Square & the Public Private Valuation Inversion for VC-Backed Unicorns


The Square IPO (ticker is SQ on NYSE) has put the spotlight on the strange inversion of the norm that we saw in 2015. The old rules were that you priced private stock at a discount to public company comparables. This was inverted during 2015 when we briefly priced private stock at a premium to public company comparables. That inversion never made sense and smacked of irrational exuberance. This inversion is ending as we enter 2016 and we now go back to the old rules. The Square IPO shined a spotlight on this and helped return us to the more sustainable old rules.

The irrational exuberance was based – as it always is – on a plausible story. The story is that with nearly half the world’s 7 billion people having a mobile phone, It is easier than ever to reach billions of people over the internet and thus get fantastically high growth rates.  Public market investors like a good story, but they also expect that story will be backed by quarterly results that demonstrate growth both in top line and bottom line.

Square was founded in 2010 and their 2014 Series E private round gave them a $6bn valuation. After their November 2015 IPO they are valued around $4bn. Is that $2bn that somebody lost? Well no, due to the financing rules that sophisticated late stage private investors play by. The Square S-1 shined a spotlight on this by revealing that investors in the Series E had negotiated downside protection through a clause known as a “ratchet”. This means that if Square floated at less than $6bn, these late-stage investors would be given new shares to make up the difference.

Qui Amisit?

Who lost? In Latin this is a qui amisit rather than qui bono analysis.

  • Late stage investors? No, thanks to ratchet they had a guaranteed profit at IPO.
  • Early stage investors, founders and early employees?No, because they invested so far below the $4bn that they did well.
  • Public market traders? They had a wild ride. The IPO was priced at $9, popped to $13, dropped to $11 and as we go to pixel is priced back around $12. Traders like a wild ride – it is how they make money. Yes, some traders lost money but this is zero sum free market economics (aka “tough luck buddy”).
  • Public market investors? Do we still have any public market investors (as opposed to traders)? Investing used to mean getting to know a company and buying shares with an expectation of a return some years later. That patient fundamental public market investing is so deep in the slough of despond that I think it will soon climb out to the plateau of productivity. That is another story, to be covered in a future Daily Fintech research note. Square is at least big enough  at a $4bn market cap not to suffer from the small cap hell discount (below $2bn market cap when you are classed as Micro Cap). At a Price Sales Ratio less than 2, valuation does not seem unduly stretched.

One group that may lose out is employees getting stock options priced at $6bn, but they did get good salaries and did not take any risk, so this could be a minor footnote. However the general marking down of late stage valuations that happens as we end this public private valuation inversion will make it harder to entice talent with stock options.

Facebook is in a league of their own

The other story backing the inversion of private vs public valuation is the story of the Facebook IPO.  The Facebook IPO valuation was nearly double the last private round led by Goldman Sachs at $50bn.

The wrong lesson – even nose bleed valuations in private markets will be rewarded at IPO time. The right lesson – Facebook is a special case, not a comparable.

Looking for bubbles in all the wrong places

Ever since the Dot Com bubble, we have been looking for another tech bubble, but we have been looking in all the wrong places. The Dot Com bubble was based on a premature story – the Internet had not gone mainstream. The next bubble was in property. The current bubble is simply driven by central bank printing and that inflated everything. Tech is no more over valued than anything else (that is damming with faint praise I know).

The re-valuation of private deals and reversion to normal private to public comparables looks like a healthy correction not a bubble bursting.

The key is that we now have enough public market comparables. If you are valuing a private payments venture you have Square and Worldpay and PayPal in public market comparables. As long as those public market comparables are not in bubble territory (they look reasonable to me) then private market valuations will also be reasonable.

Of course, many private market valuations did go crazy in 2015 and the end of the public private inversion will lead to a lot of valuation markdowns in the private market.

I am going to give the last word to Fred Wilson via this extract from his 2016 predictions:

“Markdown mania will hit the venture capital sector as VC firms follow Fidelity’s lead and start aggressively taking down the valuations in their portfolios. Crunchbase will start capturing this valuation data and will become a de-facto “yahoo finance” for the startup sector. Employees will realize their options are underwater and will start leaving tech startups in droves.”

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