Square’s low IPO price warns unicorn startups about a cynical market

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Everybody has that moment in their lives when reality comes in and eviscerates whatever expectations they had. A company that believes its mobile app will completely change the game discovers that the public couldn’t be less interested in it; a social media giant that believes it has finally cracked its chronic marketing problem, only to learn that it has made things even worse.

Whilst the latter may be bad in particular, it’s probably not as bad as the $2 billion reality check that Square has faced recently.

 

Great Expectations

The payments processing company, the much vaunted ‘unicorn’ startup, has been receiving a lot of coverage in recent times because of its desire to go public. Questions were asked about the timing, its CEO after all has another company to worry about,: Twitter, the social network mentioned above. Square persisted, convinced that the time has to be now.

Well it got its wish as the company said it will be seeking a valuation of $3.9 billion, with share prices ranging from $11 to $13.

The problem is that Square was valued at $6 billion only last year.

This will have wide-ranging ramifications, both for Square and other large tech startups.

 

Hard Times

For Square, the immediate issue is one of ratchet. By seeking an IPO valuation of $3.9 billion, i.e. one lower than the recent private valuation, the company has triggered something known as a ratchet, meaning it is now obligated to give one class of investors more shares at the expense of others. This is because it has to ensure the private investors have to receive their 20 per cent return on the investment.

The potential consequence of ratchet provisions are clear. Recently, companies such as Chegg, which pushed for highest possible valuations during funding rounds, set IPO prices that turned out to be lower than those earlier valuations, meaning they had to pay hefty penalties because they guaranteed the share price in the IPO would be higher than what the investors paid.

Ratchets also put early investors and even early employers at a distinct disadvantage because it is the late investors who have now become the priority.

 

Wider ramifications

“It’s a chickens-coming-home-to-roost moment. It might be harder for future IPOs because of how difficult it is to predict what they’ll be worth,” said Rett Wallace, CEO of Triton Research LLC, which analyzes pre-IPO companies.

The ‘unicorn’ club – made up of startups valued over $1 billion – has rapidly expanded in recent times, with there now being 120 tech companies that are worth more than $1 billion, and Square’s shock IPO price could act as a reality check for any one the private companies seeking to go public, including Uber and Airbnb.

That’s what Keith Rabois, a venture capitalist at Khosla Ventures who worked at Square, tweeted on Friday. Square’s position could finally be the warning sign serious enough to be heeded by tech companies. Research carried out this year by law firm Fenwick & West found that three out of ten of private companies valued at $1 billion or more had agreed to protect investors  against a down IPO, so it will be interesting to see how the mood changes in the near future, and whether Square’s IPO could really be a turning point.

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