For Your Eyes Only

Ephemeral-photo service Snapchat is betting that it can stick around longer than one of its trademark disappearing messages. To justify a $3 billion valuation, it has to find a way to make money and hold on to a traditionally fickle user base.

Yesterday afternoon's Wall Street Journal report that mobile photo-messaging service Snapchat apparently rejected a $3 billion acquisition offer from Facebook has come as a surprise to many in the business and tech world. The surprise is two-fold, actually -- not just that Facebook would pony up such an astronomical amount, but that Snapchat itself believes it could be worth far more. Eyebrow-raising assessments of a relatively new mobile app I first heard of only a year ago and which is most notorious for engendering media hype over the app's potential facilitation of "sexting".

As with other high-profile Internet company acquisitions, such as Facebook's $1 billion purchase in April of fellow photo-app Instagram (with its 13 employees and $0 revenue) or Yahoo's $1.1 billion purchase in May of blogging-service Tumblr (which had never turned a profit), there is again considerable general befuddlement over the economics of such a deal and whether these high-premium purchases of niche competitors are a further proof of the re-emergence of the "dot-com bubble".

So what does Facebook see in Snapchat? It's easier to first eliminate the explanations that don't make sense:

1. It's not because Snapchat makes a lot of money. Snapchat's growth has been exponential. In October 2012, its users were sharing an average of 20 million pictures a day; by this September, that figure had grown to 350 million pictures a day. Mobile insights firm Onavo claims that, as of August, roughly 21% of all U.S. iPhone users were using Snapchat. Despite that, Snapchat does not make any money. $0. It's not just unprofitable, it has zero revenue, and for now has no publicly announced plans for how its founders intend to eventually make money off of their popular product.
2. It's not because Snapchat has some special or proprietary technology. The underlying idea of Snapchat -- that messages disappear within a specified amount of time -- is shockingly basic. Any similar messaging service could theoretically introduce their own time restrictions on messages. Furthermore, although the main draw of Snapchat has been the perception of enhanced privacy, photos sent aren't actually deleted off of receivers' phones when they "disappear". People have already found ways permanently store Snapchat images, through third-party programs like SnapHack, or recover "disappeared" images just by browsing their phone's folder structure on their computers.
3. It's not because Snapchat offers marketers a rich amount of data to mine. This is a key element driving the high valuation of Twitter, which went public last week and boasts a $23 billion market cap, and even more so Facebook. Each of these services offers companies a wealth of insight into consumers' demographics, peer groups, interests, and habits, allowing for much more sophisticated targeting by advertisers. Snapchat, on the other hand, collects almost no information on its user, and the nature of the program means it leaves no data publicly visible for marketers to analyze. It's why the typical strategy of "slap some banner ads" on the app to generate revenue, employed by Tumblr and Facebook among others, is not very useful here.

Given that, what does Snapchat have in its favor?

1. Snapchat has young people. This is the bulk of the reason Snapchat is seen as an attractive commodity. Perhaps the only industry with a worse fear of aging than Hollywood is the tech industry, which is obsessed with capturing youth and cool. Pre-teens and teens have increasingly been showing disinterest in Facebook, meaning they are less active and engaged on the site. They have practical reasons for doing so, too: the near-universal adoption of Facebook means their profiles are far less private than they would like, and their profiles also have an uncomfortable permanence to them. Snapchat is the antidote to that.
2. Snapchat's large user base is attractive to Facebook (or a rival buyer) to bring into their fold as advertising targets and/or customers. Effective advertising is about going where the eyeballs are at, and Snapchat has them. Marketers will pay to connect directly with young people wherever they are -- think Adidas on Tumblr, or Starbucks and Nike on Chinese service WeChat. Advertisers could take advantage of the Snapchat medium with mobile video ads, which tend to be more effective than traditional media for raising brand awareness and driving purchases. Also, apart from advertising, Snapchat could provide add-ons (stickers, visual effects, other services) as in-app purchases to drive further revenue; this strategy has been hugely successful for Japanese messaging service Line, which made a whopping $30 million in Q1 2013 from in-app purchases alone.

Paying $3 billion for the company is still a risky bet, no doubt, and you'd have to be convinced that advertisers will believe they would see a far better bang for their buck via this kind of service than via more traditional channels. (Note the recent valuation of the Washington Post, a mainstay newspaper and advertising vehicle, bought in August by Jeff Bezos for a relatively paltry $250 million).

But going forward, the challenge may be less about developing a monetization strategy, but instead figuring out how to hold on to users. The social media universe is littered with the gravesites of once-wildly popular sites (e.g. Myspace, Digg). Facebook itself must wistfully remember from not long ago that as a service grows in popularity and is increasingly adopted by the general public, it often loses its cachet, and those that were the early-adopters wind up looking for the next "it" thing.