Big investors in Silicon Valley get to play by different rules than the common rabble. For evidence of this, just take a look at the prospectus filed today by Square, the payments company preparing for an initial public offering.
The institutional investors in Square's most recent round of private financing, completed in the fall of last year, were guaranteed a return of at least 20% in the IPO, the filing showed. This will hold true even if the company prices its IPO at a lower valuation than in that private round.
The investors, including the private equity firm Rizvi Traverse and an arm of JPMorgan Chase, will benefit from a provision they negotiated that is known as a ratchet. Increasingly common in startup financings, ratchets are promises that investors will be issued additional shares if the company's IPO prices at a disappointing value.
In Square's case, investors bought $150 million of stock last year at a price of $15.46 per share, giving the company a reported valuation of $6 billion. What the numbers didn't show was that investors had secured provisions to significantly limit their risk of losing money.
Now, if the IPO doesn't translate to 20% gains for these late-stage investors, Square has promised to issue them enough additional shares to create that return, the filing shows.
The provision is buried in a single paragraph deep into the IPO prospectus. If the IPO prices below $18.56 per share, the ratchet will be triggered, the filing says.
Of course, Square and its investors are all hoping the IPO will price above that level, creating big returns for everybody. And it very well could. But the ratchet comes into play if the IPO doesn't quite meet those hopes.
A spokesperson for Square declined to comment.
This scenario played out recently for Box, the data storage company that went public in January at a lower valuation than in its previous round of private financing.
In that private round, completed in the summer of 2014, Box promised ratchets to the big investment firms that provided it with cash. When the IPO priced at a lower valuation, those investors still made money.
In Square's case, in addition to the ratchet, late-stage investors were promised something called liquidation preferences, the filing shows. This means the investors were guaranteed their money back even if the company were sold at a lower price.
Liquidation preferences are important because they allow investors to get paid before the holders of common stock — including a startup's employees. This becomes a real issue when a company is sold at a lower valuation and there's only so much money to go around.
This type of deal structure has become common practice in Silicon Valley, particularly for later-stage financing rounds. But it's getting an increasing amount of attention from startup founders, given that many companies are declining to go public and opting to raise cash in late-stage private rounds instead.