Square 1 Financial Inc’s IPO: Investors Are Trying to Square the Circle

Shares of Square 1 Financial Inc (NASDAQ:SQBK) vaulting as much as 64% above the $9 value they were priced at initially.

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WASHINGTON, DC — Shares of online payments start-up Square (NASDAQ: SQBK) began trading in the secondary market this morning, vaulting as much as 64% above the $9 at which they were priced in the primary market.

The “pop” in Square’s stock price suggests the shares were mispriced by the initial public offering (IPO) lead managers (Goldman Sachs, Morgan Stanley, and JPMorgan). It appears the banks may have been excessively cautious in setting the price 25% below the midpoint of the $11 to $13 initial pricing range, such that Square left money on the table.

As the company is a high-profile Silicon Valley start-up, Square’s IPO is being heavily scrutinized as an indication of the public market prospects of other so-called “unicorns” (start-up companies that have achieved a valuation exceeding $1 billion in private market financings).

The number of unicorns has ballooned in the past few years, as growth companies are able to access ample funding without having to go public. According to data from The Wall Street Journal and Dow Jones VentureSource, there are now 128 worldwide, roughly two-thirds of which (84) are U.S. companies.

There is a legitimate concern that the availability of such funding and the drive to find the next Facebook has pushed valuations to unsustainable levels. Sitting on top of the unicorn ranking, Uber was valued at a staggering $51 billion in August.

An article published in the Harvard Business Review this week and co-authored by Clayton Christensen asserts that “Uber’s financial and strategic achievements do not qualify the company as genuinely disruptive.” Pr. Christensen pioneered the notion of “disruptive innovation.”

But it’s another concept, also developed by a Harvard Business School professor, that is arguably more important than any other for a business-focused investor: competitive advantage. Try as I may, I cannot find a source of durable competitive advantage for Square.

If I’m right, and if Square is unable to build one, it’s a grave problem for investors: Only companies that possess that advantage will earn above-normal returns on behalf of their owners over long periods.

Make no mistake about it, Square’s sector is highly competitive. In August, Business Insider counted 24 unicorns in financial technology, five of which could be considered direct competitors to Square with regard to payment card readers, online payments processing, or mobile payments. Those include payments processor Stripe, which is headquartered in San Francisco and was valued at $5 billion in July.

This columnist believes that, in time, the offering banks’ caution is likely to prove more consistent with Square’s actual value than the pop the shares are enjoying today. Even with the pop, the stock remains significantly below the $15.66 per share valuation in its last pre-IPO funding rounding. Justifying that valuation now looks like a case of trying to square the circle.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Alex Dumortier has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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