Facebook will pay $1 billion in cash and stock for Instagram, a 2-year-old photo-sharing application developer, in its largest-ever acquisition just months before the No. 1 social media website is expected to go public.

The price was stunning for an apps-maker without any significant revenue, even when measured by the lofty standards of Silicon Valley, where startup valuations have soared in recent years. It highlights the rising stakes in the social networking market in which services such as Facebook need to constantly excite consumers with new features and mobile applications.

By acquiring Instagram - in a deal announced days after the startup closed a funding round that valued it at $500 million - Facebook may also have sought to absorb a potential rival or at least prevent it from falling into the hands of a major competitor like Twitter or Google Inc.

Anytime you see a social platform that's growing that quickly, that's got to be cause to be nervous, said Paul Buchheit, a partner at the start-up incubator program Y Combinator and a co-founder of FriendFeed, which Facebook acquired in 2009.

It would be better to have bought Twitter at this stage, he said of Facebook. So if you're thinking this could be the next Twitter, it could be a smart thing to do.

The Instagram application, which allows users to add filters and effects to pictures taken on their iPhone and Android devices and to share those photos with their friends, has gained about 30 million users since it launched in January 2011.

Instagram says that as of the end of 2011, its users had uploaded some 400 million photos or about 60 pix per second, suggesting the sort of activity that Facebook seeks as it tries to wring revenue from mobile devices. Instagram launched its Android app just last week, garnering more than one million downloads already.

As Instagram's popularity has shot up in recent months, the company's leadership has mulled possible strategies to expand the service into a fully featured social network - much like a photo-driven, stripped-down version of Facebook, Twitter, or even Path, a company insider said.

Instagram is a property that would have been amazingly valuable to not just Facebook, certainly Twitter was in the hunt as well, said Lou Kerner, founder of the Social Internet Fund.

I'm sure Google was interested as well. So to some degree an acquisition like this is both offensive and defensive. It would be a highly leveragable asset for anybody who wanted to compete against Facebook.

Instagram, with roughly a dozen employees based in San Francisco, closed a $50 million funding round last week from investors including Sequoia Capital and Greylock Partners, according to a source familiar with the matter. The funding valued the company, founded in early 2010, at $500 million, it said.

Facebook, which is expected to raise $5 billion via the largest Silicon Valley initial public offering by May, will acquire Instagram's entire team.

This is an important milestone for Facebook because it's the first time we've ever acquired a product and company with so many users, Facebook Chief Executive Mark Zuckerberg said in a blog post. We don't plan on doing many more of these, if any at all.

The deal, a closely kept secret at the tiny start-up, is expected to close this quarter. CEO Kevin Systrom announced the transaction to Instagram employees at a 9 a.m. meeting on Monday, according to the source inside Instagram.

TAKING PAGE FROM GOOGLE'S BOOK

The acquisition marks an exception in strategy for Facebook, which has traditionally bought small companies as a means of hiring coveted teams of engineers. Facebook typically discontinues the acquired company's products or builds similar versions that it integrates into its service.

Instagram, however, will not only remain running, but Facebook will build features into it as time goes by, both companies said.

Tech industry insiders were quick to draw parallels with Google's $1.65 billion acquisition of video service YouTube in 2006. YouTube retains its own offices in San Bruno, California, and largely operates independently of Google.

Facebook is acquiring a similar company in that it's fast growing, doesn't have revenue or a business model, but has become part of the online culture, said Gartner analyst Ray Valdes.

I would wager that almost everyone is also a Facebook user, so it's not like they're expanding their market, Valdes said of Facebook. What they're buying is traction, they're buying engagement, they're buying brand value.

Facebook, the world's No. 1 social network with more than 845 million users, is facing increasing competition. Last year, search giant Google launched Google+, a rival service that offers many of the features available on Facebook.

With its purchase, Facebook said it would continue to develop Instagram as an independent app that remains compatible with other social networking services.

We plan on keeping features like the ability to post to other social networks, the ability to not share your Instagrams on Facebook if you want, and the ability to have followers and follow people separately from your friends on Facebook, Zuckerberg wrote.

EXPENSIVE HABIT

Instagram is backed by a number of Web industry bigwigs with ties to Facebook, including Benchmark Capital and Andreessen Horowitz. Benchmark partner Matt Cohler led a $7 million funding round in Instagram in 2011 and serves on Instagram's board. Cohler was also an early employee of Facebook, who still serves as a special advisor to Facebook, according to his profile on LinkedIn.

Facebook generated $3.7 billion in revenue in 2011, and ended the year with $3.9 billion in cash and marketable securities on its balance sheet, according to its prospectus.

While it was not immediately clear what portion of the Instagram acquisition price Facebook paid in cash, the price represents an extraordinary valuation, said Paul Deninger, senior managing director of investment banking firm Evercore Partners.

There are no obvious traditional valuation metrics that justify this price, he said, though he noted that that did not mean that it would be a bad deal for Facebook.

Some tech industry observers noted that deal may dramatically ramp up the valuations on other fast-growing social media companies and app-makers - such as Pinterest - as entrenched Web players seek to snap up attractive assets and bolster their social capabilities to challenge Facebook.

It will be interesting because if Facebook has to keep buying up the hot new social network, that could get expensive after a while, said Y Combinator's Buchheit.

(Reporting by Alexei Oreskovic and Gerry Shih; Editing by Edwin Chan, Lisa Von Ahn and Richard Chang)

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