CNBC Disruptor 50

What is Square—or any start-up—really worth?

Source: Smithsonian Institution

Square's mega-financing round late last year at a $6 billion valuation looked impressive on paper. It was up 20 percent from earlier in the year and almost double from 2012.

But there was more to the story. In order to achieve that valuation, the payments company had to promise investors in the round — including Rizvi Traverse and JPMorgan — that its eventual initial public offering would price at $18.56 a share, 20 percent above the $15.46 they were paying. Failing that, Rizvi and JPMorgan would be rewarded additional stock to make up for the difference.

To summarize, Square, which is currently on the road pitching its IPO to prospective shareholders, guaranteed its latest investors a minimum 20 percent return on their investment.

The Twisted Colossus roller coaster at Six Flags Magic Mountain in Valencia, Calif.
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In Silicon Valley, this sort of measure has been labeled a "ratchet." The headline valuation number is so important, the thinking goes, that some companies are willing to accept potentially punitive terms to gain billion-dollar-plus status at the expense of all else. But they're also diluting the equity of their hardworking employees by giving additional shares to investors.

"Entrepreneurs and CEOs are choosing to do this so they can make the company look more valuable," said Lise Buyer, founder of Class V Group, which advises companies as they're preparing to go public. "They're potentially taking money out of their employees' pockets for the sake of appearances."

Want to make sure the valuation this round is much higher than your last? Accept a ratchet. Need a certain price to be worth more than a competitor? There's a ratchet for you too.

From Square's prospectus:

Series E preferred stock contains a provision for the adjustment of conversion price upon a public offering. In the event of such offering, in which the price per share of the Company's common stock is less than $18.55614 (adjusted for stock splits, stock dividends, etc.), then the then-existing conversion price for the Series E preferred stock shall be adjusted so that, as of immediately prior to the completion of such public offering, each share of Series E preferred stock shall convert into (A) the number of shares of common stock issuable on conversion of such share of Series E preferred stock; and (B) an additional number of shares of common stock equal to (x) the difference between $18.55614 and the public offering price, (y) divided by the public offering share price.

Of course, there's much more to the decision than just bravado and bragging rights. Every deal has some degree of nuance and is the product of a negotiation between buyer and seller. For example, an investor may be willing to put in money with a guarantee that an IPO will happen by a certain date. The company may prefer to offer better financial terms to avoid such a time constraint.

Christopher Austin, a lawyer focusing on IPOs and acquisitions at Orrick, Herrington & Sutcliffe in New York, says that with start-ups commanding such high valuations, investors are going to continue turning to ratchets.

"There's enough nervousness in the market right now that we'll probably see more of these," Austin said. "These provisions happen when people feel prices are getting ahead of the actual valuations of companies."

Other newly public companies that have taken ratchets before their IPOs include software developer Box and solar panel installer Sunrun. Among late-stage start-ups, DocuSign and The Honest Company have handed over favorable terms to investors, according to terms published by PitchBook.

Square wraps its roadshow

While no company in a position of strength would willingly sign up for a ratchet, there are a variety of reasons why it may be the right move.

1) Optics and employee churn

Start-up-land is all about momentum. With so many fast-growing Internet companies dotting downtown San Francisco and Palo Alto, California, why does a highly coveted developer want to ride a sinking ship? A sideways or down financing round is seen as a sign of distress. Employees who thought an IPO was going to make them millionaires, or at least provide enough for a down payment on a home, start to see more promising opportunities elsewhere.

It's painful to give away more of your company to investors, but it's worse watching talent flood out the door at a critical juncture, taking employee morale with it.

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2) You're making a bet

Perhaps Square could've raised money at something less than $15.46 a share without the ratchet and thus without the pressure of reaching a certain IPO price. But what if it sold too cheaply and was able to go public at a much higher price? It would then be leaving money on the table.

As it turns out, the price looks like it will be lower, with a current range of $11 to $13. That's what makes it a bet, and that's what makes private market pricing so imperfect. You can't blame Jack Dorsey and his team for taking the bullish view.

3) It's a small amount of equity

At least it should be. In Square's case, assuming a $12 stock price, the midpoint of the range, the company is giving 5.3 million shares to the Series E investors because of the ratchet. That represents only 1.6 percent of shares outstanding after the IPO.

Also, Square raised an additional $30 million last month at the Series E price of $15.46 and without the ratchet, indicating that investors aren't running scared.

Silicon Valley's view of Square IPO

The reality is that once Square starts trading, the stock price will rise and fall based on company performance and macro conditions. Competition from other payments providers, expansion into new businesses like lending and Dorsey's ability to run two public companies simultaneously (the other being Twitter) will matter much more than Square's Series E financing terms.

Square still has plenty to worry about. While it generated $892.8 million in revenue in the first three quarters of this year, the company racked up a net loss of $131.5 million. More than half of Square's revenue goes to cover transaction costs, one of the hazards of running a business through payments networks and card processors.

Regardless of how Square performs, private companies will have to start making the tough choice of whether investor protections are worth the high valuation.

Twitter Chairman Jack Dorsey
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After all, the biggest problem with a ratchet isn't the potential dilution that comes with a lower-priced IPO. But what if the IPO window shuts — because, say, public markets get nervous about the tech sector — and a company has to again tap the private markets? That's when financial engineering can get really messy.

Venky Ganesan, a partner at Menlo Ventures, expects late-stage companies to tighten their budgets and, if possible, avoid raising cash.

"Most companies are saying, `OK, we won't do a financing right now,'" Ganesan said. "More of it is asked and less of it done because the ones that can afford not to do financing are not doing it."