Facebook’s Acquisition of WhatsApp

15 min. read

Why spend $16 billion on a 55 people Californian startup? I’ve been asking myself that question since I read about the deal. So I did some digging.

Let’s start with Facebook, the ubiquitous social network, founded in 2004 by Mark Zuckerberg who famously uttered ”if you guys were the inventors of Facebook, you’d have invented Facebook” to the people accusing him of intellectual property theft, made headlines recently when it acquired a small Californian company called WhatsApp. It should be readily apparent to anyone that Facebook is on a mission to connect the world: it currently has 1.23 billion active users, spurred by the company’s previous high-profile acquisition of Instagram, and a desire to continue growing. But what is WhatsApp?

Statistics show that smartphones are rapidly replacing traditional computers and cellphones, with communication increasingly taking place on the mobile internet. Facebook’s latest acquisition is an important step for the company to secure its dominance in an increasingly mobile world, as people abandon SMS and phone carriers inevitably turn into internet service providers.

Still, 16 billion dollars is an insane amount of money. Here’s why the deal makes sense.

The Inception of WhatsApp

WhatsApp was started by Jan Koum in California and launched on the App Store in 2009. Koum, a humble Ukrainian immigrant from a poor background, taught himself computer networking by purchasing used manuals and joining a hacker group on the Efnet IRC network. In 1997, he met Brian Acton, a Yahoo employee, while on a job. Six months later, Koum joined Yahoo while still in college before he eventually dropped out. During their 9 year stint at Yahoo, the pair developed a dislike for advertising: ”You don’t make anyone’s life better by making advertisements work better”, said Acton when interviewed by Forbes. This philosophy would have an impact on their future collaboration. Neither of them enjoyed their work at Yahoo and in 2007, they left. Ironically, both Koum and Acton were turned down when they later applied for positions at Facebook.

In January 2009, Koum bought an iPhone and discovered the impending ubiquity of mobile apps (applications). WhatsApp was initially conceived of as a contact list with statuses (similar to those on Facebook), but users soon began using the status system to chat with each other when Apple launched push notifications in june 2009; this feature made every status update show up on the phone’s display, even though users weren’t actively using the app. Koum realized he had created a chat program. WhatsApp 2.0 shipped with proper chat support, and the user base grew to 250,000.

Koum invited Acton, who was still unemployed after leaving Yahoo, to join his new company. Acton, whose resume includes work at Adobe and Apple, came from a typical middle class family with an entrepreneurial pedigree. Said Acton in an Orlando Sentinel interview: ”My mom started an air-freight company; my grandmother built a golf course … Maybe that eventually rubbed off on me a little bit”. He managed to raise $250,000 in funding and was granted co-founder status in November 2009.

There were already several instant messenger (IM) services available, but WhatsApp had an ingenious solution to an age-old problem: using it only required a phone number. Unlike its competitors, it didn’t have a tedious registration process, which meant that users could join effortlessly. It was also instantly familiar: WhatsApp looked and operated almost exactly like SMS. A BlackBerry version was developed, allowing iPhone and BlackBerry users to chat with each other for free, and in December 2009, MMS-like capabilities were added, letting users send and receive photos.

Another stroke of genius turned out to be the WhatsApp team’s efforts developing and testing J2ME apps aimed at emerging markets. These are apps that run on feature phones rather than smartphones and their development process is both tedious and difficult. But the return was enormous: it granted the company access to all the billions of people outside the developed world that didn’t have smartphones, a feat no competitor could claim. They too were interested in replacing SMS.

A look at WhatsApp’s biggest expense reveals why people sought alternatives to SMS (and MMS): ”Today SMS verification [for when users join the service] runs the company about $500,000 a month”. To pay for this, WhatsApp eventually turned to an unusual business model: the first year of service was to be free, while the following years would cost a nominal $1 per year. This was in stark contrast to the á la carte pricing phone operators often applied to SMS, and the decision ensured that the service could stay ad-free.

