Investment managers who expected the Square IPO to settle the debate on high private equity valuations have been, so far at least, thoroughly disappointed. Square, Inc. went public on November 17 at just $9 per share and opened debate in a venture community wary of high valuations on whether or not investment terms can compensate for high prices. In other words, do special investor provisions designed to protect late round investors from frothy PE valuations do more harm than good? In our last post on IPOs, we discussed the current imbalance between the public and private markets, in which an exuberance of private equity capital has driven up private valuations and created a dislocation between the privately established value of the firm and the publicly achieved value available at IPO. As a consequence of this phenomenon, IPO activity fell to new lows in the third quarter, as 16% of IPOs downsized their debuts. Square is one of a growing number of companies resorting to equity protections in order to attract late-stage investors, often at the expense of employees and earlier investors.

As most now know, Square is a financial services and mobile payment company founded in 2009 by the CEO of Twitter, Jack Dorsey. The company first broke the unicorn mark in June 2011, in a C Round funding that implied a company valuation of $1.6 billion. In the most recent E round, Square, Inc. was valued at $5.3 billion, with a share price at $15.46 a pop, well in excess of the $9 per share value of the initial public offering. Luckily for most Series E investors, Square’s ratchet provision promised investors a 20% return on their investment – even if the initial offering price fell below the $18.46 required to provide that return. The imbalance in prices would ultimately be “cured” by the additional distribution of 10.3 million shares to all investors protected under the ratchet.

According to the Wall Street Journal, Square, Inc. was forced to choose between the lesser of two evils: either the company could float the higher offering price without triggering the ratchet and potentially driving off public investors unwilling to pay the price, or some of their investors would have to endure dilution. As we said in our last IPO post, terms don’t fix price. Or do they? In the case of Square, there are two camps in the debate on whether the company did the right thing in lowering the offering price and triggering the ratchet provision, or whether they just threw their own employees under the equity participation bus to protect institutional investors.

Those in favor of the $9 per share offering note that Square experienced a more than 45% increase in share price over the course of the day. In an IPO market in which a majority of tech companies are closing day one trading 15% below offering prices, Square’s debut was a rousing success. According to MarketWatch, of the 2,236 IPOs that have priced below the minimum of their filing range since 1980, only 1.6% increased their share price by more than 40% on their first day. Although the triggering of the ratchet was most damaging to Series A through D investors, all investors gained a healthy return on their initial investment. According to Matt Levine from Bloomberg, the ratchet cost investors roughly $55 million, chump change compared to $1.3 billion in gains.

However, the fact remains that Square was unable to price its IPO near its private valuation, leading to growing concerns about the potential reverberations of Square’s pricing on other companies going public. Investors are no longer buying in on the glutinous share prices seen by companies such as Facebook and Twitter. Since going public, Facebook lost $50 billion in market value in only 90 days. Ratchet provisions and similar terms can been seen as a tacit admission that private equity pricing is high, but it’s still debatable whether anyone cares.

And big day-one gains aren’t necessarily anything to be proud of, as money made by investors buying at the IPO comes at the expense of money raised by the company going public. The $9 per share price left nearly $110 million dollars on the table as compared to the $13.09 share price the company closed out at (the price has bounced around some since the offering and was about $12 at the drafting of this blogpost). In addition, the 10.3 million additional shares triggered by the ratchet provision diluted the share base of early investors, primarily employees. Although these first round investors still saw a return on their investment, the dilution threatens company loyalty and increases the risk of talented (and disgruntled) employees jumping ship.

Ratchets and investor protections are quickly becoming the norm among jaded (nervous) investors, with Fenwick & West reporting in the first quarter alone, 30% of private companies valued at $1 billion or more had agreed to give late stage investors some form of a ratchet. At the expense of employees and early investors, the ratchet provision has the potential to undermine company loyalty and drive off talent. You can reallocate returns all day long, but price is (ultimately) a zero sum game. It remains to be seen whether private valuations may normalize and diminish the threat of (eliminate the need for) the ratchet. It appears that the Square IPO may be a turning point in the venture community on many counts.