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Why Instagram just made the lives of Facebook's IPO bankers a lot easier

Persuading institutional investors to buy into a company still sorting out a mobile strategy has been harder than it seems.

Paul Sloan Former Editor
Paul Sloan is editor in chief of CNET News. Before joining CNET, he had been a San Francisco-based correspondent for Fortune magazine, an editor at large for Business 2.0 magazine, and a senior producer for CNN. When his fingers aren't on a keyboard, they're usually on a guitar. Email him here.
Paul Sloan
4 min read

Besides the 13 lucky engineers working at Instagram, another group lucked out when Mark Zuckerberg decided it would be a good idea to plunk down $1 billion to buy the company: the bankers charged with drumming up interest in Facebook's (presumably monster) IPO.

While the SEC has yet to bless Facebook's S-1, its lead bankers at Morgan Stanley are apparently already out there selling the story to big institutional investors to fill out what's known as the "order book" -- a commitment by mutual funds and other biggies to buy a certain number of shares.

Pitching Facebook's story -- 845 million users, $3.7 billion in revenue -- would seem like an easy job for the bankers. Not so fast. The story's one big hole: A largely nonexistent mobile strategy. In fact, the mobile problem is one that Facebook highlights in the risk section of its S-1, saying, in effect, that Facebook has 425 million active mobile users and growing and that, still, the company has no way to make money off them.

Now comes Instagram, a startup phenom that has picked up more than 30 million users in less than 18 months of existence. While Zuckerberg reportedly orchestrated the Instagram purchase almost entirely on his own -- surprising even the company's board members, according to the Wall Street Journal -- Facebook's bankers are now working the benefit of the acquisition of the photo-sharing app their into their talking points about the IPO.

This tidbit comes from George Zachary, a venture capitalist at Charles Rivers Ventures. Zachary was the lead investor in Millennial Media, a mobile ad network whose explosive IPO last month was underwritten by the same bankers at Morgan Stanley who are handling the Facebook deal. Zachary talks with the Morgan crew regularly, both about Millennial and other deals that Morgan is trying to win.

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"Institutional investors were debating whether they want to own something that has cracks in the armor around mobile," said Zachary. "And in the mutual fund world, they now think the problem is solved."

Instagram solving the mobile problem is a mighty big statement. After all, Instagram has a revenue stream of zero and no plan that we know of for monetizing all those users. But to big fund managers, Zachary said, such details just don't matter: Facebook now has a far more compelling mobile story. Period.

"What I've learned from doing the Millenial IPO is that the mutual fund buyers are really only asking high-level questions," he said.

Will the IPO sell to big institutions?
The bankers have another challenge in selling the IPO to big holders. They have a known valuation that they need to meet because Facebook was actively traded on SecondMarket and other private aftermarkets that have sprung up in the last few years. Before those trades were halted -- leading SecondMarket to lay off some workers -- Facebook was valued at more than $100 billion, with shares reportedly trading for as high as $40 a piece.

In putting together the order book, Morgan Stanley is under big pressure to assemble enough orders so that the deal comes in at least at $100 billion. Anything shy of $100 billion would be viewed as a failure.

Moreover, should that happen -- and Facebook's market valuation begins at, say, $70 billion -- there will be an untold number of shareholders out there who paid too much, which could hurt the performance of the stock in the coming months as those people try to dump their shares once they hit the price they paid on the private markets.

"That would be a nightmare scenario," said Zachary. "It's a problem if they have all these sellers at $100 billion level."

It's, of course, hard to know how large the upcoming IPO loomed in Zuckerberg's mind while he was negotiating the terms with Instagram founder and CEO Kevin Systrom at Zuckerberg's home in Palo Alto. His role in the IPO process has been astonishingly hands off for a CEO, opting out of a meeting with analysts at Facebook headquarters and choosing not to go on the road show at all. But clearly it played a role, and his frustrated bankers must be happier now.

Systrom initially asked for $2 billion, according to the Journal, and Zuckerberg negotiated by suggesting he look at the value of the deal as a percentage of Facebook's value. If Facebook earns a $200 billion market cap, Systrom would get closer to his price.

That possibility probably helped Systrom agree to the terms, which, according to the New York Times, is 70 percent stock and 30 percent cash. And from Zuck's perspective, if Instagram helps push the stock higher, that alone will largely pay for the deal. And fast.