WhatsApp’s razor sharp focus on simplicity has clearly paid off: as of February 2013, the user base had grown to 200 million and at the time of writing, it’s now surpassing 465. ”I want to do one thing, and do it well”, Koum told Forbes, and reporters seem to think he has succeeded in doing so:

If WhatsApp had abandoned its goal to create a platform for games, or jump on the photo-sharing app bandwagon, it might not have been in the position it is in today.

– Ellis Hamburger, The Verge

The Second Most Expensive Acquisition

It’s not surprising then that Facebook became interested in acquiring WhatsApp. But what may be surprising is the seemingly extraordinary amount it paid to do so. To understand why this is significant, it’s helpful to look at some comparisons:

In November 2013, the EU approved Microsoft’s purchase of Nokia’s phone division, an acquisition for which it paid $7.3 billion. Nokia, a previous behemoth of the phone industry, has been in trouble lately as it fails to compete in the smartphone market. This has undoubtedly affected its valuation. According to a Nokia press release, some 32 000 Nokia employees are to be transferred to Microsoft. For reference, Microsoft had previously scooped up internet calling (VoIP) company Skype in 2011 for $8.5 billion – Microsoft’s largest acquisition at the time.

In May 2012, Google acquired phone maker Motorola Mobility and its some 3,800 employees for $12.5 billion in what became a much ridiculed affair. Google CEO Larry Page stated in a press release that ”the team at Motorola will be creating the next generation of mobile devices that will improve lives for years to come”. Pundits, however, claimed that Google was more interested in Motorola’s patents. In January 2014, Google sold Motorola, sans most patents, to Lenovo for $2.91 billion.

In fact, only the 2001 acquisition of Compaq by HP for $25 billion has been costlier than Facebook’s purchase of WhatsApp. Facebook is not new to acquisitions, but its only previous high-profile purchase was met with some concerns that the company might have overpaid when it snapped up photo sharing service Instagram for $1 billion in April 2012: a company with no revenue. The price was the highest for a profitless startup since Google acquired YouTube. In an interview with The Guardian, Facebook CEO Mark Zuckerberg said about the Instagram affair: ”We don’t plan on doing many more of these, if any at all”. He also ensured that Instagram was to remain independent from Facebook’s core business. The acquisition gave Facebook access to Instagram’s (at the time) 30 million users that used social networking differently than Facebook’s own.

Nevertheless, almost two years later, Facebook bought WhatsApp, a small company with estimated earnings of $20 million (2013), for roughly sixteen times the price of Instagram. What may seem equally surprising as the price tag is the fact that Facebook already had its very own messaging platform, Facebook Messenger, long before it acquired WhatsApp. Despite this, it paid $4 billion in cash and $12 billion in stock (valued according to a February 19 SEC filing). The deal also included an additional $3 billion in stock to employees that will vest over four years, to retain talent at the company, totaling $19 billion.

WhatsApp’s two co-founders became billionaires over night following the acquisition. Acton’s net worth is estimated to $3 billion, according to Orlando Sentinel. When interviewed, his former math teacher Michael Bouch said: ”You wonder in your career whether you’ll ever touch the life of someone who goes on to make it really big. But this, uh, this is just beyond belief”. For Koum, whose net worth is an estimated $6.8 billion, the story reads like the elusive american dream, but he seems determined not to let it change his ways: ”I can’t see a reason for there being a sign. It’s an ego boost. We all know where we work”, he responded when asked if WhatsApp would finally put up a sign outside its offices. Furthermore, WhatsApp’s lone investor, Sequoia Capital, is estimated to have made approximately $3.4 billion on the deal, according to CNN.

With all of this in mind, it’s not surprising then that an acquisition of these gargantuan proportions is making big waves. There’s no question that Koum and Acton have built an immensely popular service, and there’s no question that the two companies share a common goal in connecting the world. The question is what it is exactly that makes WhatsApp worth its price tag of $16 billion to Facebook.

