Google Acquisition of Youtube

¶ … 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 brand value or market share of YouTube. Google was one of the few that could have built that size. However, what YouTube would have done for the increasingly "less relevant" Yahoo or the fledgling Microsoft search properties would have been substantial. Consider the statistics from April 2011: Yahoo had 187 million unique American visitors (87% of all Internet users), Microsoft 178 million (83%) and Google 175 million (82%).

This tight competition for Internet dominance dates back further than 2006. Had either of these two firms outbid Google for YouTube, the competitive landscape may have been significantly different. Google relies on its core Google sites, but adding YouTube added a second major brand to the company, but also kept it from the competition. Neither Yahoo nor Microsoft has a credible competing site to YouTube to this day.

Financially, the ability of Google to maintain competitiveness with these other two firms has significant value beyond the advertising dollars that could be gained from YouTube. The Internet business is not about having one or two good sites, but a whole family of sites.

Four of the top five Internet companies (AOL being the other) rely on families of sites that drive traffic to each other as a means of generating their revenue (the fifth site in the top five, Facebook, was not considered to be a competitor in terms of traffic in 2006). For Google, competition is not based strictly on search dominance, but on total traffic dominance. YouTube represented an opportunity to improve the competitive position of all three major companies.

For Google, the only of the three without a solid non-search property, YouTube was strategically essential. Critical Assessment of the Merger Financially, the acquisition of YouTube was an interesting proposition. The first step in determining a valuation for YouTube would be to determine the present value of its expected future cash flows. At the time of the acquisition, YouTube had barely introduced advertising, and had made almost no money from it.

Figures for the privately-held company were not available, but YouTube would surely have been losing significant amounts of money each month. The company also faced legal action from hundreds of different parties. The company had attempted to deflect this action by offering a share of future revenues to complainants, but with no future revenues expected there were few firms willing to bite. The legal issues added as much as half a billion dollars to the purchase price, according to unofficial sources (Cuban, 2006).

Ultimately, the NPV of YouTube's expected future cash flows was negative. The second step is to estimate the incremental cash flows that Google would add to the transaction. By adding its proven ability to convert traffic into cash flow to YouTube's strong and rapidly growing traffic, Google could have estimated the cash flows that it would generate if it owned YouTube. This is a more accurate way of looking at the deal than simply looking at YouTube as an independent entity.

While YouTube did retain its own brand, location and management, Google added to it, and allowed YouTube to monetize that traffic almost immediately. If Google is able to generate $10 billion in revenue from its traffic at the time, then YouTube would be worth approximately x percent of Google's current cash flows, with x representing the differential in traffic between the two firms. YouTube was at the time of the acquisition the #32 most-visited website in the U.S.

Appendix A shows the popularity of YouTube around the time of the merger (MacManus, 2006). Doubling its viewership in May 2006 alone, and surpassing Yahoo as the pre-eminent video site in just six months of operation, YouTube was on trajectory to rival Google's traffic level (Ibid). If it came close -- that is worth billions in cash flow for Google over just the first few years of the deal. The other financial element of the deal is the value of keeping YouTube away from Google's competitors.

Google's competitive position as a whole is enhanced by owning YouTube. The traffic that YouTube drives to Google and vice versa can also be captured for revenue. In addition, the acquisition shuts off a major growth opportunity for Yahoo and Microsoft. In an industry where critical mass of quality properties is deemed essential for long-term growth, there is tremendous value in owning a property as hot as YouTube.

This value is difficult to quantify directly, but consider that at present Google is only on a part with those other two site families in the U.S. With YouTube in the hands of either competitor, Google would be a distant third. This would significant reduce Google's ability to compete in this market. Financially, therefore, the deal was a good one for Google. At the time of the acquisition, YouTube had no intrinsic value. It was undoubtedly bleeding red ink, but was nonetheless a dominant property in its field.

