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How Startups Like Square Ratchet Up Their Valuation

Some companies are willing to accept potentially punitive investment terms to gain billion-dollar-plus status.

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Square’s mega-financing round late last year at a $6 billion valuation looked impressive on paper. It was up 20 percent from earlier in the year and almost double from 2012.

But there was more to the story. In order to achieve that valuation, the payments company had to promise investors in the round — including Rizvi Traverse and JPMorgan — that its eventual initial public offering would price at $18.56 a share, 20 percent above the $15.46 they were paying. Failing that, Rizvi and JPMorgan would be rewarded additional stock to make up for the difference.

To summarize, Square, which is currently on the road pitching its IPO to prospective shareholders, guaranteed its latest investors a minimum 20 percent return on their investment.

In Silicon Valley, this sort of measure has been labeled a “ratchet.” The headline valuation number is so important, the thinking goes, that some companies are willing to accept potentially punitive terms to gain billion-dollar-plus status at the expense of all else. But they’re also diluting the equity of their hardworking employees by giving additional shares to investors.

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This article originally appeared on Recode.net.