Blue Ocean

We have all heard about it. On Wednesday, Microsoft invested $240M into Facebook, beating Google to the punch, and giving the folks on University Avenue a $15B valuation ("yes, mini-me, $15B dollars...") and a war chest large enough to start buying a few buildings even in Palo Alto.

Of course, everybody is wondering why paying so much for so little ($240M for 1.6% of the company). With revenues around $150M and 50M registered users, elementary school maths already tells a lot about Microsoft's fascination for Facebook. According to Microsoft, Facebook is worth 100 time current revenue or $300 per registered user. Such multiples would make any VC sell their mother and first born. So, let us try to understand this Balmerian burst of generosity (or desperation depending how you look at it).

The OS theory.

The first theory is the Operating System theory. In the last year, Facebook has been very successful attracting developers to build applications using its APIs. Facebook must therefore be the new operating system. Microsoft being the incumbent OS dominatrix, it must pay to control the new Web OS. Hum...The theory is daring but not quite convincing. Although Facebook as a widget platform is definitely powerful, it is not the entire Web OS. Social networking is an important primitive but it is only one facet of the Web. Facebook applications are great but none of them truly measure to Microsoft Office. So, Facebook as a programming platform is certainly part of the attraction but there has got to be more to the story.

The International theory.

The second theory is International growth. 60% of Facebook users are non US. Since Internet growth is faster outside the US, the deal gives Microsoft a stronger position in the race for global domination over the fast growing advertising market. No doubt that the foreign dimension of Facebook is strategically valuable to Redmond. Nevertheless, despite the fast growth and a 30M foreign user base, this alone cannot justify the numbers either.

The conspiracy theory.

The third theory is a conspiracy theory. All along the negotiations, Google raised the stakes to drive the price higher. Then at the last minute, they withdrew, leaving Microsoft all alone at the bidding table with an insanely high bid. I know that guys are Google are smart but this sounds more like a James Bond movie than corporate development to me. It is clear Google was at the bargaining table. It is likely that they bargained hard, forcing Microsoft to move aggressively. However, I have to believe that it takes more than such a simple trap for Mr Ballmer to sign such a large check.

Ok, so what is it? Clearly, it must be about advertising. Advertising is a soon to be $80B market. It is one of the few markets large enough to move the Microsoft needle. This is also the oxygen tank of Microsoft's #1 rival, Google. In plain English, advertising is a highly strategic market to Microsoft. You don't win strategically by being cheap, especially when you are the underdog.

Think AD Sense 2.0 and Facebook deportalization.

Microsoft views Facebook as as an advertising platform, the asset that can help Redmond make up for the lost time to Google in search. An interesting fact about Facebook is that they know a lot about their users. With Facebook, folks like you and me expose their complete profile well beyond ZAG (Zip code, Age and Gender). Many reveal their personal interests by joining specific groups and registering to special events. So, Facebook has deep segmentation and behavioral information about consumers. Such consumer intelligence should allow them to do more precise ad targeting. In turn, relevant targeting should allow them to command a premium in advertising rates.

How does it compare to Google? Google draws advertising relevance from queries and hyperlink rank. In fact, Google is the undisputed king of the hill when it comes to contextual advertising. However, outside of search, contextual match may not always provide the most effective targeting. In many ways, demographic and behavioral targeting may prove more effective when it comes to videos and the long tail of content available on the internet. Behavioral targeting is where the advertising balance of power could eventually shift, creating a chip in the Google armor. That chip alone may well be worth $15 billion dollar to Microsoft.

Interestingly, social networking sites such as Facebook may not be the best place to advertise. The rumor is that Google AdSense has led to abysmal click-through on MySpace. After all, when interacting with friends, one has little attention span for ads. So,maybe, the true leverage of Facebook may be to evolve it into an advertising network for relying party sites such as MSN. After the Facebook application platform would come the Facebook advertising platform: a behavioral and social ad network to drive improved monetization outside of Facebook.

Today, AdSense is the only real game in town and a significant driver of revenue growth for Google. With 245M of new R&D dollars, fueled by identity intelligence, but respectful of user privacy and trust, Facebook may well hold enough assets in hands to become the alternative ad platform. IDSense anyone? Easier said than done of course, but at least, this perspective sounds like a worthwhile $15 billion bet to me.