Photo-centric startup Instagram was rumored to be raising huge second round of funding over the past month, which makes the news of its $1 billion sale to Facebook a bit surprising.

The rumors of the round, which haven’t been confirmed by Instagram, indicated that the startup closed a $50 million second round at a hefty $500 million valuation led by Sequoia Capital, with participation from Thrive Capital, Greylock, and Benchmark. That round apparently closed just before the Facebook deal, indicating that the company was probably in talks with both investors at the same time.

Many people are left scratching their heads over why Instagram was bothering with such a large round while knowing that it was being courted with an acquisition  offer from social network giant Facebook. But, it actually makes perfect sense, according to venture capital adviser Christine Herron.

In a blog post about the timing of the funding coinciding with the Facebook acquisition, Herron writes:

“The reason is simple: playing chicken with a potential acquirer can drive a much higher valuation. And more importantly, the acquisition is more likely to close quickly and successfully if the target company has a war chest of cash and a strong, fresh investor group… it’s smart to use an impending investment valuation to drive a higher acquisition valuation. Strategic/acquisition values are typically much higher than investment values. eg, as of today, Instagram is worth more to Facebook than it is to Sequoia, because Facebook gets strategic value in addition to market value.”

If the new round did close, Sequoia essentially made a $50 million “gamble” that doubled its money virtually overnight. For Instagram’s part, its pursuit of the $50 million Series B meant that if the Facebook acquisition didn’t go through, the company would still be in a good position to become a successful startup going forward.

Casino photo via VojtechVlk/Shutterstock


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