Google Acquisition of Youtube in 2006 for Research Paper

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Google acquisition of YouTube in 2006 for $1.65 billion. The deal will be analyzed in both the financial and strategic contexts. With respect to the former, the net present value of YouTube's future cash flows will form the basis of the evaluation. With the latter, there are a number of considerations including the market position of each of the companies at the time of the merger and during the post-merger period. The analysis leads to the conclusion that YouTube was a money-losing entity in 2006 and remains so today, giving it a negative intrinsic value. The company does have significant strategic value for Google however. While this strategic value may be difficult to quantify, it should be taken into consideration, especially since Google could easily afford the deal.

Introduction

In October, 2006, Internet giant Google purchased the young startup YouTube for $1.65 billion. Despite being only a year-and-a-half old, YouTube was already one of the most popular sites on the web, with 72 million users as of August 2006. The deal was financed entirely by stock. At the time, Google claimed that the two sites were "natural partners" in entertainment media, but for the time being the two companies were slated to continue operating separately (BBC, 2006).

When making mergers, there are a number of considerations that firms must take into account. These include the book value of the firm, the present value of future cash flows, the degree of synergy between the two companies, other bidders and the cost of financing. For the acquiring firm, it would not want to pay the PV of future cash flows because the opportunity cost of doing so would be reinvesting in its own business -- there is nothing to gain from a transaction with no net present value and the discount rate for Google at the time would have been very high. For the firm being acquired, it would not want to take market value, but something much higher. Both firms need to feel that there is value in the combined entity that will ultimately be reflected in the value of the firm being acquired. Clearly, Google felt that this was the case, but it may have had less to do with the inherent value of YouTube than with the strategic value of outbidding Yahoo!, the rival firm that was reportedly involved in a bidding war with Google for YouTube (Arrington, 2006).

This paper will investigate the deal from both the strategic and financial points-of-view in order to determine the value of the deal -- was $1.65 billion a fair price at the time, and has it proven to be a fair price in hindsight? Certainly, both parties felt that there was considerable strategic value in tying up. YouTube's CEO felt that it had a paradigm-shifting service that would add value to Google, while the latter's size and financial strength would allow YouTube to create "the next-generation platform for serving media worldwide" (Google Press Release, 2006).

Background on Both Companies

Google was founded in 1998 on the basis of work by a pair of Ph.D. students designing a search engine. Google has grown rapidly since its inception, going public in August of 2004, the same year the company moved into its current corporate headquarters. The opening price was $85 per share (Google.com, 2011) but it moved up immediately to over $100 (New York Times, 2004). The company had come to dominate Internet search and has steadily added to its service offerings. It still dominates search, with a 65.6% share, compared with 16.1% for Yahoo and 13.1% for Microsoft (Kell, 2011). At the time of the acquisition, Google was searching for ways to not only leverage its high stock value, which was around $375 at the time, but was looking for ways to grow the company. Google's cash holdings at the time were around $10 billion (MSN Moneycentral, 2011), so it could have purchased YouTube for cash rather than stock -- this decision will be analyzed further in the report. For Google, however, there was also the consideration that it needed to consolidate its position in the industry because even at the time of Google's IPO the widely-held industry view is that it was going to face intense competition from both Microsoft and Yahoo on search, with the superior engine ultimately prevailing (New York Times, 2004).

YouTube was founded in early 2005 and by the summer of 2006 the company had reached 100 million video views per day and 65,000 new video uploads per day. By August, just a couple of months before the merger, YouTube began its first advertising -- the company had been financed to that point entirely by venture capital. The company at this point had very little revenue and probably had a high burn rate. YouTube was, however, clearly established as a favorite of the Internet community in much the same way that Google was. The only issue was to find a way to monetize that traffic. YouTube could have qualified for another round of venture capital, gone public or allowed itself to be acquired.

Situation at the Time of the Merger

Google was flush with cash, growing rapidly, with its stock not too far from its all-time high. The company was seeking opportunities to grow. However, internal growth opportunities were primary for Google at the time. The company's rapid growth rate would have implied a very high discount rate for any project, including an acquisition. YouTube would have been able to overcome this based on its meteoric rise to Internet dominance, which in many ways mirrored that of Google. Google was facing ongoing competition in search, which would have naturally led to a pair of strategies: bolstering its search options (adding mapping, new languages, new territories like China, and new features like image and video search) and related diversification. YouTube would have fallen into the latter category.

For YouTube, the company's rapid growth had clearly put it on the acquisition map. The company was going to need an injection of capital to finance not only its future growth but its current operations, as the company had just barely began to generate income from advertising at the time of the merger. By contrast, Google recorded revenues of $10 billion in 2006 and operating cash flows in excess of $3.5 billion (MSN Moneycentral, 2011). The company clearly had an advertising model that was able to capitalize on high traffic volume. Google must have felt that if it could apply this model to YouTube's traffic, that alone would add value to the video site.

The young YouTube was facing a difficult situation with respect to legal action, as content was often the property of third parties. The company was unable to handle this legal action, and behind the scenes there was significant concern with respect to YouTube's impending legal liabilities. Unofficial sources have had significantly more to say on the subject (Cuban, 2006), but part of the impetus for the deal for YouTube in particular was the need to gain the ability to resolve these legal issues, particularly with the major media companies.

Reasons for the Merger

Strategically, YouTube needed the merger because it needed money -- for continuing operations, for growth and for its legal issues. For Google, there are a number of potential reasons for the merger. The simplest theory of M&A activity is that the acquisition should be based on the deliverance of a positive net present value of future cash flows. The valuation of the deal will be addressed in a different section of this report, but the underlying concept is that Google would be able to apply its expertise at monetizing web traffic to YouTube's 100 million daily video views. YouTube had been unable to do this, so any advertising revenue gained post-acquisition would be incremental to the deal. Google would simply be paying for the traffic to which it would apply its standard advertising.

There are a few different strategic reasons why this deal would be seen by Google as having a positive net present value. In terms of growth, Google would gain a business with an exponential growth curve. Google would already be familiar with this curve from its own growth and would have a sense of what the future of YouTube's business would look like. Google had a viable video business already at this time, making it one of YouTube's competitors, but if YouTube survived, it was the market leader and would likely continue to be so. As YouTube's CEO noted at the time of the acquisition, the company had changed the way people were consuming media, "creating a new clip culture" (Google Press Release, 2006). With the purchase, Google solidified itself as the top player in online video.

Just as important, Google ensured that nobody else became the dominant video player. YouTube had a number of suitors, including Yahoo, Microsoft and News Corporation (AP, 2006). At the time there were a number of video properties online, but none had the…

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