Thanks to some new data from Silicon Valley law firm Fenwick & West, we’re starting to get a better idea of what the 2016 market for initial public offerings might look like.
It looks like the Square IPO.
Square, a payments company co-founded and led by Jack Dorsey, raised eyebrows when it went public at $9 a share, well below the $15.46 paid by investors in its most recent private round. Well, Fenwick & West did a study of U.S. tech IPOs that did a private financing within three years of their IPO. They found that in 2015, 43 percent of these IPOs priced below their most recent private round.
Similarly, Square activated a rachet provision meant to protect its late-stage investors from an IPO price lower than that of its last private round. Fenwick & West says that a full half of IPOs in 2015 did the same.
Some of those rachets, says Fenwick & West partner Barry Kramer, do more than protect against a decline in price--they're locking in profits for late-stage investors. Although the report doesn't say how many rachets were supposed to lock in profits, as opposed to prevent against losses, Kramer says they were more common in 2015 than in 2014. "You are seeing more investors negotiating for [all kinds of] rachets this year than last year or the year before," he says. "There is more concern as private valuations get high and as public markets get volatile."
The increasing prevalence of these rachets, says Kramer, reflects the changing timeline for startups more than it does any particular lack of investor confidence. In early stage deals investors used to commonly ask for a provision preventing the company from going public for less than a certain price. This usually wasn't considered a huge deal, since the company was a long way from going public and had plenty of time to create value before then.
Now, late-stage investors could be putting their money in relatively close to the date of the IPO. They don't want to block an IPO, but if the price could be below what they paid, they want to be protected. "If you’re investing at $10 billion, it’s very possible [that a] company could go public at $6 billion," says Kramer. "You don't want to block them from going public at $8 billion if that's the right thing to do."
Another trend uncovered by the report is the creation of two different classes of common stock. This is not new--Facebook and Google did this--but it's becoming more common. Just 9 percent of companies in the S&P 100 have a so-called dual class structure, which can allow a founder to keep control well after the IPO, and even after he or she owns a relatively small percentage of the company. Of the venture-backed companies that went public in 2015, 43 percent had dual class common stock, compared to just 15 percent the year before.
It's also worth noting, as the report says, that when companies raise their last round before the IPO, they're valuing their common stock, on average, at 67 percent of the value of their preferred stock.
That sounds arcane, but it has some important implications for valuations, especially of all those unicorn companies that may or may not be about to go public. It means that companies and investors are valuing the provisions given to investors via their preferred stock--rachets and other preferential terms--at a full third of the share price.
So when a private company says it’s valued at $1.5 billion, it very well may be worth that much--but only to its private investors, and to others who hold preferred stock. If the company were to go public that very same day, it might suddenly lose $500 million in value--at least on paper.