Creating, rather than destroying, value through acquisitions is probably the most difficult process in business management. Although acquisitions are an essential part of most companies' growth strategies, there are plenty of examples in which the final outcome was disappointing, especially when the premium paid by the acquirer is perceived as too high by the market.
When social network giant Facebook (NASDAQ:FB) acquired Instagram for $1 billion in cash and stock in April 2012, several investors criticized the move, as Instagram had yet to develop a model for generating revenue. However, recent user metrics suggest Instagram could be on its way to becoming one of the best acquisitions in the tech world, surpassing even the acquisition of YouTube by Google (NASDAQ:GOOGL). How does Instagram plan to keep growing its user base, and how does Facebook plan to monetize Instagram's traffic?
Monetizing and growing Instagram
All Facebook needs is to sustain Instagram's user growth by periodically introducing new features -- for example, the addition of video to Instagram three months ago -- and, more importantly, implement a business model for the app that leads to consistent profits.
The social networking company has chosen a handful of well-known brands in the Instagram community to begin monetization efforts, like Adidas, Macy's, Michael Kors, and PayPal. Although it is too early to estimate Instagram's conversion rate, preliminary results show Instagram is on its way to becoming an indispensable tool for digital marketers. According to CEO Kevin Systrom, over 5% of ad impressions on Instagram led to Facebook "likes," which was a "tremendous" conversion rate considering that most ads on the Internet are ignored. Analytics company Nitrogram analyzed an Instagram marketing campaign by Michael Kors and estimated the company got over 218,000 "likes" from Instagram.
In the future, Facebook could introduce additional marketing tools to Instagram. Some promising features include the ability to relate ads to hashtags, or to the location where a photo was taken. This could make ads more personalized, increasing Instagram's conversion rate. In this context, Instagram's acquisition cost does not look particularly expensive.
When tech acquisitions generate value
Tech giants such as Google and Yahoo! (NASDAQ:YHOO) are well-known for being active start-up buyers. Although empirical evidence shows most acquisitions do not generate value to shareholders, there are important exceptions, as the potential return of acquiring start-ups with high growth potential is unlimited.
Yahoo! is a great example of a company that has been able to build an attractive portfolio of tech investments. The company owns a 24% stake in Chinese e-commerce giant Alibaba, which generated $1.73 billion in revenue in the second quarter of 2013. Moreover, since Marissa Mayer became CEO of Yahoo!, the company has acquired more than 20 start-ups, from a movie-making iPhone app, Qwiki, to microblogging platform, Tumblr, valued at $1.1 billion. The company's portfolio is well-diversified, both in terms of region and demographics, and has exposure to plenty of promising tech trends.
Final Foolish takeaway
Despite receiving strong criticism, Facebook made the right call when it acquired Instagram. Although the photo-sharing app did not have revenue when was bought, its growth potential and possible synergies with Facebook's social network made it an attractive investment. Bottom line, acquisitions in the tech world are a high-risk, high-reward game. However, companies that build diversified portfolios pay enormous attention to due diligence, identifying potential market leaders at an early stage. Those companies have a higher chance of buying the next Instagram, Alibaba, or YouTube.
Adrian Campos has no position in any stocks mentioned. The Motley Fool recommends Facebook, Google, and Yahoo!. The Motley Fool owns shares of Facebook and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.