The key to the transaction was that Google immediately knew how it could make money from YouTube's traffic even though YouTube had not been able to capitalize on its popularity. This alone was likely to give the deal a positive net present value. That Google also stood to gain financially over the long run from the gains in competitive position that accrued as the result of keeping its main competitors -- the other main bidders -- away from YouTube also make the deal viable from a financial perspective.

From a strategic perspective, Google also had little to lose. The company was flush with cash and had a sky-high stock value, but Google also realized that the growth of the Internet combined with its strategy meant that going forward it was likely to make even more money and have an even higher stock value. This minimized the downside risk in that Google could easily afford to lose the entire $1.65 billion on the YouTube deal. The upside, however, was very high.

Google noted at the time of the acquisition that it saw a little bit of itself in YouTube's meteoric rise. The Internet video business had been long dominated by Yahoo, but when Google entered the business it immediately captured the number one position. It was almost immediately surpassed by YouTube. While Google had slow growth, YouTube had exponential growth (McManus, 2006). Thus, it was evident at the point of the acquisition that YouTube was going to dominate video.

Google knew YouTube needed to be purchased, and that whoever made that purchase was going to dominate video on the Internet. Google entered Internet video because it wanted to dominate the space, and when it became apparent that it would not beat YouTube, it seemed only reasonable that Google purchase YouTube so that it could fulfill its strategic goal of dominating the Internet video space. At the time of the merger, however, there were predications that the purchase was unwise.

YouTube was viewed by some as a flash in the pan site, largely because its legal problems were poised to bring it down in the same way Napster had been taken down. However, with Google's might and savvy behind the company, it was able to sign deals with the major media companies that pre-empted the bulk of legal action, clearing the path for Google to make the purchase (Geist, 2006).

The major form of risk had been eliminated, leaving behind a rapidly-growing property that Google was free to monetize using technology and knowledge it already had. That its main competitors were effectively shut out of video by the same deals that Google signed with the major media companies was an added strategic bonus that was only facilitated by Google purchasing YouTube. Post Merger Problems? The critics of the merger proved to be unwise.

Google's strategy of addressing the legal issues with the major media companies in advance of the acquisition proved to be highly successful. YouTube has since grown to become the world's #3 website, with Google.com being the #1 (Alexa.com, 2011). While Google is fighting it out for the top family of sites in the U.S., it has become established as the top choice worldwide, and YouTube has become a major part of that.

The two companies did not have any issues with respect to the corporate culture nor to the ability of Google to integrate YouTube into its operations. YouTube has retained its own business identity, but has introduced ads, experienced a continuation of its growth trajectory and become as popular a site as Google had anticipated. The legal issues that formed the bulk of the concerns of many external analysts prior to the deal never materialized, as a result of the deals Google made prior to the acquisition.

The company takes full advantage of the safe harbor provision that allows for material to be removed without fault and this has allowed for the continued growth of both Google and YouTube (Wu, 2006). By all accounts, there have simply not been any post-merger problems for the two companies. The merger has been a financial success for Google, which now earns in excess of $29 billion in revenue, compared with $10.6 billion in 2006 (Google 2010 Form 10-K).

Google does not break out YouTube revenues or profits specifically, so it is difficult to determine with certainty that the deal was a financial success, but this success can be extrapolated from rapid growth of both YouTube and Google post-merger. If any of the anticipated problems emerged, that has gone unreported. How has Google Monetized the Acquisition of YouTube? The plan from the outset for YouTube was that Google was going to monetize the transaction by introducing its advertising formula to YouTube.

The second element of the plan was to reduce the legal liability that YouTube was facing, as that creating negative net worth for the company. On the latter issue, Google addressed this in advance. It still faces legal issues for YouTube, but these primarily relate to minor content providers rather than major media companies.

Google does not make clear mention in its 2010 Form 10-K about any specific lawsuit, but Google was able to defend against the most significant suit it faced in relation to YouTube, a $1 billion suit filed by Viacom. Google succeeded with a defense based on safe harbor (Letzing, 2010). This defense is believed to be keeping Google from experiencing significant losses on YouTube. Google's primary strategy beyond loss minimization was to professionalize YouTube, introducing advertising and licensed content from the major media providers (other than Viacom, apparently).

