One of the big business stories of the moment is the acquisition of Skype by Microsoft for $8.5 billion. Skype had been planning an IPO which was expected to raise around half that much when Microsoft came in with an unsolicited bid. Many analysts have panned the acquisition, with a principal complaint being that Microsoft paid too much.
I can think of three reasons why Microsoft may have made such a large bid -- one optimistic, one pessimistic and one tactical.
On the optimistic side, Skype may be worth more to Microsoft. Microsoft has a very strong position in the business software market but lacks an application that people want to use every day at home. Skype is that product and moreover Microsoft may be able to leverage their strength in the business market by selling an upgraded Skype service for business users that can be integrated into their other Microsoft products. Lots of other synergies have been offered as well, e.g. Xbox and Windows Phone integration. So maybe Skype is really worth $8.5 billion or even more?
That's not a very satisfying explanation. If something is worth $8.5 billion to your company but only $5 billion to anyone else, the answer isn't to bid $8.5 billion but to bid just over $5 billion and capture the rest of that value for yourself. At worst you have to pay a premium, but not like this.
This brings us to the pessimistic reason. In addition to the value Skype offers to whichever company acquired it, there is also the loss of value to that company's competitors. If an asset offers a significant competitive advantage and ends up in auction it can actually be rational to pay far more than it's worth.
Let's use a simple illustration. A market is divided evenly between two major companies, each with 50%. The companies are offered the chance to bid for a new technology that offers enough of a competitive advantage for the owner to capture 10% of the market from the other. If 10% of the market is worth $5 billion (we'll keep it simple and not try to adjust for scale, costs of downsizing, etc.) where is bidding likely to end?
Not at $5 billion. At that price the winner of the auction is break-even (they've paid $5 billion for $5 billion in value) but the loser is down $5 billion because they're losing market share. They'd much rather pay $6 billion (losing a net $1 billion in value) but that's not high enough either -- the first company would rather pay $7 billion than lose the auction (losing $2 billion is better than losing $5 billion). In fact, the rational point for bidding to end is at $10 billion -- twice the value the technology provides.
In situations like this, the ideal outcome for the potential bidders is for the auction not to start -- in this case for neither Microsoft or Google (or anyone else) to make a bid, with Skype left independent. That may have seemed unsustainable to Microsoft, however. If they concluded that Skype would eventually end up being acquired and that the dynamic we just discussed would mean the price would be too high, the next step is deciding how to minimize the damage. This means buying Skype for less than it would go for in a full-out auction.
This brings us to the final reason -- the tactical one. Let's assume for the moment that Skype is "really" worth more like $7 billion to Microsoft but that in order to keep it out of Google's hands they would be willing to pay up to $10 billion. They know if they make a $6 billion or even $7 billion bid there's a real risk of a bidding war. What else might they try?
My guess is when the dust settles we'll learn that Microsoft engaged in a "shut down move" to close off the auction before it started. A simplified version of this would be, "We're offering $8.5 billion but you have an hour to decide. If any of you leave this room or make a phone call the deal is off and we will not bid again." The key is to take the possibility of a competitive auction off the table by saying Microsoft won't bid in an auction.
If this threat is credible then Skype's owners have to choose between $8.5 billion and trying to get more through negotiation rather than auction. A bidding war might have raised more but negotiating with Google when Skype's BATNA is $4-5 billion through an IPO is almost certain to raise less. Microsoft would still be paying a premium* but much less than might have been paid in an auction.
* To be clear, I have no basis for evaluating the "pure" value of Skype to Microsoft. It could be that Skype is worth $10 billion or that Microsoft's management thinks it is. The point I want to make is that even if Skype is worth less than $8.5 billion it might have been rational for Microsoft to pay what it did.