Unicorns, Busted IPOs & the Specter of Insider Trading

“A million dollars isn’t cool. You know what’s cool?…A billion dollars valuation.”

These words were uttered by a fictionalized version of Sean Parker in the blockbuster film The Social Network and these words almost seem to be the siren call for startup founders today – be “cool” by getting a billion dollar valuation for their business. The tag, unicorn, is given to those purportedly rare species of startup companies that have achieved this valuation pre-IPO.  And it seems we are seeing more and more unicorns in the media spotlight recently. Because of this media attention, some startup founders and early investors actively seek to sell small percentages of stock at higher prices in order to obtain a billion dollar-plus valuation.

To achieve this valuation, a corporation could simply sell 5% of its equity for $50 million to get a $1 billion post-money valuation: welcome to the unicorn club! The attention attached to billion dollar valuation gives the appearance of a strong operating business [“fake it ’til you make it”] and likely increases the demand for the corporation’s stock at its initial public offering (“IPO”). I’ve always wondered why would sophisticated investors, especially those who had already invested in a hot startup in earlier rounds, invest at significantly higher prices per shares in later rounds?

Well, the Square IPO may have given us all a peek as to why some late-stage private investors are willing to invest at certain prices to create a unicorn and raises some interesting conflict of interest issues.

According to its prospectus, Square disclosed that:

“Series E preferred stock contains a provision for the adjustment of conversion price upon a public offering. In the event of such offering, in which the price per share of the Company’s common stock is less than $18.55614 (adjusted for stock splits, stock dividends, etc.), then the then-existing conversion price for the Series E preferred stock shall be adjusted so that, as of immediately prior to the completion of such public offering, each share of Series E preferred stock shall convert into (A) the number of shares of common stock issuable on conversion of such share of Series E preferred stock; and (B) an additional number of shares of common stock equal to (x) the difference between $18.55614 and the public offering price, (y) divided by the public offering share price.” (See Square Prospectus, Note 13, p. F-34).

Although some considered Square’s IPO pricing to be a bust, others made significant coin as a result.  Since Square’s IPO was priced at $9 per share, JPMorgan, one of the Series E investors and one of the underwriters of Square’s IPO, received twice as many shares as JPMorgan would have received if Square IPO was priced about $18.56. So by pricing the Square IPO at $9, the Series E investors, who had received 9.7 million shares for their $150 million investment ($15.46 per share), are now receiving an addition 10.3 million shares por nada.  This fact alone would not necessarily be an issue if JPMorgan had not participated in the IPO pricing process. Well, technically, J.P. Morgan Securities, LLC, who acted as a representative of an underwriter, participated in the Square IPO pricing process:

“The initial public offering price has been negotiated among us, the selling stockholder, and the representatives. Among the factors to be considered in determining the initial public offering price of the shares, in addition to prevailing market conditions, will be our historical performance, estimates of our business potential and earnings prospects, an assessment of our management, and the consideration of the above factors in relation to market valuation of companies in related businesses.” (See Square’s Prospectus at pp. 190-192).

Presumably, the entities most knowledgeable of “prevailing market conditions” are the investment banks whose business is to trade in these markets.  Notably, when Square closed for trading, its share price was $13.07 per share, in line with the expected $11-13 offering price range [markets sure seem efficient].  $13 times the 10.3 million additional shares received as a result of pricing Square at $9 ultimately put an additional $134 million in pockets of the Series E investors, which includes JPMorgan [not a bad day in the office]. Even though the Series E investors are down about $2 per share as of the IPO’s first day of trading, Series E investors made a net profit of 73% overall.  Securities practitioners in the large investment banks should make sure there are adequate Chinese Walls (safeguards) during the IPO pricing process to avoid any appearance of impropriety.

A provision such as the one highlighted in this blog post is known as a “Ratchet” clause. Ratchet clauses are pro-investor anti-dilution clauses that protect investors from declines in implied valuations due to future investment rounds (sometimes referred to as a “down round”).  Nothing is inherently wrong with these clauses as long as startup founders understand the potential dilutive effect if there’s a down round.  As the Square IPO has demonstrated, ratchet clauses may explain one of the reason why a private investor may be willing to invest at a high valuation.