TechCrunch is reporting that Sequoia doubled their money in a couple of days by investing in Instagram. At first, I was pretty amazed, why take the dilution just before closing a round. But I think I've worked it out.
People offering to buy Instagram were probably making offers with the thought that the venture investors already in the company would be happy with a 10X on a $7M round. So they were probably thinking they could buy the company for around $100M. Given that investors thought it was worth more, they probably kept talking about taking a round, and running with it rather than sell out so soon. So it makes sense that they ran dual tracks, selling the company and preparing for a round.
Now, I've often seen it that if you think you're going to sell the company, you state that if you do so within some number of days, perhaps 60, that the new investor just get's their money back. The thinking is that northing really changed in that time, and so they shouldn't get outsized compensation for that. So why didn't Instagram make that deal?
I think Instagram was essentially paying Sequioa to signal to buyers that their hands were now tied. The new minimum was going to be 1B since that is what Sequioa would want since they put new money in. In Game Theory this is known as Burning Bridges. So, by giving Sequioa 10% of the company ($100M in the end) Instagram was signaling they wanted $500M more total.
Finally, why didn't they just use the current investors? Well, for the pricing to be counted as real, it had to be done by an outside investor. Also, going with a firm with such deep pockets signaled that the company would be able to go the distance with other well financed firms. Of course Sequoia had to also believe that even if their wasn't an offer in the next week that the company was worth the $500M.
All in, this was probably a pretty crafty move. By burning their bridges and showing to FB that Instagram couldn' sell for less than 1B they netted the current team an extra $400M (after paying Sequioa their $100M).