Case Facebook WhatsApp Q+A 20240415

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1 Q&A FACEBOOK buys WHATSAPP Version: 4/15/24 Weaving together the FSAV skill areas of analyzing intangible assets and M&A activity, both individually and in combination together, this case asks you to analyze Facebook’s 2014 acquisition of WhatsApp from strategic, financial statement, and valuation perspectives. [FB = Facebook, WAPP = WhatsApp]. Note: You may use any information to answer these questions that would have been available as of the date of the case, which per the bottom para on p.2 of the case, we’ll define as being May 4, 2016. Q0. Wh o is the person in the case who’ s doing the FSAV on Facebook? (0.5 pt) Susan Shaw is doing FSAV on Facebook (FB). Why is he/she doing FSAV? (1 pt) Susan is doing FSAV in part because one of Susan’s many interests/hobbies is investing in the stock market, and she’s “ intrigued with the idea of investing in a company that sure seemed like an investment winner” (p.1). She sees that Facebook ’s B/S and I/S showed huge increases going from 2013 to 2014, and she suspects it’s due to a merger. She thinks she needs to do good FSAV to get a clear assessment of the implications of FB’s 2014 acquisition of WAPP for FB’s future financial performance (FSA) and invest well based on the resulting valuation implications (V). Why is his/her FSAV task a very challenging one? (1 pt) Her task is a challenging one because WhatsApp (WAPP) is a classic example of a massively intangible-intensive business, where the economics are non-standard and the accounting is biased. Combining these features with the limitations and asymmetries of M&A accounting, and the fact that Susan is a novice at FSAV, I believe Susan will have a hard time getting at a clear assessment of the implications of FB’s 2014 acquisition of WAPP for FB’s future financial performance. I think it’s worth noting that Susan’ s task and her FSAV is also likely to be especially challenging because she’s doing her FSAV on 5/4/16 (p.2, bottom para). This is more than two years after the acquisition of WAPP was announced and 18 months after the deal was closed in Oct. 2014. So while from a left- eye perspective she can indeed learn about WAPP and FB’s acquisition from FB’s 2014 10 - K and financials, what she’ll learn from these sources will be quite dated and stale. Moreover, from the right-eye capital market perspective, it must surely be the case that the stock market long ago fully impounded into FB’s stock price a ll the information about WAPP contained in the 2014 10- K about WAPP’s financials. As such, while she may enjoy doing FSAV, it’s extremely unlikely that her FSAV will earn her positive expected risk-adjusted investment returns. At the same time, other than maybe un-diversifying herself a bit, the efficient pricing of WAPP’s old financial statement information means that —although she likely doesn’t realize it—she’s “price - protected” by the stock market and therefore can’t hurt herself much either!

