic metrics for assessing the return on these investments.  There is no reason to spend a billion dollars on something if the business case cannot be made that it will add more than a billion dollars value to the company, and generate revenues (or defend against losses in revenues) at least equivalent to the purchase price over a reasonable time-frame.

ARE WE HEADING FOR A WORLD OF HURT?

During the dot-com boom, sceptical voices advocating a return to business models based upon traditional metrics such as P/E ratio were dismissed by the ‘new order’ as emanating from dinosaurs who had failed to move with the times, and grasp the disruptive effect of information technologies on conventional commerce.  It turned out, however, that you cannot just rely on magically escalating valuations to generate wealth.  You actually do need to create products and services of real value which are capable of generating real revenues, however old-fashioned that may seem.

The inevitable bursting of the dot-com bubble brought great pain to huge numbers of people, decimating entire industries.  Let us hope that we are not seeing a repeat of the kind of irrational behaviour that has led to disaster in the past.

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