Why is WhatsApp worth $16 billion?

The short answer is that WhatsApp has a slightly different use case than Facebook Messenger, that it has an active and rapidly growing user base and, in some regions, superior reach in important countries like Spain and Switzerland. It seems poised to dominate the future of mobile messaging.

But there were, of course, other options for Facebook to consider. Apple’s iMessage, a service similar to WhatsApp which is built into every iPhone and thus very popular, wasn’t up for sale, and since it’s iPhone-only (or, more accurately, iOS only), it wouldn’t fulfill Facebook’s goal of connecting the entire world. BBM, BlackBerry’s popular messaging service, has limited geographical reach and far fewer users (85 million as of February 2014) than WhatsApp. WeChat, a Chinese IM service, has an estimated 600 million registered users as of October 2013, according to China’s state-owned Xinhua, which makes it the largest IM service in the world, but its geographical reach outside China is lacking and the service has had problems with censorship. There are many more examples, like Kik and Line, and, although primarily focused on voice based communication, Skype and Viber. These are all popular services, but without WhatsApp’s impressive reach, simplicity and rapid growth.

It’s the combination of these attributes that made WhatsApp so attractive to Facebook. According to a Facebook press release issued to announce the acquisition, 450 million people use WhatsApp every month. That number has since gone up to 465. An astonishing 70% of those are active every day, which represents the highest engagement on any social network except Facebook itself. Users are important, but active users are no doubt even more important, and those are increasing rapidly – one million users are added daily and the volume of messages is approaching that of SMS:

“Over 450 million people using the service each month; WhatsApp is on a path to connect 1 billion people. The services that reach that milestone are all incredibly valuable.”

– Mark Zuckerberg

Zuckerberg added in a conference call that WhatsApp is the only app he’s seen with higher user engagement than Facebook itself, as reported by The Verge. This is critically important in understanding why WhatsApp was the IM service of choice for Facebook: users don’t matter if they aren’t actually using the service. Then the price starts to make more sense: at the time of the acquisition, Instagram had only 30 million registered users, 15 times less than WhatsApp, for 16 times less money.

In addition, Facebook had already lost its lead to WhatsApp, according to analysts at On Device Research, which specializes in mobile research. They surveyed 3,759 users in five countries to find that WhatsApp had a market share of 44%, with Facebook Messenger coming in second at 35%. When combined, this puts Facebook in a very strong position. Moreover, some argue that Facebook simply isn’t ”cool” anymore, prompting teens to switch to other chat services, again like WhatsApp. Professor Daniel Miller of University College London explained to The Daily Mail that ”young people are turning away in their droves and adopting other social networks instead, while the worst people of all, their parents, continue to use the service”.

Critically, what has allowed social networking to really prosper is the rise of smartphones and the move from desktop to mobile. Traditional computers and feature phones are being replaced by tablets and smartphones, which provide people with internet access wherever they are. IM apps are now the primary way smartphone users stay in touch, according to On Device Research, which reports that 86% of users use them daily, while only 75% and 73% use SMS and voice, respectively. Consequently, SMS usage declined for the first time ever in 2013, according to a report from Strategy Analytics. Research firm Ovum concludes that carriers globally lost out on $33 billion in texting fees.

WhatsApp timed the rise of mobile perfectly; it’s exceptional growth matches that of the smartphone market, which is currently on a hockey stick type trajectory. Technology journalist Om Malik has aggregated statistics for the various IMs. The numbers show that WhatsApp has reached an unprecedented level of operating efficiency; at just 55 employees, WhatsApp has more than eight million active users per employee. The second and third most efficient companies are Instagram and SnapChat, and according to The Wall Street Journal, Facebook also tried to acquire the latter, a photo messaging service, for $3 million in 2013, but the deal fell through. Nevertheless, Facebook now finds itself the owner of two out of three of the world most efficient and rapidly growing IM services.

