Yesterday, we learned that the latest high profile tech IPO, that of Twitter CEO Jack Dorsey’s payments company Square (SQ), will price at $9, significantly below the indicated range of $11-13. That is no doubt disappointing for Square, but two conclusions that many seem to be drawing from that are not necessarily true. The lower price is not a financial blow to most of the late round investors in all cases, nor is the lower price indicative of problems for tech companies generally. The $9 price reflects a Square problem, not a tech problem.
Most of the late round investors will be protected by what is known as a “ratchet” agreement, which guarantees them a return on their investment by simply issuing them more stock in the event of a lower than expected offering price. That protects them but leaves the latecomers, the investors who buy at or shortly after the IPO, effectively paying for that protection by having their holding diluted.
That would not be a problem if Square was a focused money-making machine, but it is not. I have written before that the problem comes when tech companies go public before they have demonstrated the ability to perform the most basic function of a company: making money.
Square is the latest example of this.
According to filings related to the offering, the company showed significant sales growth from the second half of 2014 to the first half of this year; revenue increased from $371.9 million to $560.6 million. The bottom line, however, barely moved. Losses in H2 2014 were $79.4 million. From January to June this year, Square reported $77.6 million in negative cash flow.
Admittedly it would be more of a red flag if losses actually increased with revenue rather than fell slightly, but there are two reasons that investors should be wary of these numbers. The first is that we have been here before. Back in November of 2013 I pointed out in these pages that the high profile Dorsey led IPO at that time, Twitter (TWTR), faced the same problem. Many were comparing it directly to Facebook (FB), but as I pointed out then there was one fundamental difference; Facebook was profitable at the time it went public, Twitter was not.
What has become known as the Amazon (AMZN) model - the relentless pursuit of growth at the expense of profitability - works well if it is done in the same way as Amazon, which is embarking on it once the ability to turn a profit has been demonstrated. Many lose sight of the fact that AMZN has reported positive EPS in 10 out of the last 12 years. Diversification, when it is funded from retained profits as Google (GOOG) for example has done, can also be good for investors. Running before you can walk, however, is rarely a good idea.
For many the fact that Square’s core payment business is growing rapidly is tempered by worries that they are already losing focus. Getting into the trendy but extremely crowded food delivery business, for example, is hard to see as a positive for the company’s future.
The lower than expected offering price for SQ does further indicate a disconnect between the valuation placed on some tech start ups by private equity investors and the more prosaic view of such companies adopted by the market. That, though, is as it should be. The light that public ownership sheds on young companies is designed to illuminate potential problems. It should, though, be a problem for those private equity firms that invest at inflated valuations, not a comment on the viability of tech start ups in general. As long as those investors are protected against loss by ratchet agreements, however, that is unlikely to change.
Overall the only reasonable conclusion is that the $9 price tag for SQ is disappointing, but simply reflects the real value that those not protected against loss are prepared to put on the company. In other words, this is, as I said, a Square problem, not a tech problem.