Much is being made of Square’s recent announcement that their initial public offering may be priced at a 30% discount to their last privately-established valuation. It’s easy to point to this high-profile “down round” and draw rash conclusions about the future prospects of so-called Unicorns and the appetite of the market for tech IPOs. While there are certainly some different factors at play here, I think that the truth is far simpler and more uncomfortable. Square fell victim to the same temptations that have plagued startups over the past few years; they raised too much money at too high of a valuation far too early—behavior that carries with it significant challenges for the company, its outside investors, and its employees.
Overcoming the “hype deficit”
As I’ve discussed before, raising too much money can hurt you. We’ve somehow found ourselves in a situation where every new company that “matters” has to be on a quest to disrupt the universe, rather than simply build a great business. When Square made its debut on the market, it solved a tremendous need for small and mid-sized businesses by making it easy and relatively affordable to accept credit card payments. Unfortunately, when valuation and growth expectations get out of line, it forces companies to build up what I refer to as a “hype deficit.”
Square CEO Jack Dorsey speaks at a news conference in San Francisco, Friday, June 14, 2013. (AP Photo/Jeff Chiu)
Hype deficits represent a gap that businesses have to fill to get from where they are today to a level that justifies their valuation. The core of Square’s business is credit card processing, which has always been somewhat problematic from an economic perspective. Like many other card processors, Square takes a percentage of the overall transaction amount in the form of a fee. This fee, however, has to be shared with banks, credit card companies, and others. Early on, Square actually lost money on each transaction in processed, though their economics improved over time. Still, this model effectively forces Square to play the volume game to generate sufficient revenue to justify its valuation. The trouble is that to do this, Square would have to effectively dominate the entire market. As a result, Square has to seek out diverse revenue opportunities that are non-core to their main business, leading to a trial-and-error that stretches resources thin and confuses the overall strategy. To pursue all of these opportunities, Square has had to raise more and more capital, perpetuating the cycle.
Difficult realities for shareholders
Square’s last private capital raise was at a valuation of about $6 billion. An IPO valuation of around $3.9 billion begs an important question: what happens to investors who participated in the last round? Normally, when a company goes public, all of their outstanding stock classes automatically convert to common stock, meaning that everyone’s shares have the same preferences. In the case of Square, however, things are more complex.
According to a recent prospectus filed by the company, several late-stage investors were guaranteed a return of at least 20% on any IPO, regardless of whether or not the public offering price was lower than the last established valuation. This provision is called a ratchet, and it means that if the IPO price is less than $18.56/share, it will be triggered and the company will be forced to issue additional shares to those investors to comply. The issuance of these additional shares further dilutes earlier investors who, at least in theory, took on more risk.
Difficult realities for employees and founders
To make matters even more messy, many of the late-stage investors who participated at the $6 billion valuations also received what is called a liquidation preference. Liquidation preferences allow certain investors to get paid all of their money back ahead of people who hold common stock, like employees and founders. Liquidation preferences aren’t problematic as long as growth is strong, and valuations continue to increase. However, when a company has to take part in a “down round” and there is less money to go around, common stockholders are often left out in the cold.
The lessons of Square apply to startups of every size. Raising a significant amount of money early on at a high valuation may seem like the right thing to do, but it often lays the foundation for future challenges. The “hype deficit” leads to high expectations and desperation on behalf of the company. Further, dangerous fine print like ratchets and liquidation preferences often protect late-stage investors to the detriment of early shareholders and employees. The best advice I can give to any entrepreneur is to be incredibly careful when raising capital. As with most things in life, the devil is often in the details. When times get challenging, as they often do, those details come back to bite you.