Square’s S-1: Of Ratchets And Unicorn Valuations

Over the last 18 months, those of us following the venture and startup space have gone on a rollercoaster ride of mega rounds, unicorns, sky-high valuations and bubble fears. Look beyond the hyperbolic headlines and you’ll see that there is more than meets the eye to that shiny new unicorn valuation.

Square’s recent IPO registration statement provides an opportunity to peel the onion on unicorn valuations (i.e., valuations of $1 billion or greater).

Square’s Ratchet

A little more than a year ago, Square raised a $150 million Series E round at a reported $6 billion valuation. The round was led by the Government of Singapore Investment Corporation, with participation from Rizvi Traverse and Goldman Sachs. What we didn’t know then, that we know now, thanks to the S-1 filing, is that the Series E investors had in place an IPO protection known as a ratchet.

A ratchet, in this context, provides that if the IPO price does not meet a certain level, say at least the price paid by the investor in the private round or some baked-in rate of return above that price, the IPO conversion of those shares to common shares is adjusted such that an additional number of shares which would meet the predetermined level are issued to investors.

I know — that wasn’t easy to follow. But Square’s ratchet will bring the abstract to reality. A quick aside on venture investments. Venture investors are typically issued preferred stock that, in the event of an IPO, converts to common shares, based on a given formula.

From Square’s S-1, we know that its Series E investors paid $15.46 per share for Series E Preferred Stock. The ratchet in Square’s Series E provides that if the IPO price is less than $18.56 per share, the IPO conversion formula is adjusted such that the Series E investors would receive a number of common shares equivalent to a number if the IPO price had been $18.56. What does this mean? Square’s Series E investors were guaranteed a 20 percent return in an IPO.

On November 6, 2015, Square announced that it expects to price its IPO between $11 and $13 per share. If the IPO were to price in the midpoint of the range ($12 per share), the Series E investors would be issued approximately an additional 5.3 million shares — or $63.6 million of value — under the ratchet in order to achieve the guaranteed return.

Zooming Out

Square is not alone in providing its investors with protective provisions like a ratchet. Box had a similar ratchet in place. It’s increasingly common in mega rounds to build in protections such as IPO ratchets. It’s a sort of win/win for companies and investors. Companies get their shiny unicorn valuation (which helps with recruiting, in addition to being the vanity metric du jour), and investors get some downside protections, which can even guarantee a minimum return, as in Square’s case.

In fact, the law firm Fenwick & West LLP studied venture-backed companies that raised at unicorn valuations in the twelve months trailing March 31, 2015. That study found that 30 percent of venture-backed companies that raised capital at Unicorn valuations provided IPO protections in the form of a ratchet.

It’s increasingly common in mega rounds to build in protections such as IPO ratchets.

There are other protective provisions being given by companies, which indicate that unicorn valuations come with plenty of fine print. In addition to IPO protections, like the ratchet, late-stage investors bestowing unicorn valuations are also receiving acquisition protections. While the 1X liquidation preference is standard, the Fenwick & West study reveals that 19 percent of financings analyzed included senior liquidation preferences for the investors in the latest round over other series of preferred stock (in simpler terms: last money in, first money out).

Additionally, issuance of participating preferred stock is on the rise, having been issued in 5 percent of deals in the Fenwick & West study. Participation rights afford its holder a claim to not only the liquidation preference in an acquisition, but also a pro rata share (on an as-converted basis) of proceeds due to common holders.

This “double-dip” was common following the dot-com bubble, but had disappeared in the recent bull-run in VC. These elaborate provisions give investors in unicorn financings (i.e., the Big Boys) significantly more downside protection than public-company common-stock investors.

Rethinking Valuations

The salient point here is that unicorn valuations often come with asterisks. One may argue that following its Series E round, Square was actually not worth $6 billion (prominent VCs have recently debated this point on Twitter). It’s important to consider the entire capital structure of a company, which typically includes various series of preferred stock and also common stock. One way to think about valuation is in terms of what someone would or did pay for the company.

We know that Square’s Series E investors paid $150 million for 3.3 percent of the company. Since Series E preferred stock has rights superior to other classes of stock, namely the ratchet discussed above, it’s fair to assume some discount for the other series of preferred stock and for common stock. Applying a discount factor for each class of securities in the capital structure, one can sum up the costs for all classes of securities and arrive at a more nuanced valuation, which, in Square’s case, following its Series E round, was likely lower than $6 billion.

This granularity also helps to fine tune scenario modeling (e.g., what happens if Square IPOs with a market cap of $5 billion?). To be sure, there are other factors to consider, which may in fact mitigate against a discount, such as an access premium (which certainly plays a role in the secondary markets).

I’ll be the first to admit this approach is not precise, but it is a more granular approach to valuation and doesn’t simply apply the value of one class of securities to all classes. And while we can argue about what discount factor to apply, let’s at least agree that the headline valuation numbers don’t tell the whole story.