Square’s Big Value Gap is in Options

When payments company Square prices its initial public offering late Wednesday, there’s sure to be plenty of analysis comparing its new public market valuation with its most recent private valuation of $6 billion. If its preliminary IPO price range is any guide, Square is expected to be worth only about $3.9 billion when it starts trading.

That expected big drop has helped fuel bearish sentiment towards the private tech sector in recent weeks. But most of the difference between Square’s private and preliminary public valuation numbers was due to how observers count the number of shares the company has outstanding, due to how stock options are treated.

The Takeaway

Private tech companies typically include options and other dilutive securities in their valuations, unlike traditional public company analysis. For example, Square’s widely cited $6 billion private valuation included some $1.7 billion in options and other dilution, filings show. It’s yet another reason comparing private and public market valuations isn’t easy.

The IPO price has limited significance for other reasons, particularly for venture capitalists and other early investors in the company. As is common, most of the early shareholders have to wait six months after the IPO before they can cash out. The flood of more stock coming to market can depress the price at that point (see separate story).

Still, the issue of a company’s share count is worth understanding. It’s a reminder that private and public company headline valuation numbers aren’t comparable, even aside from the fact that private company investors have preferences, such as downside protections, not available to public companies.

In the private market setting, venture capital firms calculate the value of companies by counting all securities that could become shares, including options, restricted stock units, warrants and sometimes option pools reserved for future issuance, as if they were already converted into stock. That way, when they buy a stake in a company, they know how much their stake could be diluted.

In Square’s case, its $6 billion private fundraising valuation was calculated assuming about $1.7 billion in stock options and other securities were turned into shares, public filings show.

But the commonly used public market metric of basic market capitalization–what one might find on Yahoo or Google Finance, and in most media reports about IPO pricing–usually assumes the opposite. Those metrics only count actual shares outstanding at the time of IPO.

Comparing apples to apples shows a drop that isn’t as steep. When looking only at outstanding common and preferred shares, Square’s private fundraising round last year valued the company at $4.3 billion, while an IPO at range midpoint would value it at $3.9 billion.

When looking only at outstanding common and preferred shares, Square’s private fundraising round last year valued the company at $4.3 billion, while an IPO at range midpoint would value it at $3.9 billion.

Alternatively, if you assumed all the options and similar securities were exercised, the IPO midpoint valuation would be $5.7 billion—not that far from Square’s last private valuation of $6 billion. If the IPO is priced above range, it would top the last private valuation using the first method, while merely pricing at the top of the range would top last year’s valuation using the fully diluted method.

Square isn’t the only company in this situation. Pure Storage made headlines last month when its $3.1 billion IPO market cap struggled to top the post-money valuation of $3.2 billion in its last private fundraising. But the latter number included some $900 million in options and dilutive securities excluded from the former, public filings show. In other words, its market cap valuation of $3.1 billion was actually a big increase on the comparable private valuation of $2.3 billion.

Box’s last private valuation of $2.4 billion included some $400 million in dilutive securities not included in its $1.7 billion IPO market cap. In each case, options and dilution accounted for at least 20 percent of outstanding shares. Nor did these dilutive securities go away by the time of the IPO, in fact increasing in number in some cases.

There are a couple ways to think about this: One, it’s yet another reason–on top of investor protections such as “ratchets,” which grant more shares to make up for a drop in share price–to greet private company valuation announcements with skepticism, as outsiders don’t know how much dilution there is and how it’s being counted. Two, commonly cited IPO market cap valuations for many tech companies are flawed, as they leave out a large number of options hanging over the company. Either way, it takes more legwork to compare like with like.

“Ratchets and options can be used to turn a $600 million company into a $1 billion company,” said Aswath Damodaran, a finance professor at NYU’s Stern School of Business.