If the tip of a unicorn’s horn falls off, as Square’s seems to have in its initial public offering, then it must surely now be a uninub.
And if, as in Square’s case, profit guarantees were made to late-stage private market investors, then more of that nub goes to satisfying those guarantees.
Square, a mobile payments company, offered shares on Thursday at an initial price of US$9 each, well below its forecast range of US$11–$13, only to see them immediately ratchet higher to as much as US$14.78. Square was one of the group of so-called unicorn companies, private firms with the until recently vanishingly rare value of US$1bn or more.
That trading action Thursday wasn’t the only ratchet, as investors in its most recent round, including Rizvi Traverse and JP Morgan, came in at US$15.46 per share but had extracted a promise, known as a ratchet, which entitled them to a 20% profit, in the form of additional shares, if the company IPOs below a pre-set price.
That entitled them to US$93m more worth of shares at the IPO price, diluting the value of equity owned by founders, employees and earlier investors.
All investors appear to have made money on the deal, then, though it is possible that some may be forced to mark down to market stakes they were valuing based on the most recent private round.
While it isn’t terribly surprising that investments fluctuate in value, this after all being a bit of fine type by now familiar to all, today’s events illustrate the vagaries that follow from the widespread belief that private markets for equity, particularly in the technology sector, have matured to the point where they rival public markets in efficiency and usefulness.
Square is, after all, now both a roughly US$4bn company but one which, while growing rapidly, is only now, according to founder Jack Dorsey, breaking even, having lost US$131.5m in the first three quarters. And it is far from alone. There are now 143 private market unicorns, according to data firm CB Insights, with a cumulative valuation of US$510bn. Many are loss making.
Investment vs living quarter to quarter
There is a fascinating contrast here between the private markets which are supporting fast-growing technology firms with, arguably, too plentiful capital, and public companies which prefer buying in shares (and handing them out to executives) to investment in core and new markets.
Both groups, in different ways, appear to have taken their core values, ‘grow earnings per share’ and ‘grow revenue’ too far. It is certainly tempting in this contrast to side with the private markets, in which direct owners of equity have a greater sway. That’s in contrast to publicly traded companies, where executive desire to increase the volatility and value of their share options combines with the quarter-by-quarter blinders of the buy side to create an investment drought.
The argument for private markets is that only there, free from the drudgery of disclosure and not forced to live quarter to quarter, only there can growth companies invest for the future. There is also something to be said for the idea that more mature private markets allow for easier buying and selling, making for a lower illiquidity premium which companies must pay in exchange for private equity capital.
The widespread use of ratchets to protect investors in private companies does raise some concerns. NYU professor and valuation specialist Aswath Damodaran cautioned about their use in an analysis from June.
“There is also the very real concern that some venture capitalists who believe that they are protected from downside risk (even if that belief is misplaced) may be inclined to take reckless risks in investing,” he wrote.
Private markets, while possibly containing more clued-up investors than public ones, also have some features which could make them prone to self-reinforcing and irrational behavior. Private markets are dominated by people with a strong interest in private market prices rising, and who face fewer sources of potential friction to block irrational pricing. No short sellers, and heaven knows very few with the motivation to publicly trash deals. Compare that to a private company which can face activists and short-sellers.
The ratchets may simply facilitate deals, but they may also be used to wrench valuations to levels which they otherwise would have trouble reaching.
Public markets may not always play along.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
