I realize it is already old news, but I had to throw my hat in the ring about Instagram.  By any standard Instagram was a typical Silicon Valley start-up, building a user base while it figures out a revenue model.  Except this story ended when Instagram was purchased by Facebook for $1BN.

Instagram is a reminder that every company has two valuations.  On one hand you have “fundamental” valuation, which is the sum of discounted future cash flows.  This is how research analysts look at public companies.  On the other hand you have “speculative” or “trading” value, which is the price a future buyer is willing to pay for an asset.  Speculative values are most common in the market for art, antiques, and other collectibles.

In theory, companies should trade at fundamental value.  However Facebook was clearly not buying Instagram for cash flow, so we are left to guess why it commanded a $1BN valuation.

The media’s take is that we are once again in a speculative bubble.  Facebook believes that Instagram will be worth much more than $1BN and they wanted to get in early.  Plus Facebook is trading at an inflated valuation, so the dilution was not that great.  This is compounded by optimism in Silicon Valley, where every start-up with interesting user data is treated like it is the next Facebook.

I am sure there is some truth in there – particularly when it comes to perennial optimism in the valley – but I am struggling with two parts of the story.  First, photo sharing sites have traditionally been poor media businesses.  Facebook knows this because they have over 100BN monthly photo views and these are the worst performing inventory on the site.  Second, the last thing Facebook should do leading up to an IPO is hint that they are trading on speculation.

So I believe Facebook made the acquisition to fix a mistake.  Facebook has made very few missteps in its short history, but they made a glaring one in mobile.  Facebook’s application was launched too late, and when they released it it was buggy and replete with problems.  As a result it currently sits at #29 on the list of most popular free apps – lingering just behind an app called “Flash Light” that turns your screen white.  What does that say for the world’s most important social utility?  

On the other hand, Instagram is #4 and has proven staying power.  The Instagram app is also responsible for more than half the content in my Facebook stream – thankfully Instagram photos have replaced Zynga requests over the past year.  Down the road I think Facebook will regret paying $1BN, but in the meantime this acquisition will quell criticism about the company’s mobile strategy leading up to an IPO.

And for my friends in the venture business, we can’t ignore the effects of speculative valuations.  We try to build big, profitable companies, but a component of the business will always be driven by speculation.  No one could have guessed that AOL would purchase Bebo for $850MM, Yahoo would purchase Right Media for $850MM, and NewsCorp would purchase MySpace for $580MM.  And there are many more examples out there.  The mistake is allowing these unlikely events to influence early stage valuations.  There are over a half million apps in the Appstore, but only one Instagram.

[Addendum:  We invested in Viddy, which is currently #1 in the Appstore and has been for the last few weeks.  To the extent YouTube, Twitter, or others wish to spend $1BN we can have a conversation, but I think Viddy is worth more than Instagram.  Just sayin’.]