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