Google has moved in this direction successfully, but as of 2009 the company noted in one of its quarterly reports that "it has yet to realize significant revenue benefits from our acquisition of YouTube" (Sorkin, 2009). Research at the time showed that YouTube continues to lose half a billion dollars per year, despite its popularity and the introduction of ads (Ibid). The monetization of YouTube therefore could only come in the form of additional traffic generation, including links and other form so cross-site traffic generation.

Any incremental traffic would exposure more eyeballs to Google ads, and this would create indirect incremental cash flows. However, if the direct cash flows are minimal, the indirect cash flows are not likely to be significant either. There is also the value in keeping YouTube away from Yahoo and Microsoft. Even if Google is losing substantial amounts of money on YouTube, the company has the traffic to compete as one of three roughly equal-sized companies, rather than as a distant third to Yahoo and Microsoft.

Financially, it is difficult to say if this is worth anything, yet it might be the most valuable part of the acquisition for Google. Certainly, Google's ongoing success, sky-high stock price and extensive cash holdings indicate that YouTube has not hurt the company, even if it has contributed next to nothing financially to Google since its acquisition. The lack of monetization is cause to revisit the issue of YouTube's worth.

The most significant dilemma in making a business out of the Internet is turning eyeballs (page views, unique visitors) into revenue. Google has been successful at doing this not only for its affiliate sites but for its own family of sites as well. Google generates 66% of advertising revenues from its own websites, yet it has not been able to do this with YouTube.

This would appear to be something of an anomaly, but taken at face value it appears that YouTube has suffered from the standard Internet problem of revenue conversion. Given that, Google has clearly underperformed, as normally it is one of the leaders when it comes to converting traffic to revenue. If Google cannot make YouTube profitable, then maybe nobody can. How Much is YouTube Worth? The best model for determining the worth of YouTube is the net present value model.

The assumptions for future cash flows can be a combination of past performance and expected future performance, as long as the future performance expectations are reasonable. The numbers at the time of the acquisition were clear, but the short life of YouTube also meant that no definitive pattern could possibly be drawn. YouTube did not even attempt to make money until just before it was acquired.

Thus, while it is clear that YouTube had no intrinsic value and no expected future revenues based on past performance at the time of acquisition, it was also evident that this would have been a poor way to gauge the company's future cash flow potential. Google could reasonably have assumed that it would be able to monetize YouTube to the level that it monetized itself.

There were many similarities between the growth of the two companies, the way that consumers use the two sites and the ways that the two could be monetized. Google receives a search query and returns advertisements based on that search. The same thing happens with YouTube. Therefore, Google could reasonably expect to deliver roughly the same revenue per page view with YouTube as it did for itself.

That YouTube would grow to be its current size was easily predicted based on its growth curve and on the way it was changing the way people used the Internet. Google had seen this pattern before with itself, and could reasonably have known YouTube would see the same pattern. This leaves a relatively straightforward calculation. The exact numbers are not available, but in 2006 Google earned $10.6 billion in revenue while dominating Internet search.

If YouTube could be projected to generate around 75% of Google's traffic -- something that has come to pass according to Alexa -- then that would equate to roughly 75% of Google's revenue. Could YouTube conceivably have earned even $7.5 billion in revenue? This is a high figure simply because the idea of extrapolating these revenue figures to a website that has failed to generate revenues is pushing the bounds of reason. However, Google and YouTube today are both substantially larger than they were in 2006.

Whatever deflator is chosen, YouTube could easily earn $7.5 billion in revenue today, if that figure was a starting point in 2006 for the company's potential. The second issue other than revenue that needs to be considered is the cost of running YouTube. Google has a fairly low cost associated with generating a page. The company therefore has a low cost of goods sold for its advertising revenue. YouTube's model is different in that a "hit" is a video. With this comes a large amount of.