Valuation vs. Market Cap and the Square IPO

(photo courtesy of money.cnn.com)

On November 19th, Square, Inc. entered the public market. Leading up to its IPO, the company valuations quoted by the media were all over the board — $2.4 billion, $2.6 billion, $3 billion, $4 billion, $6 billion… So which one is it?

Because various ways to value a company can get quite technical, misinformation and misunderstanding are inevitable. While taking Square through the process of its initial public offering, I noticed a lot of incorrect assumptions and thought a simple guide would help as others go down the same path.

Valuation can mean so many things. Is it the price an investor is willing to pay right now? Is it based on common shares outstanding, or fully-diluted shares, or fully-diluted shares using the treasury stock method? How do weighted average shares fit into the equation? What do these calculations mean and what are the differences?

Valuation and market capitalization are easily confused. Though they do have similarities, the differences between them can have significant impact on the way we value so-called “unicorns,” particularly in today’s changing tech market. You can’t compare apples to oranges and call the difference dramatic. I’ll explain below.

Private Company Valuation

This is the most common valuation for private start-ups we hear about in the media, and what current “unicorn” statuses are based on. This valuation is based on the price paid per share at the latest Preferred stock round multiplied by the company’s fully diluted shares.

“Fully diluted shares” is defined as:

Common Shares outstanding
+ Preferred Shares outstanding
+ Options outstanding
+ Warrants outstanding
+ Restricted Shares (RSUs)
+ Option Pool (sometimes included)

Using this method, we get to the $6 billion valuation for Square commonly referred to by the media. It is calculated by taking all shares, options, and warrants noted above and multiplying by the latest funding round — the Series E price of $15.46 per share.

Why is this method different than how public companies are valued? Valuing a company using this method is like valuing a concert by taking the price of a front row seat and multiplying it by every seat in the house. A front row seat commands a premium over other seats in the house, and in the case of Square (and many other tech “unicorns” and start-ups), that premium includes preferences upon liquidation, and in some cases guaranteed pricing upon an exit. The preferred shareholders are buying different rights than the common shareholders bought during an IPO roadshow.

But the big thing to keep in mind here is that all outstanding options, warrants and RSUs are included in this number. The importance of this becomes apparent when a company goes from private to public, and valuation then becomes primarily determined by market cap.

Market Capitalization

Market Capitalization or “Market Cap” is the value that public companies are based on. Apple (AAPL), for example, has a market cap of around $662 billion, the largest out there today. Market cap is calculated by taking a company’s outstanding common shares multiplied by its current stock price. In the case of an IPO, this would be the number of common shares outstanding + the number of preferred shares which convert into common upon the IPO + the number of shares sold in the offering, multiplied by the IPO stock price.

Note the difference here. Market cap does not include the options, warrants or RSUs included in private company valuations.

So by comparing a private company valuation to its market cap value once public is a bit like comparing apples to oranges, and differences become especially apparent when there are a significant amount of options outstanding. In Square’s example, let’s call the market cap “apples” and the private company valuation “oranges.” The market cap at the closing stock price on the first day of trading ($13.06) was around $4.3 billion — the apple. If you added up the same amount of shares, options and warrants included in the private valuation noted above and multiplied this by this same closing stock price, you would get around a $5.9 billion valuation — the new orange. A pretty big difference. But remember that the original orange, the private company valuation, was $6 billion. Now you can see that the two oranges aren’t that different after all.

Now that we’ve mastered apples and oranges, let’s throw in a few more tools used in valuation — the Treasury Stock Method and Weighted Average Shares. These calculations are not often reported in traditional media, either because they are not properly understood, or because of a lack of information, but are important indicators of valuation, and therefore worth better understanding.

Treasury Stock Method

This method comes from accounting literature and defines how to convert the outstanding options left out of market cap into your diluted earnings per share (EPS) calculation. The Treasury Stock Method calculates the net common shares potentially created by unexercised “in-the-money” options.

For example, let’s assume that a company currently has in-the-money options for 10,000 shares with an average exercise price of $50. If the current market price is $100, the options are in-the-money, and based on the treasury method, need to be added to the fully diluted EPS denominator. The proceeds the employees holding these options will receive upon sale will be $500,000 ($100 — $50 = $50 x 10,000), which theoretically allows them to purchase 5,000 shares at the $100 current market price ($500,000/$100).

In terms of valuation, banks use this calculation to convert all those outstanding options and warrants not calculated in the market cap into shares of common stock. In our example, the 10,000 options would add 5,000 common shares to your share count. This method doesn’t count every outstanding option as one share, but it doesn’t exclude their impact either (like market cap would), and therefore gives you a valuation somewhere in the middle of the first two methods. Sort of an apple-orange hybrid.

Weighted Average Shares

Here is an entirely different concept that causes additional confusion. Weighted Average Shares is calculated under accounting guidance solely for purposes of the earnings per share (EPS) calculation, and should not be used to value a company. Often, banks, investors or the media take this number from the financials, multiply it by the stock price and call it the valuation. This is incorrect. The weighted average shares number is based on a daily weighted average, so it will always be smaller than the ending amount of outstanding shares, assuming no large buybacks.

Continuing with our Square example, it had around 150 million common shares outstanding before the IPO. On November 19th, all 137 million preferred shares were converted to common shares, as well as 27 million offering common shares. But remember — these new shares are only weighted for a portion of November and December, and were not outstanding the other ten months of the year. So your final weighted average shares outstanding does not simply add these all together, but will weight them to give you a much smaller share number — higher than the 150 million common shares but much lower than the 314 million combined shares (150 million common +137 million preferred +27 million offering). The key here is that weighted average shares and total outstanding shares are different. The weighted average share number should not be used to value a company, and on the flip side, the total outstanding shares should not be used to calculate EPS.

The Takeaway
When valuation numbers are reported to the public without understanding the calculations behind them, and without the context of the differences in calculation methods, swings in tech company valuations can sound like a big deal. The drama makes for a good story. But when you understand the difference between private company valuation and market cap, you can cut through the sensationalism and see that the reality is far less dramatic.

(Disclaimer: This post is intended to be educational and represents my personal views and not of the company. Any and all numbers included above are public information and can be pulled directly from the S1)