2 Q1. Give two good business reasons why Facebook may have decided to buy WhatsApp when it did, and two bad reasons, business or otherwise. (2 pts) “Good business reasons” might include: • Access to big-big-data, viz., 450+ and growing million phone numbers, users’ contact lists , and usage patterns, all of which Facebook would plan on monetizing sometime down the road. 1 "WAPP is on a path to connect 1 billion people. The services that reach that milestone are all incredibly valuable," said Mark Zuckerberg. (2.0 billion users as of 3/31/20). • Immediate + substantial penetration in overseas markets. 2 Facebook had stressed international growth in pre-deal investor conference calls, especially in the developing world. • Immediate + substantial presence on mobile devices, enabling Facebook to diversify beyond a web presence. 3 Messenger, Facebook's a standalone messaging app for mobile devices, is second only to WAPP in its share of the smartphone market. • Defensive: To keep Google or Yahoo from buying WAPP. Had Google bought WAPP, that might have severely threatened Facebook’s Messenger app. • Younger audience: Gain them without losing the existing older audience on Facebook. 4 Facebook may have seen WAPP as a threat to its dominance, as reports at the time were suggesting that younger users were fleeing Facebook because it was becoming 'uncool' by way of more parents joining. Messaging apps like WAPP provide young users more privacy from the older generation and a direct way of communicating with their friends. • Signal other companies that might be valuable to Facebook that Facebook can and will buy targets it finds attractive — it ’s not shy to get right up into Google’s face. • Mission consistent: with Facebook’s mission in 2014. • Diversify and expand its portfolio of services to its worldwide set of customers. “Bad business reasons” might include: •  Hubris or Overconfidence on the part of the 29-30 year old CEO Zuckerberg. •  To satisfy CEO Zuckerberg ’s ego .. . or any non-financial, psychological/emotional motivation. •  Mistake: It was a mistake by Zuckerberg — just an error (we all make them, and he does too). Q2. What was the main short-term barrier to Facebook being able to monetize WhatsApp once it had bought it? (2 pts) Per p.3 of the case, the main short-term barrier to FB being able to monetize WAPP was WAPP itself … “After being acquired by FB, WAPP remained adamant that it would not move to a model relying on 3 rd party ads to compensate for the loss of annual revenue fees”. Brian Acton and Jan Koum, the founders and key shareholders of WAPP, deliberately built a huge business based on the premise that their fast, simple, robust and secure VOIP/WiFi- based app would have “No ads, no games, no gimmicks. ” (p.3) … a nd they would only charge their users $1 dollar a year, if that! WhatsApp’s business model was therefore 180 degrees opposite to FB’ s ad-heavy business model. It was because Action and Koum were crucial to the continued growth of WAPP, that FB needed to retain them and “keep them happy” after the acquisition. But this meant that FB would have to 1 “Facebook Purchase of WhatsApp Builds on Aim to Dominate Social Messaging”. Electronics Weekly , 2014. 2 K. Reinhart, “Facebook Dilemma: Monetizing WhatsApp”. Investor’s Business Daily , 9/16/14. 3 B. Bajarin, “The Value of Facebook and WhatsApp: Connecting the Unconnected”. Time , 3/17/14. 4 “Decoding Facebook and WhatsApp”. Women’s Wear Daily , 3/5/14.

3 go very slowly in its thirst to monetize WAPP via ads, or via anything that ran against Action and Koum’s ethical perspective . Although, of course, Acton and Koum had to know that the only reason that FB was willing to pay them $19 bn was because one day WAPP would be monetized! This is the clear Ethical Irony or Quandry involved in WAPP’s agreeing to be bought by FB! Q3a. What’s on WhatsApp’s 2013 year -end balance sheet that would have been appealing to a prospective acquirer willing to pay $19 billion for the company? (2 pts) NOTHING! This is crucial — Facebook is not buying WAPP ’s on-B/S assets. Indeed, there’s nothing special in or on WAPP ’s financial statements as a set, not just in and on its B/S. This is classically the case when an acquirer buys an intangible-intensive target like WAPP. The unusual economics of intangible-intensive companies (spend now, spend big on R&D, branding, IP, etc.) + the unusual accounting = expense everything, means that almost nothing is put on the B/S. Per Exhibit 2, WAPP ’s 12/ 31/13 balance sheet shows that it has working capital of just under $22 million (= $48.4 - $26.6), of which $45.5 million is cash, leaving – $21.3 million of non-cash working capital. Moreover, stockholders’ equity is big -time negative = – $430 million. Even WAPP’s large NOLs likely amount to < 1% of FB’s $19 billion price. [Note: A lot of the – $430 million stockholder deficit is “artificial” in that it does not reflect huge losses by WAPP that exceed the money put into the firm by common and preferred (VC) shareholders. Instead, it reflects the effect of an issuance of Series B redeemable convertible preferred stock in July 2013 , when WAPP had a $1.5 billion valuation.] Q3b. What’s not on WhatsApp’s 2013 -year end balance sheet that would have been appealing to a prospective acquirer willing to pay $19 billion for the company? (2 pts) EVERYTHING! Facebook is buying WAPP ’s rich set of intangible assets— its technology, current and potential future users, market reputation, growth options, talent, future prospects, potential synergies with Facebook’s existing and potential future businesses, etc. None of these are on WAPP ’s B/S (nor really in its I/S either) because they are either potential future cash inflows that have not been created by past cash flows or business transactions, or even where the potential future cash inflows have been created by past cash flows or business transactions, such expenditures were required under U.S. GAAP to be expensed — they were not allowed to be capitalized. Key examples would be R&D spending, compensation of WAPP ’s 55 employees, and whatever small spending was incurred in selling & marketing. Q4a. In Facebook’s press release on 2/19/14 (“Facebook to acquire WhatsApp”), what is the total amount that Facebook announced it had agreed to pay for WhatsApp? Prove out the “krill level” arithmetic that arrives at this total amount. (1 pt) Per FB’s press release dated 2/19/14— which I wanted you to get directly from the Internet — the total amount FB announced it agreed to pay for WAPP was “ approximately ” $19 billion. On the one hand in para 1 of the press release it looks like FB agreed to pay “ approximately $16 billion ” for WAPP. But it was in fact exactly $16 bn (ok, $1 short) = $4 bn of cash + $16 bn of FB Class A common stock. But in addition, FB said it would grant RSUs to WAPP employees worth “ $3 billion ” (to keep key WAPP employees around, especially Acton & Koum; Koum got $1.6 bn). This made the total amount that FB agreed to pay for WAPP be “approximately” (but essentially exactly) $19 billion. The arithmetic on all this (to the nearest $1) is shown below. It shows that you can’t get closer to $19 bn exactly than this given the price of one share of FB’s stock.

