This article was written by Greg Sandoval.
Since 2006, many observers have scratched their head over what prompted Google to. We're now a little closer to the answer.
The blockbuster acquisition for the 18-month-old start-up played a large role in sending valuations in the tech sector skyrocketing. Although YouTube made little revenue, the all-stock transaction gave Google control of a company many believed would change the face of mass entertainment. It also led to criticism from skeptics who thought that Google would never get its money back.
Google has revealed little about how it decided to pay $1.65 billion but CEO Eric Schmidt said under oath last spring that he was willing to pay a premium - a big one - for YouTube. Leading up to the acquisition, Schmidt told Google's board of directors that his estimate of YouTube's worth was somewhere between $600 million and $700 million, according to court records reviewed by CNET.
A Google spokesman declined to comment about Schmidt's valuation.
Schmidt had his reasons for asking his board to OK an offer of $1 billion more than what he thought the site was worth. The CEO made the comments during a deposition he gave in May as part of the. In short, he believed that Google had to offer that much, or competitors, presumably Microsoft or Yahoo, would walk away with the increasingly popular video site.
"This is a company with very little revenue," Schmidt said while being questioned by Stuart Jay Baskin, a Viacom attorney. "(YouTube was) growing quickly with user adoption, growing much faster than Google Video, which was the product that Google had. And they had indicated to us that they would be sold, and we believed that there would be a competing offer - because of who Google was - paying much more than they were worth ... We ultimately concluded that $1.65 billion included a premium for moving quickly and making sure that we could participate in the user success in YouTube."
Three years later, that user success continues: YouTube has grown from 12 million unique users (in May 2006) to more than 100 million users just in the United States. Every minute, more than 10 hours of video is uploaded to the site. But Google is also fighting a $1 billion copyright lawsuit with entertainment giant Viacom, which claims that YouTube encouraged users to violate its copyright. On top of that, the company is still trying to figure out how to turn its prize acquisition into a profitable business.
YouTube managers have toiled to find the right way to generate revenue, experimenting with a wide range of advertising methods and models - everything from prerolls to overlays. Perhaps most importantly, managers changed their approach to copyright owners.
Whereas Hollywood executives once called YouTube a "rogue company," the video site can now boast numerous partnerships with top entertainment companies, including as Walt Disney, CBS (publisher of CNET News), Sony Pictures, and Metro Goldwyn-Mayer. YouTube also has deals with all four major music labels. And YouTube's finances may finally be turning the corner: company representatives have hinted in the past several months that it's on the road to becoming the kind of revenue generator that Google always envisioned.
(Left: Google CEO Eric Schmidt)
"It actually becomes worth the additional value because Google can tie all of its advertising expertise and search traffic into YouTube," McQuivey said. "It's not like it's going to pay back that $1.6 billion any time soon, but what it does is, it ensures that these millions and millions of viewers are coming to a Google-owned site rather than someone's else's site ... As a loss leader goes, if it never makes its money back, its still going to be worth it."
McQuivey acknowledged that those focusing only on hard business numbers are probably not going to agree with him. Count Josh Martin among them.
Martin, a research analyst, was an early skeptic of YouTube's profit potential, arguing on behalf of Yankee Group Research that Google overpaid.
"I don't think Schmidt is wrong in assuming that someone would have overpaid for YouTube," Martin said. "If Google was willing to overpay for it, then someone else would have too. But it was a bad business decision for Google. We said it at the time, and three years later, we have been proven right."
Martin said that when Google priced YouTube, it should have deducted heavily for the legal liabilities, as well as for the company's ability to draw an audience, if it couldn't offer pirated content.
"You go back to the reason why YouTube was popular, and it was because of (the "Saturday Night Live" skit) 'Lazy Sunday,'" Martin said. "That is what put YouTube on the map. So it was popular because it had access to content that it shouldn't have had and that you couldn't get elsewhere because no one else was willing to put it up illegally...Clearly, (Google's leaders) needed to understand what was driving momentum behind YouTube."
The following is an edited excerpt of Schmidt's deposition:
Viacom attorney Stuart Jay Baskin: And what was management's valuation?
Schmidt: Much lower than we paid for it.
Baskin: And how was that communicated to the board?
Schmidt: I told them.
Baskin: So why don't you tell us what you remember telling the board in connection with the valuation?
Schmidt: I believe YouTube was worth somewhere around $600 million to $700 million.
Baskin: And you communicated that to the board?
Schmidt: I did.
Baskin: Of Google?
Schmidt: I did.
Baskin: What methodology did you use to come up with that number?
John P. Mancini, an attorney working for Google, objects.
Schmidt: My judgment.
Baskin: Was it based on cash flow analysis? Comparable companies? What were you using as the basis for your judgment?
Schmidt: It's just my judgment. I've been doing this a long time.
Baskin: So you orally communicated to your board during the course of the board meeting that you thought a more correct valuation for YouTube was $600 million to $700 million; is that what you said, sir?
Mancini objects to characterization of the testimony.
Schmidt: Again, to help you along, I believe that they were worth $600 million to $700 million.
Baskin: And am I correct that you were asking your board to approve an acquisition price of $1.65 billion; correct?
Schmidt: I did.
Baskin: I'm not very good at math, but I think that would be $1 billion or so more than you thought the company was, in fact, worth.
Schmidt: That is correct.
Baskin: Can you tell us what reasoning you explained?
Schmidt: Sure, this is a company with very little revenue, growing quickly with user adoption, growing much faster than Google Video, which was the product that Google had. And they had indicated to us that they would be sold, and we believed that there would be a competing offer - because of who Google was - paying much more than they were worth. In the deal dynamics, the price, remember, is not set by my judgment or by financial model or discounted cash flow. It's set by what people are willing to pay. And we ultimately concluded that $1.65 billion included a premium for moving quickly and making sure that we could participate in the user success in YouTube.
By Greg Sandoval