Every other week, the Fueled team hosts our own take on a book club. We call it Article Club and we all pop into a big conference room in our SoHo office to debate and discuss ideas and issues affecting tech. The basis of this conversation is 2-3 articles selected by senior members of the team. Articles and notes from each week appear here.
On Tuesday’s Article Club, Fueled’s Venture Director, Aaron Cohen, led the discussion on how a drop in company valuation affects investors, founders, and employees. Aaron used this Wall Street Journal article as a case study in how ratchets can benefit investors at the cost of the company invested in. Ratchets allow investors a larger stake in a company that did not deliver on their value promise. A downround or an IPO that fails to meet expectations can prompt a ratchet, among other triggers.
A downround is a financing round for a company at a lower valuation than the previous round. These downrounds can often cause ‘ratchets,’ which are special terms that reward earlier investors with a bigger stake in the company if valuation expectations are not met. For example, Square’s recent IPO was priced at $9, significantly less than the $15.46 investors paid last year. In response to this tumble in value, Square had to distribute $93 million worth of shares to investors such as J.P. Morgan and Rizvi Traverse. These additional shares “come at the expense of employees and earlier investors who see their stakes diluted.”
The frequency of ratchets among startup fundraising could suggest that there is benefit to overvaluing a young company. It might mean a big reward once this company fails to deliver, which is probable. So, when you see a $1 billion valuation for your favorite startup, think twice.