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Unicorn valuations: Square’s un-common stock

22/11/2015

Square’s IPO filings give us the chance to look at the VC financing of a unicorn. We wrote back in August on the upward distorting effect on valuation of liquidation preference shares and ratchets. Square has them all, and it turns out wasn’t funded in common shares at all, but in convertible preference shares that look a lot like zero-coupon convertible debt. Even the series-E investors who bought in at an apparent share price of over $15 have profited from the $9 IPO*. Convertible funded businesses might seem like a good solution since they offer new shareholders extra protection and so incentive to invest.  But some VCs structure deals so that their shares have more rights and downside protection than people in the business. Founders, angels and employees need to consider very carefully what different future valuations for the business will mean for them. And take some of the valuations being bandied around in the press with a huge pinch of salt.

Square caused great excitement in fintech circles when it launched allowing businesses to take card payments using a small attachment to a smartphone. By 2011 when I was writing about the sector as an equity analyst it was already on its series-C funding round and expected to disrupt many existing acquiring banks.

Roll forward to 2015 and things aren’t as rosy as anticipated. Traditional acquirers WorldPay and First Data just IPO’d in the UK and US respectively. Square is still loss-making and it’s headline tie-up with Starbucks looks such a problem that it is separately reported in its financial statements and will soon be shut down. However Square has also gone public at just under 10x EV/2015 sales. The $9 IPO price was cut from the planned $11-13, valuing the business at $3.2bn. But it quickly traded up to close at $12.85 two days later.

Square’s IPO filing details its series A to E private funding rounds. We’ve charted the amount raised and apparent valuation above, with more details in the table below.


Square funding table

Each of the series A to E funding rounds were classed as convertible preferred stock, not common stock. The early founders would have common stock, as would any staff who received shares. As the table shows (column 4), at the time of the IPO, these common stock shareholders accounted for 51% of the ownership of the company.

Convertible preferred stock doesn’t pay interest (which is why it’s not strictly convertible debt), and often has a right to a dividend if any is paid to common stock owners (this is true in Square’s case). But like debt holders, these investors get all their money back before common stock holders in the event of a sale of the business. This is known as a liquidation preference and in some failed start-ups has meant that founders and staff walk away with nothing in the event of a trade sale below later stage funding round levels.

Running across the table, column 3 shows the shares issued in each round, 4 the conversion price of the debt (which for Square was usually also the price paid), and column 7 is the value of the debt, i.e. amount claimable by the holders in the event of a sale of the business below the conversion price. The total of column 7 tells us that series A to E investors would have got all their money back down to a valuation of $551m, at which point other shareholders would receive nothing.

Column 8 shows the stated valuation of the business after each funding round, and column 9 the dilution which, as expected, declines with each subsequent round as valuation rises. The stated valuation is somewhat up for debate because the price of convertible debt does not directly translate into the value of the business. Shriram Bhashyam at TechCrunch notes that this has created a Twitter debate amongst VCs on the validity of using preference share prices to value a business. If you paid $11 for convertible shares, as the Series D investors did, you would obviously pay less for common stock with no liquidation preference protection.

Series E investors came in at a share price of $15.5. They did not lose money as a result of the $9 IPO because they had a ratchet meaning that in the event of an IPO at a share price of less than $18.6 they would be issued additional shares. So they too have made money, at the expense of all the other shareholders who have been diluted by 3%. The S-1 does note that an additional Series E round was made in October 2015 and that these two shareholders waived the ratchet rights, so they are under-water at time of writing.

 

Related links and information:
Square IPO: $9 share price on 18 November 2015, 355m shares in issue excluding greenshoe.
Share price at time of writing $12.85 at close on 20 November 2015 (Google Finance)
Square S-1 filing
Private valuation high-wire act (Oakhall)
Venturing forth: the push and pull of early stage valuations (Oakhall)
Of ratchets and unicorn valuations (TechCrunch)
Square IPO profile (FT Partners)
 POST SCRIPT – January 2016: US law firm Fenwicks publishes a survey of the impact of ratchets on 2014 and 2015 tech IPOs. Which ratchets were triggered in 2% and 50% of IPOs in 2014 and 2015 respectively, the dilution impact was just 1% and 3% of total shares, so on balance, ordinary shareholders weren’t too negatively impacted. It will be interesting to see if that changes in 2016 given the rocky start to the year.

Andrew Griffin spent almost two decades as a technology equity analyst before working in investor relations, corporate development and market intelligence for a UK listed software company. In 2015 he set up Oakhall to provide smart financial analysis and articulation for European public and private companies.

* see last paragraph of article for small exception to this statement