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.