Network Effects in Reverse: Facebook's Problem with Teens

Facebook spooked investors yesterday when it announced earnings.  Actually, profit levels themselves were not the problem.  Facebook reported robust financial results.  However, management informed investors that the number of teens visiting the site declined in this recent quarter.  What's happening?   I believe that teens are migrating to other social media sites, one of which Facebook now owns (Instagram).   I hear many parents of middle school and high school students noting that their kids are not asking first to join Facebook.  Instead, they are first asking to join Instagram or some other social media sites.   

Here's the potential bigger problem coming down the road for Facebook.  When you are growing as a social media site, you have network effects in your favor.  The more users on the site, the more value per each user - it's a virtuous cycle.    However, when the number of users begins to decline, you have the potential for a downward spiral to begin.  As someone's friends leave Facebook (or don't join in the first place), he or she derives less value from the platform.  Then that person defects perhaps.  Their friends now derive even less value from the site, and they may defect.  We've seen this story before, of course... just ask the folks at MySpace.  Now, I'm not predicting such a dramatic fall for Facebook, but I am suggesting that investors have a right to be worried about the drop in teen usage.  It will be an interesting metric to watch going forward.

Facebook and Instagram: Where was the Board?

The Wall Street Journal reports today that the Facebook Board of Directors was not involved until very late in the process with regard to the Instagram acquisition.  According to the article, "By the time Facebook's board was brought in, the deal was all but done. The board, according to one person familiar with the matter, 'Was told, not consulted.'"  Later in the article, it describes an amazing meeting that took place at Zuckerberg's home:

At around 6 p.m. that evening, Facebook board member Marc Andreessen showed up at Mr. Zuckerberg's house for a regular meeting. What he didn't know was that Mr. Systrom was in another room, getting his own board to sign off, people familiar with the matter said. Mr. Andreessen, whose venture-capital firm was the second to invest in Instagram, cutting a $250,000 check before the service launched, was surprised when Mr. Systrom walked into the room about an hour into his meeting with Mr. Zuckerberg, the people said.

You can imagine the reaction of corporate governance experts!    Most people have pointed to the fact that the Board and Mr. Zuckerberg will have to interact much differently when Facebook becomes public.  If not, minority shareholders will be quite concerned.  It's interesting, of course, because agency theory says that we ought to like it when CEOs own lots of shares of a company. In those cases, according to theory, there's less divergence of interests between shareholders and executives as opposed to publicly traded companies in which top executives own a tiny ownership stake.  The theory says that we like it when CEOs are playing with their own money, not other people's money.   While I generally agree with that theory, there are limits to the applicability in the real world.   In particular, the interests of minority shareholders need to be considered, particularly when a founder is CEO.   Good governance processes matter, even if we assume that the CEO generally is trying to do right by all shareholders.  Moreover, founder/CEOs rightfully should get held to a different standard when a company goes public.  

The Facebook-Instagram Deal

Wow! What else can you say?  Facebook pays $1 billion for a company with 12 employees and no revenue.   I'd love to see the discounted cash flow model that my students could come up with to determine that valuation! 

What's going on with this acquisition?  First and foremost, we have to remember that photo-sharing is a crucial element of the Facebook experience.  As my former colleague Mikolaj Jan Piskorski likes to say, Facebook made it socially acceptable for all of us to become exhibitionists and voyeurs to some degree!   In that sense, Instagram has emerged as a major threat to Facebook.  As people spend more time sharing their photos via Instagram's mobile app, they are likely to spend less time on Facebook.   That reduced time on Facebook will cost the social media heavyweight a significant amount of advertising revenue.  Moreover, rumors of a possible link-up between Twitter and Instagram (or perhaps even Google and Instagram) surely made Mark Zuckerberg more than a bit nervous.

What challenges will Facebook face with this acquisition?   Zuckerberg has announced that he intends to continue operating Instagram as an independent company with relationships to other social media platforms such as Twitter.  Users will still be able to post photos on other social media services, follower users outside of Facebook, and can choose not to share photos on the Facebook platform.   In some sense, this move is a type of vertical integration.  When that happens, firms also face the challenge of competing with their customers.  Instagram will now be competing with its customers - i.e. Twitter and Google Plus compete with Facebook.  Will that cause friction?  Will it cause Instagram competitors such as Hipstagram and PicYou to steal away users?  Facebook will have to be quite careful as it manages those relationships.

Some experts have wondered why Facebook could not have achieved some of the same benefits without having to acquire Instagram. Could they have formed an alliance or partnership with Instagram?  Perhaps they could have.  However, such an arrangement may have made it more difficult to engage in the type of close coordination required to integrate Instagram more deeply into the Facebook platform moving forward.  If Instagram simply were to remain an independent company, then an alliance might have made more sense.  However, I think more intense coordination and integration is coming... and a merger probably makes more sense in that instance.