There’s still plenty of room for WhatsApp to flourish, however. According to a 2013 report by United Nations, six of the world’s seven billion people have mobile phones. IDC reports that ”smartphones accounted for 55.1% of all mobile phone shipments in 2013”, while Gartner reports 55.0% for Q4 2013. More than one billion smartphones were shipped in 2013, which are record breaking numbers, but it also means that almost half of all mobile users aren’t yet on the internet. (The aforementioned J2ME capable devices are limited, and don’t support proper internet access. Even though some do support apps like WhatsApp, they are expected to eventually be replaced with smartphones.)

A mobile presence is a must-do in the current digital environment, and this massive acquisition makes it clear that Facebook has decided that its core strategy will be to create or buy up must-have apps that consumers demand to have on their mobile devices.

SMS and MMS messaging is still a yearly $104 billion business, according to Strategy Analytics. With WhatsApp now under its umbrella, Facebook is in a strong position to emerge as the number one IM service as mobile phone operators inevitably become internet service providers.

What’s Next?

Because this transformation is inevitable. The extinction between a phone carrier and an internet service provider may seem obvious: one connects your calls and the other gives you access to the internet. But thanks to smartphones and apps like WhatsApp, the line is quickly blurring.

The bulk of messaging has already moved from SMS to the internet, and voice calling will inevitably go down the same road. This will put an end to per-message pricing and costly call minutes that have long been the cash cows of phone operators. Instead, users might end up paying more for access to the internet as they consume more and more data. Additionally, WhatsApp will incorporate voice calling in a future update, announced Koum on Mobile World Congress, and it plans to sway users from competitors like Skype, Viber and FaceTime with its renowned simplicity and by leveraging its branding. ”We will focus on simplicity”, he said when interviewed.

Just like Instagram, WhatsApp will remain independent, and Facebook Messenger will continue to exist alongside it. ”We think that those are two different use cases, and that the world needed both”, said Zuckerberg to The Verge, explaining that Messenger is mostly used by people to communicate asynchronously, like e-mail, while WhatsApp is used to communicate in realtime.

The WhatsApp team is going to remain in Mountain View, California and it will continue focusing on growth: ”It would be silly to get in the way of that,” said Zuckerberg to New York Times. In addition, Koum will join the Facebook board of directors.

Some users have expressed concerns that WhatsApp will become ad-supported under Facebook’s management, but Koum took to the company blog to refute such claims:

“There would have been no partnership between our two companies if we had to compromise on the core principles that will always define our company, our vision and our product.”

– Jan Koum

Facebook has been compared to Disney by a source who spoke to ReCode, explaining that it now owns all the good brands in its space and operates them independently, like how Disney does with Pixar and ESPN. Both companies have the resources to buy competitors they can’t beat. ”The company simply doesn’t want to mess with the formula that’s ostensibly killing it, whether it’s Instagram, WhatsApp, or the next hot communications app”, writes The Verge.

The Facebook conglomerate has now become so big that some people have voiced concerns that the company might exploit its position in a way similar to the phone carriers it’s trying to replace, but the difference is that Facebook doesn’t own the infrastructure, which has been key to the exorbitant pricing set by carriers. In fact, nobody controls the entire internet, which is part to its success.

So there we have it, then. Facebook bought WhatsApp to secure its place in the communications revolution currently taking place, because that’s what it is: a revolution. The influence of phone carriers diminishes as the internet replaces á la carte SMS and call minute pricing with flat rate instant messenger and internet calling services. In order to fully participate in this change, it was critical for Facebook to attract a younger audience and people in developing countries, both of which it did with the acquisition of WhatsApp. The price it paid might seem extraordinary when it spent a tenth of its market cap on the deal, but consider this: Facebook is now in the position to become the single most important communications platform in the world. In fact, I believe it already is.

Such influence is worth a lot. 16 billion dollars, apparently.