Google's $1.65 Billion YouTube Acquisition: Financial & Strategic Analysis

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, paying the full present value of future cash flows would be undesirable because the opportunity cost of doing so would be reinvesting in its own business — there is nothing to gain from a transaction with zero net present value, and the discount rate for Google at the time would have been very high. For the firm being acquired, accepting market value alone would be insufficient; it would expect something substantially higher. Both firms need to feel that there is value in the combined entity that will ultimately be reflected in the acquisition price. Clearly, Google felt that this was the case, but its reasoning 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 investigates the deal from both strategic and financial perspectives in order to determine the value of the transaction — 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 joining forces. YouTube's CEO felt that the company had a paradigm-shifting service that would add value to Google, while Google'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 two Ph.D. students designing a search engine. The company grew rapidly from its inception, going public in August 2004 — the same year it moved into its current corporate headquarters. The opening price was $85 per share (Google.com, 2011) but the stock moved immediately above $100 (New York Times, 2004). Google had come to dominate Internet search and steadily added to its service offerings, ultimately holding a 65.6% share of search, compared with 16.1% for Yahoo and 13.1% for Microsoft (Kell, 2011). At the time of the acquisition, Google was seeking ways not only to leverage its high stock value — around $375 at the time — but also to grow the company. Google's cash holdings were around $10 billion (MSN Moneycentral, 2011), meaning it could have purchased YouTube for cash rather than stock. There was also the strategic consideration that, even at the time of its IPO, Google was widely expected to face intense competition from both Microsoft and Yahoo in search, with the superior engine ultimately prevailing (New York Times, 2004).

YouTube was founded in early 2005, and by the summer of 2006 the site 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; prior to that point the company had been financed entirely by venture capital. It had very little revenue and 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 challenge was finding 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, and trading not far from its all-time high. The company was actively seeking growth opportunities, though internal growth remained primary. Google's rapid growth rate implied a very high discount rate for any project, including an acquisition. YouTube was able to clear that hurdle based on its meteoric rise to Internet dominance, which in many ways mirrored Google's own trajectory. Google was also facing ongoing competition in search, which naturally led to a dual strategy: bolstering search options by adding mapping, new languages, new territories, and new features such as image and video search, alongside related diversification. YouTube fell squarely into the latter category.

For YouTube, rapid growth had placed the company squarely on the acquisition map, but it was also going to need a capital injection to finance both future growth and current operations. The company had only just begun 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). Google clearly had an advertising model capable of capitalizing on high traffic volume, and must have believed that applying this model to YouTube's traffic would alone add substantial value to the video site.

YouTube was also facing a difficult situation with respect to legal action, as content on the platform was often the property of third parties. The company was ill-equipped to handle this exposure, and behind the scenes there was significant concern about YouTube's impending legal liabilities. Unofficial sources indicated that legal exposure added as much as half a billion dollars to the effective purchase price (Cuban, 2006). Part of YouTube's impetus for the deal was the need to gain the resources and credibility required 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 to address its legal problems. For Google, there are a number of potential motivations. The simplest theory of merger and acquisition activity holds that a deal should be based on the delivery of a positive net present value of future cash flows. The valuation is addressed in a later section of this paper, 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 on its own, so any advertising revenue gained post-acquisition would represent incremental value. Google would essentially be paying for the traffic to which it would then apply its standard advertising approach.

There are several strategic reasons why Google would have viewed this deal as having a positive net present value. In terms of growth, Google would gain a business with an exponential growth curve — a trajectory it already understood from its own history and could therefore project with some confidence. Google had a video business of its own at the time, making it one of YouTube's competitors, but YouTube was already the market leader and would likely remain so. As YouTube's CEO noted at the time of the acquisition, the company had changed the way people consumed media, "creating a new clip culture" (Google Press Release, 2006). With the purchase, Google solidified itself as the top player in online video.

Equally important, Google ensured that no competitor would become the dominant video player. YouTube had a number of suitors, including Yahoo, Microsoft, and News Corporation (AP, 2006). At the time, there were several video properties online, but none had the brand recognition or market share of YouTube. Had Yahoo or Microsoft won the bidding, the competitive landscape could have shifted significantly. Consider the traffic 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 rival secured YouTube, Google's position would have been severely weakened. Neither Yahoo nor Microsoft has a credible competing site to YouTube to this day.

The Internet business is not about having one or two strong sites but an entire family of properties that drive traffic to one another. Four of the top five Internet companies at the time relied on such site families to generate revenue. For Google — the only one of the three major players without a solid non-search property — YouTube was strategically essential. Acquiring it both improved Google's competitive position and prevented a major uplift for its rivals.

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