The Weirdest Thing About the Instagram Deal

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Why did Instagram's founders dilute their own stake in the company just four days before finalizing its acquisition? 615_Facebook_Instagram.jpg

Reuters

A million dollars isn't cool. You know what's cool? Instagram.

A mere 551 days after its founding, the photo-sharing startup sold itself to Facebook for a very cool billion dollars. Even Sean Parker would be impressed. But one part of the sale has confused rather than impressed people. Why did Instagram close a second funding round just four days before it finalized its acquisition?

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Let's back up. There are three ways a startup can fund itself: (1) debt, (2) equity, or (3) some hybrid of the two. Most companies sell stock, although hybrid instruments like convertible debt -- that is, debt that gets turned into equity at a later date -- are also common. Founders love hybrid financing because it lets them stockpile their most valuable asset, which is shares in their company. After all, any time a startup does sell stock, its founders get diluted. Their shares make up a smaller piece of the pie, which means they're worth less. In Instagram's case, their Series B round -- which, again, came four days before today's sale -- raised $40 million at a $500 million post-money valuation. Whatever the size of the pie, the founders has reduced their slice by 8 percent. Meanwhile, the value of the Series B investors doubled.

As a former entrepreneur myself, my sense is that there's no way Instagram would have knowingly shrunk it valuation slice if they knew a potential sale was imminent. It's more likely that either the Facebook deal floored them, or that they were using the latest round of venture funding to show off their accelerating valuation to Facebook.

Instagram was already beating Facebook in mobile photos -- a space Facebook thinks is critical to its future success. With a swelling war chest, Instagram could keep growing and beating Facebook in this space. Maybe Facebook panicked a little bit. Maybe they made a savvy deal. Regardless, it looks like Instagram's venture funding kicked Zuckerberg into making them an offer they couldn't refuse.

All of which goes to show the real lesson of Silicon Valley: If you can't beat them, buy them.






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Matthew O'Brien

Matthew O'Brien is a former senior associate editor at The Atlantic.

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