Billion-Dollar Whac-a-Mole

First Instagram, now WhatsApp. How many “next Facebooks” will Facebook have to buy?

Illustration by Robert Neubecker

Businesses rise and fall. Internet businesses rise the fastest—and, if they’re not careful, fall the fastest. AOL, Netscape, Yahoo: The history of the Web is full of companies that enjoyed a brief and heady reign before the ground crumbled beneath their castle.

Facebook knows this well. After all, MySpace was just fluffing the cushions of its social media throne when Facebook stormed in and snatched the crown. So today, as he stands atop the social-media hill and surveys his domain, Mark Zuckerberg is keeping an eye out for any smaller rival who might be sneaking up from behind—or worse, burrowing quietly underground, digging the soil right out from under him.

At least three times in Facebook’s short history, Zuckerberg has spied a lean and hungry rival rearing its head from the netherworld of third-party social-media apps to stake a claim on his turf. Each time, he has taken a thunderous whack at it, with a mallet made of stock certificates and $100 bills.

This game of Whac-a-Mole began in earnest in 2012 when Instagram poked its head up, displacing Facebook as the photo-sharing app du jour. Zuckerberg swatted it with $1 billion. Last year it was Snapchat that came from nowhere to steal young people’s attention. Zuckerberg swung with $3 billion and missed. Fortunately for him, that particular rodent appears to have ducked its head back underground for the time being. (His eyes on the prize, Evan Spiegel had forgotten to lock his own back door.)

Last week the tech world shuddered as Facebook took its heaviest swing yet—an unprecedented $19 billion in cash and stock for WhatsApp, a mobile messaging service that had managed to avoid the spotlight while making inroads in some of the world’s largest markets. Zuckerberg got his mark, but it cost him dearly: two years’ worth of Facebook profits, plus up to $15 billion in equity, for an add-on business with no clear path to serious monetization.

As the power play reverberated through the valley and beyond, the question everywhere was how a company that made just $20 million last year could possibly be worth $19 billion—reportedly the most anyone has ever paid for a Silicon Valley tech company. The answer is that WhatsApp’s value to Facebook has very little to do with its value as an independent business.

Many have speculated as to how Facebook might extract more than $1 a year from each of WhatsApp’s 450 million users, who use the service to keep in touch with friends and family and send group messages. For one thing, Facebook might find value in having a direct path to those users via their mobile phone numbers rather than just their Facebook accounts. That access is worth something, no doubt, but nothing on the scale of $19 billion.

Facebook makes billions by placing targeted advertisements in your news feed. But Zuckerberg immediately ruled out the idea of ads in WhatsApp. The cynical will note that Zuckerberg has been known to change his mind about such things, but others in the mobile-messaging business agree that the revenue potential for ads on WhatsApp is limited. “Advertising is not the way to go,” says Arnie Chaudhuri, co-founder of a new messaging platform called Chaatz and a former developer of Facebook’s first mobile app. “It’s intrusive and people don’t like it. Part of the reason you go to WhatsApp and not Facebook is that there are no ads, no gimmicks.”

More likely, Facebook will find ways to harness the information generated by WhatsApp’s users to refine its own algorithms. WhatsApp is one of the few mobile apps that people use as habitually as Facebook itself. Without access to it, Facebook would be locked out of a vast and exponentially growing realm of online social interaction. For a company whose mission is to build the world’s most comprehensive “social graph,” that could be disastrous. 

Therein lies the key to understanding this deal, and Facebook’s future. Facebook didn’t buy WhatsApp expecting to recoup its investment. It bought it to cover its flank. That’s why, as I and others have noted, the $19 billion should be understood not in the context of WhatsApp’s potential revenues, but in the context of Facebook’s own astronomical valuation, which today stands at $180 billion. (That’s especially evident when you consider that Facebook paid only $4 billion in actual cash for WhatsApp; the rest of the deal was in Facebook stock.) Facebook may not have $19 billion to gain from WhatsApp, but in Zuckerberg’s judgment, it had much more than $19 billion to lose by ignoring WhatsApp—or worse, letting it slip into the hands of a rival like Google, which is rumored to have bid on the messaging startup earlier last year.

In business-strategy lingo, Zuckerberg diagnosed Internet-based (or “over-the-top”) mobile group messaging as a disruptive innovation with the potential to transform the communications industry. And so he was willing to spend almost 10 percent of Facebook’s market value on a company with seemingly limited revenue potential rather than allow it to undermine his market.

That’s a shrewd and farsighted move if you assume that such disruptive innovations don’t come along every day, and that you don’t have to spend too dearly to take them out. Facebook has already found success by buying Instagram for $1 billion, a sum that seemed lavish at the time but looks like a screaming bargain in retrospect. Perhaps we’ll one day say the same about WhatsApp.

But here’s the catch: Part of WhatsApp’s appeal is that it isn’t Facebook. It’s not just that WhatsApp doesn’t have ads. It’s that people like being able to communicate with their close friends and family without having to simultaneously broadcast to a ton of faux-friends (and, implicitly, advertisers). Even more, they like being able to send a message and know that their real friends and family will actually see it, rather than having to hope that Facebook’s algorithms see fit to display it in their loved ones’ feeds. Facebook can buy WhatsApp, but it can’t stop people from continuing to seek new ways to communicate more directly, more cheaply, and without having to worry that their interactions are being mined for the benefit of advertisers. Already since news of the WhatsApp deal broke, an even newer and more private messaging app called Telegram has surged to the top of app stores.

Facebook just whacked one giant mole at the cost of two years’ worth of profits. It had better hope that another one just as big doesn’t come along, at least not within the next two years.

Update, Feb. 25, 2014: This article has been updated to clarify that “two years’ worth of Facebook profits” refers only to the cash portion of what Facebook paid for WhatsApp. The rest of the $19 billion was paid in Facebook stock and earn-outs.