Amid much fanfare, Square Inc. went public in an IPO at the New York Stock Exchange on November 19, 2015. Founded in San Francisco by, among others, Jack Dorsey who still runs the company to this day, the company has been part of Silicon Valley’s Unicorn-iverse, reaching billion-dollar status in 2011. Square is a provider of hard- and software enabling merchant businesses to accept card payments. Its signature product is a tiny square-shaped payment card reader which can be plugged into smartphones or tablet PCs.

Since its inception in 2009, Square reached notoriety among industry insiders and the interested public for its rocky valuation road: Within a matter of four short years, Square reached the $1bn-valuation-Unicorn status in its Series C financing round, then saw its (paper-) valuation double from $3bn to $6bn in its Series E round, and then slashed again by 50% to under $3bn at its IPO in November 2015. The IPO pricing was quite volatile as well: the company announced an initial valuation range of $11-13 per share, but went public at an offer price of $9. During the first trading day the stock price jumped to over $14 and finally closed at $13.07. Even by Palo Alto standards, this seemed a bit out of the ordinary.

Since this development is quite remarkable, what happened in detail in Square’s pre-IPO funding rounds? In total, Square received twelve different cash injections. They had Series A-E major Venture financing rounds, one larger debt injection, and six intermediary financing rounds with minor capital injections. Square’s largest source of funding were the Series A-E Venture Capital financing rounds, totaling $519.4mn. Round D was the single largest round with $222.1mn. All other intermediary equity injections were much smaller, oftentimes only in the single-digit million range, as Visa’s investment in April 2011. In April 2014, Square got its first major debt injection, a syndicated loan worth $100mn. In a way, this funding history is representative of the pre-IPO funding structure of many startup and growth companies. What clearly stands out, however, are the aforementioned changes in implied valuation of the company across the different rounds. Series A and B pushed the value up to around $250mn. This happened roughly two years after the company’s inception. The Series C in June of 2011 was the Unicorn-round. Square was valued at $1.6bn (post-money) in a $100mn. round lead by Kleiner Perkins and Tiger Global. About a year later, the value doubled in the Series D round. Rizvi Traverse, Citi Ventures and Crunchfund, among others, injected $222.1mn. to push the value to $3.25bn The value doubled a second time in the Series E round in late 2014. A $150mn. investment by both VC and non-VC investors priced the company at an implied TEV just north of $6bn The development up to this point is not super surprising. A lot of successful Start- and Scale-Ups see their TEVs manifold with every financing round. However, what happened after the Series E round was interesting. The IPO in November 2015, roughly a year after the Series E round, valued the company just south of $3bn For the naked eye, this looks like a 50% drop in value within one short year – and not any year, but the year leading up to the IPO.

The natural question then arises: why was this valuation road rocky? Did investors not know how to value the company because it did not have a proper business model, or perhaps showed strong fluctuations in sales or earnings? The financial history of the company does not support this argument: Since its inception, Square steadily grew its revenues by an average annual growth rate of over 80%, and its operating income margin by over 20%. And in contrast to many of its Start- and Scale-Up peers, Square has a transparent operating business model with a product that generates a small but positive gross margin. Instead, there are some indicators suggesting that the erratic jumps in valuation were perhaps not primarily driven by the company or its intrinsic value, but rather by the specific (contractual) features of the shares that were sold to investors in each funding round.

Pre-IPO investors in Square obtained certain rights with the shares they bought in the different funding rounds. In contrast, IPO investors bought ordinary common stock without such rights. Naturally, shares with different rights attached to them will be priced differently by investors. More and stronger rights will be more valuable, thereby being able to push valuation. In Square, Series E shares offered investors more valuable rights than Series A-D investors – and IPO investors got less valuable rights than all pre-IPO investors. These different rights might therefore be a determinant of the push in valuation at the Series E round, and the sharp drop in valuation at the IPO.

So what were these rights and how could they effect valuation? All Pre-IPO shares sold in the Series A-E rounds were ‘convertible preferred stock’. These shares could be converted into common stock when the company would be sold or went public, and it was preferred in the sense that it had preferred rights, such as liquidation preferences. These rights are mostly the same for all Series A-E investors. Each Series has a 1:1 conversion right of their preferred stock to common stock. This essentially allows the investors to exchange their preferred stock at a 1:1 rate for shares which can be sold in an IPO or traded in public markets. The liquidation preferences are also the same across all Series. In case of liquidation (like the sale of the company), each Series A-E investor obtains the price they originally paid for the stock in preference of all other shareholders. Voting rights do not differ, either. All convertible preferred stockholders are entitled to the number of votes equal to the number of shares of common stock into which the preferred stock is convertible.

However, in spite of all the equality, there is one primus inter pares among the VC investors: the Series E investors. First, they obtain preferential treatment in case of liquidation, meaning that they are paid off first, before Series A-D investors, and all other common stockholders. Second, they obtain the most valuable form of an additional conversion right which is triggered by Square’s IPO. This right essentially guarantees selected pre-IPO investors a minimum stock price. Series A and B investors do not have this right. For Series C investors, the minimum guaranteed price is $6.96, and for Series D it is $13.22. For the Series E investors, the minimum price is set at $18.55, by far the highest of all pre-IPO investors. If this price is not reached, two things happen. First, investors get all of their preferred stock converted to common stock on a 1:1 basis. Second, for each preferred share the investors hold, they get issued an additional number of shares, essentially for free. The number of shares that are issued is calculated based on the difference between the actual offer price and the minimum guaranteed price. Since Series A and B investors did not obtain this right, and Series C investors had a lower guaranteed price than the IPO offer price, this rule only matters for Series D and E investors. And it matters substantially, especially for the Series E investors: without the issuance of additional shares due to the conversion right, Series E investors would have lost almost half their money in IPO share sales (from a $150mn. investment to only $87mn. in proceeds). The conversion right, however, pushes the proceeds to $180mn., a return of roughly 20%. Disregarding all other rights, this right alone makes Series E shares more valuable than Series A-D shares, keeping the intrinsic value of Square constant.

So, in conclusion, what can we learn from that? The implied valuations of young or growth companies in connection with funding rounds are not necessarily meaningful or representative of the company’s intrinsic value at the time they are made. Instead, the valuations might just be driven by the type of security exchanged for cash, or the contractual terms and conditions of the investment. The implied valuations of Square during its Series A-E financing rounds are perhaps not hugely representative of its intrinsic value – at least the delta from Series A-D to the Series E valuation. This is due to the simple fact that the investments were made on different terms and in exchange for different rights which overstated the (paper-) value of the company at the time the investments were made. The aforementioned conversion right is a prime example of that. This also means that Square’s rocky valuation past hasn’t perhaps really been that rocky. If the value of the conversion right would be deducted from the Series E round, it perhaps wouldn’t have doubled Square’s value. Perhaps, it would have even stayed close to $3bn, and the IPO might not have been a down-round.

The preceding post comes to us from Dr. Christian Rauch, a Postdoctoral Researcher and Barclays Fellow in Entrepreneurial Finance at Said Business School, University of Oxford.  The post is based on his recent article, which is entitled “Square, Inc. – Business Model, Venture Financing and Valuation” and available here.