Was Tumblr’s Valuation Instagram Part 2?

The story of Yahoo’s $1.1 billion purchase of Tumblr, a microblogging and social networking site, lit up media channels yesterday.

The deal stands as one of the largest social media acquisitions in years, beating out Facebook’s $1 billion acquisition of Instagram last year. The acquisition — along with the ten others already made by CEO Marissa Mayer — indicates the aggressiveness with which Yahoo is looking to rebrand and reposition itself in the online community. With the purchase, Yahoo hopes to gain a 50% increase in its user base, increased web traffic, a new engagement channel for its historically weak sectors (fashion, art, travel, etc.), and the one thing it’s argued can’t be bought: the cool factor.

While the strategic implications are interesting, the biggest unanswered question is around Tumblr’s billion dollar price tag. How did a company that generated just $13 million in revenue last year get acquired for $1.1 billion?

To find the answer, we did not look very far — the same question was being asked just over a year ago in the aftermath of Facebook’s acquisition of Instagram.

Insiders chalked up Instagram’s inflated price tag to the buyer competition Instagram CEO Kevin Systrom created for the start-up. While in talks with Twitter, Systrom shopped the deal to Zuckerberg who, in a whirlwind weekend of deal-making, offered to buy the company for $1 billion. By creating competition and by playing on Zuckerberg’s fears of becoming outdated, Systrom was able to significantly grow Instagram’s value.

The Instagram story shows the importance of having multiple buyers in a process — competition among highly qualified buyers is the best way to drive your business value. By pitting different buyers against one another, Systrom was able to garner a premium price for his profitless business.

It appears that Tumblr may have benefited from similar competition. As it turns out, there were rumors that Facebook might make a last-minute play for the micro-blogging platform, leaving Mayer and Yahoo concerned. Like real competition, the threat of competition can be just as useful for driving up purchase price. The desire to acquire Tumblr may have driven Mayer to extend an unusually high offer.

While generating unnecessary competition may risk the deal, it is essential to have a system in place to help foster and encourage competition between interested and qualified buyers. One of the best approaches is to simply incorporate multiples types of buyers into your list. As investment banker Walter Bailey of Pickwick Capital recently told us, “a broad sampling of buyers tends to create a better value outcome for your client.” He continued, “If your mandate is to maximize value, then diversity definitely contributes to that maximization.”

Strategics are arguably the most important presence on your list if you are looking to drive a bidding war. Since strategics have more to lose if a competitor acquires a one-of-a-kind asset that ensures the dominance of a particular market, they will take extensive measures to counter the acquisition — especially if they think you are knowledgeable about the competitive landscape and have brought the deal to competitors and other qualified buyers. Strategic acquirers also look beyond just the financials to consider the possible synergies an acquisition would provide, typically driving up the price tag they are willing to pay.

Just as Facebook felt during the Instagram process and Yahoo may have felt during the Tumblr acquisition, buyer competition (or the illusion of it) can increase the odds of the highest price for a business. By making the deal known to more buyers, you’ve effectively created a marketplace — and if you’re lucky, that marketplace may be worth $1 billion.