Why Square’s IPO Flop Is Good for Investors

The alarm bells were blaring in Silicon Valley last week when digital payments processor Square Inc. (SQ) priced its IPO at $9.

That’s a 25% discount to the midpoint of the proposed $11 to $13 per share range – and a hefty 42% lower than its latest private equity funding round at $15.46 per share.

Okay, so what? The IPO missed the mark – it happens.

Well, the news had tech analysts fearing that it would set a dangerous precedent. Namely, that it would prevent more than 140 unicorn companies from going public.

What are “unicorn companies”?

Basically, they’re private tech startups with valuations north of $1 billion.

Heck, the most apocalyptic pundits went as far as suggesting that Square’s IPO flop would bring about the complete extinction of tech unicorns.

Puh-lease!

If anything, Square’s IPO pricing is a healthy development and a potential blessing for everyday investors like us, not a harbinger of some Techpocalypse.

Here’s why…

Hitting the Valuation Reset Button

As Bloomberg View’s Matt Levine points out, “valuing companies is hard.”

That’s especially true for fast-growing, early-stage technology companies.

We’ve recently seen a healthy debate rage over private market valuations for tech companies. The consensus sentiment is that companies are definitely skewed towards being overvalued.

That’s fine… but here’s the thing: An IPO is a check-and-balance in the system. It’s merely a pricing mechanism that provides an opportunity to hit the “reset” button on a company and its valuation, if necessary.

That’s clearly what happened with Square. But it’s not the only one.

I expect the trend to continue, too.

I know… I’m suggesting that a bout of rational behavior is actually going to sweep over capital markets, which is admittedly atypical. However, evidence is piling up in support of it. At least in the tech sector.

Mutual Funds Cutting Back

Not only are IPOs like Square and Match Group Inc. (MTCH) getting priced at lower valuations, large mutual fund investors are pre-emptively marking down the value of their private holdings, too.

For example…

  • Earlier this month, Fidelity Investments wrote down the value of its stake in Snapchat by 25%, according to Morningstar.
  • The $13.3 billion T. Rowe Price Global Technology Fund and the $1.4 billion Hartford Growth Opportunities Fund are also proactively marking down their tech investments.

These actions speak louder than any of my predictions.

For the record, though, I’m not the only one who expects saner times ahead.

Survival of the Funded

Ken Polcari, Director at O’Neil Securities, says, “You’re going to see some of them [tech unicorns] become more conservative in their pricing because it makes sense.”

I couldn’t agree more.

Remember, the goal of an IPO is to raise money in order to expand and continue operations. Postponing a deal prevents that from happening. So even if it means pushing ahead at a lower valuation, companies are going to just do it.

Or as famed venture capitalist Fred Wilson puts it, “Sometimes, you just need to get the deal done. When you’re burning through cash and need to finance your company, the terms might suck, but the cash doesn’t. So you do the deal and live to fight another day.”

We’re not at a point where early investors are going to vehemently oppose such behavior, either.

Thanks to liquidation preferences, they’re still guaranteed to get their money back, and then some.

In fact, law firm Fenwick & West LLP estimates that at least 30% of unicorn companies have agreed to some form of ratchet with investors – basically, a form of protection that allows early investors to retain their initial stake and value if subsequent funding rounds are lower.

In Square’s case, the last round of private investors were guaranteed a 20% return, so they’ll receive an extra 10.3 million shares of the company.

Here’s how this could end up benefiting us…

This Is the Beginning, Not the End

As I’ve written before, IPOs are rigged to maximize value for existing owners and private investors.

As for everyday investors like us? We’re counted on to be the bag holders – the naïve, unsophisticated ones, rushing in to scoop up newly minted public company shares so the former groups can realize handsome profits.

When valuations get stretched, the financial risks to us only increase. And that’s why I typically recommend avoiding hot IPOs – like I did with Groupon and Zynga.

However, if we’re entering a period of saner valuations, tech IPOs are bound to be less risky and, dare I say it, could ultimately become compelling opportunities for everyday investors.

So the skepticism over tech company valuations and the corresponding IPO resets like Square’s are anything but the end of the world. Instead, they could actually mark the beginning of a profitable investment trend for us.

Rest assured, I’ll be following the situation closely and will alert you of any irresistible opportunities.

Ahead of the tape,

Louis Basenese

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