There are many recent examples of tech and media companies with low or no revenue being acquired at astronomically high valuations. Instagram did not have revenue when it was acquired for $1 billion by Facebook. Viber was acquired by Rakuten for $900 million – 600 times its revenue of $1.5 million. Facebook acquired WhatsApp for $19 billion – 1,900 times its revenue of $10 million.
Many people scratch their heads and wonder why companies with such low revenue command such high valuations. Is it because some silicon-valley nerd in a hoodie thought it made sense? Is it because a smooth talking Wall Street banker overhyped a Board of Directors? Well maybe, but it is more likely because of potential synergistic value.
To better understand the term “synergistic value”, consider the Facebook acquisition of WhatsApp. How did Facebook justify such a seemingly insane price? It did so by considering the potential synergistic value of owning WhatsApp.
According to recent public information, Facebook has 1.3 billion active users, each generating on average about $9.60 of revenue per year. Whatsapp had 450 million active users when it was acquired, each producing on average about $0.02 of revenue per year. It is likely that Facebook will use its monetization expertise and infrastructure to increase WhatsApps average annual revenue per user. Hypothetically, let’s assume that Facebook can enable WhatsApp to increase its revenue per user by $4 per year within five years following the acquisition. That would equate to an incremental synergistic revenue of $1.8 billion in year five.
While we’re at it, let’s also assume that cross platform promotion causes 5% of WhatsApp Users to become new Facebook users within five years following the acquisition. That’s an addition of 23 million new Facebook users. Since Facebook users on average generate $9.60 of revenue per year, this user increase results in incremental synergistic revenue of $216 million in year five.
Lastly, let’s assume that cross platform promotion causes 10% of Facebook users to become new WhatsApp users by the end of year five. That’s 130 million new users of WhatsApp. If WhatsApp is making $4.02 of revenue per user by the end of year five, this user increase would result in incremental synergistic revenue of $523 million.
Add it all up and it turns out that in our example Facebook will be enjoying an incremental $2.5 billion of synergistic revenue within five years of completing the acquisition. Multiply $2.5 billion by the recent Facebook price to revenue multiple of 17.7 and the result is incremental year five value creation of $45 billion. Discount this back into today’s dollars using an assumed cost of Facebook capital of 12% and we find that the synergistic value to Facebook of owning WhatsApp is $25.5 billion. Since Facebook only paid $19B for the acquisition, the net value created for Facebook shareholders is $6.5 billion.
So why would Facebook pay $19 billion for a company only generating $10 million of revenue? Because it’s synergistic value is higher than the $19 billion cost. Of course, the real trick will be for management to actually achieve the synergies Facebook assumed in its calculations. This is typically where many acquisitions fail to realize their potential to drive synergistic value.