4 Component Number Price per Value Cash $4,000,000,000 FB Class A common stock 183,865,778 $65.2650 $12,000,000,001 Subtotal $16,000,000,001 FB Restricted Stock Units 45,966,444 $65.2650 $2,999,999,968 TOTAL = $18,999,999,969 Q4b. What strikes you about the total amount and the components? (1 pt) • They’re all very big , nay huge , especially relative to what’s on WAPP’ s B/S. • The total amount in Q4a is remarkably round at $19 billion --- virtually to the penny round. • The components of the total amount are also remarkably round = $4 billion cash, $12 billion FB stock, $3 billion RSUs. • Cash makes up exactly 25% of the cash + FB common stock $16 billion. • Stock makes up 79% of the $19 bn … suggesting that either FB was strapped for cash (unlikely), or FB thought its stock was overvalued (also unlikely), or Acton & Koum wanted to avoid paying capital gains taxes right off the bat at the closing. • I believe this means that the $$ amounts were determined at the top of the ocean, not in the krill! The roundness of the amounts suggests that Zuckerberg and Koum talked round number billions in their one-on- one negotiations. I’d spitball that once the three of them had settled on “OK, $16 ($4 in cash and $12 in FB stock ) plus $3 in retention RSUs” (nonchalantly leaving off the presumed word “billions”) they then punted the ball down over to their finance people/minions to determine the exact number of FB Class A common shares that would be involved, etc. etc. • Key is that the round $4 billion, $12 billion and $3 billion numbers were NOT the result of some really huge elaborate DCF model! No, just three guys around a table negotiating in round units of billions, almost certainly with little more than their business gut instincts to guide them in the presumption that they had the decimal in the right place ☺ ! If it was otherwise , I’ll eat my hat. Q5. Suggest the two most likely methods Zuckerberg and FB’s investment bankers would have used to defend the price FB was willing to pay for WhatsApp to Facebook’s Board . (1 pt) Six methods that Facebook + its I-Bankers may have used to “ value ” WAPP are as follows. I list them in order of likelihood: 1. DCF I believe it is highly likely that a formal DCF valuation would be part of the Fairness Opinion that Facebook’s Board would have required and received from one or more investment banks. Since WAPP was deeply free cash flow negative in 2013, creating a plausible DCF valuation would/should have required I-Bankers to have explicitly forecasted free cash flows a long way out into the future, specifically, up to the point in time where WAPP was in steady state and where free cash flows were positive and large. 2. A non-accounting multiples method, such a price per [current] monthly active user (MAU) This is a common benchmark-type of valuation method in the technology sector. At the time of Facebook’s Feb 2014 acquisition of WAPP, WAPP had 450 MAUs, translating the $19 billion all-in purchase price to about $42 per MAU. As indicated in Exhibit 1 of William Blair’s day - after-the-deal-announcement-date 2/20/14 analyst report, $42 per MAU compares quite

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