Why the Instagram Deal Scares Me

Zero revenues. 12 employees. One billion dollars. These numbers are scary surreal and shouldn't happen in reality. It's like an egomaniacal Hollywood movie produced by Michael Bay.

Facebook (Nasdaq: FB) announced yesterday that it will pay $1 billion for the social photo-sharing app Instagram, which has the aforementioned stats and has been in operation in all of two years.

The standard pundit analysis offered this: Facebook's photo-sharing capabilities are weak, Facebook needs to defend itself against growing social site Pinterest, and Facebook needs to beef up for the battle against Google (Nasdaq: GOOG). All correct, but $1 billion? You mean to tell me that you are the most powerful social-networking company in the world, and you can't come up with a better photo-sharing app than 12 hackers in pajamas?

The deal will come in a combination of cash and stock and will close later in the quarter, according to Facebook CEO Mark Zuckerberg.

It's all a bit strange, but this is a strange world. Let's keep in mind that Facebook is all of seven years old and is about to launch a $5 billion IPO that may give it a valuation of $75 billion to $100 billion. This could be one of the most successful technology IPOs of all time when the rest of the Western World is mired in a stagnant economy. Those public shares are going to come in handy for deals like this.

Let's make it even more strange: A week prior to the deal, Instagram landed $50 million in financing from Silicon Valley venture capitalists including the elite Sequoia Capital. The valuation on that deal was $500 million. That means Facebook's offer doubled the valuation on the venture investment in one week.

What scares me is that there is no sensible or rational way to come up with valuations like this for companies. Zero revenues, $1 billion. You may as well put some numbers up on the wall and throw darts up at them.

If the private market for social-sharing apps is getting this frothy, what does that mean for the public market? If a garage full of coders can beat Facebook with a photo-sharing app in two years, does that mean there might be more risk in the social-networking market than people think? Yes.

Clearly, social-networking is moving at the speed of light, and as soon as Facebook gets its public ticker symbol, hundreds of startups will be gunning for it -- or at least gunning for its shares -- and building apps that are more addictive than anything Facebook is offering. It's perhaps the most dynamic and competitive technology market ever seen.

And what does that mean for valuations? For startups, it will be great, because they will continue to be in great demand -- if they are hot. But for the public companies like Zynga Inc. (Nasdaq: ZNGA) (Nasdaq: ZNGA), Google, and the soon-to-IPO Facebook, it means there is a lot of unrecognized risk in the market because overnight you can be beaten at your own game.