Instagram and the risk of selling low

By Felix Salmon
December 17, 2012

Nick Bilton’s column about the Instagram fairness hearing is annoying on a number of levels. When I mentioned one of them this morning, Dave Winer asked for “a brief post” explaining a bit more. OK then!

It’s worth saying up front that Bilton has got himself a genuine story here: it looks as though Instagram’s CEO, Kevin Systrom, was economical with the truth when he testified in front of the California Corporations Department in August. He said that Instagram “never received any offers” from any potential acquirers other than Facebook, and generally dissembled madly:

At the end of the hearing, regulators asked Mr. Systrom a third time about other offers: if there had been “any other inquiries from third parties about a possible acquisition of Instagram” after the Facebook deal was announced. Although Twitter executives had since tried to contact Mr. Systrom, he replied, “I and the board have not received any.”

The first annoying thing about Bilton’s column is that although he quotes Systrom at some length, he never provides a transcript of what was said at the hearing: we just have to trust him that he’s characterizing everything correctly. Bilton is happy to tell us what “the transcripts show”, so there’s no excuse for not showing us those transcripts as well. Once again, we’ve got a situation where the NYT doesn’t care about posting primary documents, and in this case there’s no copyright reason not to post them.

The second annoying thing about Bilton’s column is that he’s approaching decisions made in March with the benefit of great hindsight. “Given that the privately traded Twitter is expected to make $1 billion in revenue next year, which would increase its valuation considerably,” he writes, “Instagram investors might have made millions of more dollars.” But of course at the time that Systrom made his decision, he had no idea what Twitter’s 2013 revenue was going to be. And even Bilton, frankly, has no idea what’s going to happen to Twitter’s valuation next year: it’s just as likely to go down as it is to go up.

The third annoying thing about Bilton’s column is that he’s he’s desperate to find a deeper scandal here, beyond the issue of what Systrom said when under oath. The fairness hearing, he says, “sought to determine if Facebook’s acquisition of the photo sharing service was in the best interest of Instagram investors”, and it’s possible that if Instagram had put itself up for a more public auction, then the final sale price could have been higher. “It is possible investors would have been better off selling in an open auction, to Twitter or even to Google or Microsoft,” writes Bilton, as though it’s somehow self-evidently scandalous that anybody might ever sell their company for less than the maximum possible amount of money.

But the fact is that the fairness hearing was not at heart an attempt to see whether Instagram sold for the maximum possible amount of money. It was rather, as the name implies, an attempt to see whether the price paid was a fair one. It was necessary because Facebook issued new stock to pay for Instagram, and as a result of issuing stock the company had to go through an arduous registration process with the SEC. In California, a fairness hearing is just a cheaper and easier way of being able to issue stock without having to go through the SEC — so that’s what Facebook did.

Bilton’s most annoying sentence comes when he writes this:

Although it might seem unimportant whether wealthy investors made a few million dollars less than they could have, those investors often represent funds that include workers’ pensions and mutual funds.

Firstly, wealthy investors, just like much poorer investors, always make less money than they could have; no one ever succeeds in maximizing their returns. This is especially true of investors who take minority positions in closely-held private companies. As Bilton notes, Instagram was controlled by its two co-founders: they could and did, within reason, sell to anybody they wanted, at whatever price they wanted. What’s more, Systrom was no naïf in such matters: he had a previous stint in Google’s M&A department on his résumé. The venture capitalists who invested in Instagram, like all venture capitalists, knew full well that they were taking a risk that the founders might sell for less money than the VCs wanted.

It’s one of the most well-known and biggest risks in the VC business: when founders are faced with the opportunity to make an eight- or nine-figure sum for themselves, they are very tempted to accept that offer, even if they would be better off holding tight. What’s more, personal relationships often make founders more receptive to approaches from certain individuals (like Mark Zuckerberg) than from other potential acquirers.

A VC investing in Instagram, then, or any other company controlled by its founders, is well aware that if the founder decides to sell to a certain company at a certain price, then that’s what’s going to happen. Even when the founder doesn’t control the company, the same thing can happen: once Arianna Huffington decided she wanted to sell the Huffington Post to AOL, for instance, her investors basically had to go along. The people running the venture capital funds take those risks on behalf of their own investors, the limited partners in those funds. And if you’re not comfortable with such risks, you certainly should never be an LP in any venture capital fund.

And while it’s true that pension funds do sometimes invest a small percentage of their holdings in venture capital, that really doesn’t change anything. I see this kind of argument all the time: talk to any demonized vulture funds, for instance, and they’ll very quickly bring up the fact that some of their investors represent pensions and teachers and motherhood and apple pie. (For a classic example of the genre, take a look at the press release headlined “US teachers march on the Capitol for a solution on unpaid Argentine bonds”.)

Bilton’s wrong about mutual funds: they don’t invest in venture capital. But never mind that. Systrom controlled Instagram, and he sold it for a billion dollars before it had a single penny of revenues, making his VC backers lots of money in the process. He had every right to do that, even if there was a better formal offer on the table from Twitter or someone else, which there wasn’t. His minority investors were never an obstacle in his way, and they never had any right to hold out for a better deal.

In fact, the only obstacle between Systrom and the Facebook acquisition was antitrust concerns. If the antitrust authorities thought that Facebook and Instagram were getting together in a sweetheart deal to sew up a large part of the social-networking market, then they could block the whole thing. Systrom didn’t dissemble in front of the fairness hearing because he was worried about being accused of short-changing his minority investors. Instead, he dissembled in front of the fairness hearing because he was worried that the FTC might block the deal on antitrust grounds.

In any event, it’s the dissembling which is the story here, not the fact that Systrom might have been able to get more money from someone else. It’s not a crime to sell too low.

3 comments

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Don’t they have a fiduciary responsibility toward the minority shareholders? Just because they have control doesn’t mean they can sell for less than the company is worth, particularly if there’s a side deal where Kevin gets nice personal perks upon joining Facebook (something the minority shareholders don’t benefit from). It *is* a crime (well, maybe a tort) to sell too low if you receive benefits that other equity holders don’t. Otherwise nobody would ever be a minority investor.

Also, it sounds like you agree that he ‘dissembled’ while under oath. From the specifics of the Dealbook article, it sounds as if he actually perjured himself.

Posted by absinthe | Report as abusive

They have a fiduciary duty to all shareholders, but that doesn’t necessarily mean they have to take the highest offer, especially when they are being paid in shares of a privately held and hard-to-value company. At least Facebook was a month or so away from IPO and the value was easier to approximate. There would have been no way to come up with a reasonable value for twitter shares, and if they took twitter’s offer, and twitter lost 50% of its value by the time they went public, then you would have some lawsuits.

You’re right about selling for less if you get benefits the other shareholders don’t get, but that wasn’t the case here.

Posted by KenG_CA | Report as abusive

Yeah I get that they have to take the cash and mix/type of stock into account, but that’s more a matter of risk-adjustment than accepting a ‘low’ offer. I don’t think Systrom could have gotten a better offer, but if that’s the case why the shadiness?

If I had to guess, he set himself up for a higher acquisition cost by minimizing the antitrust concerns very early on. I don’t see any other motivation for refusing to physically take term sheets from other bidders, but IANAL.

Posted by absinthe | Report as abusive