Episode 006 – UNICORN-MANIA – WeWork & its Investors Confront Reality

Introduction

• Welcome to Distilling Venture Capital. I am your host, Bill Griesinger
• Distilling VC is a visionary podcast that provides an insightful and informed view of the key trends affecting the VC and tech startup world. My mission is to cut through and go beyond the hype that tends to dominate the tech landscape. And provide you with information you can use

Opening Observations:

• Hello everyone, and welcome back. I promised you in the prior Episode that I would devote this Episode to distilling down one of the most famous poster-kids for Unicorns-aren't-real; WeWork
• Today, I am going to provide you the insights and analysis that the technology and financial press, investors and others have failed to deliver to you over the last few years regarding this tarnished unicorn.
• To set the stage though, let's do a quick timeline review of WeWork leading up to and then after its failed IPO of Sept. of 2019:
• • WeWork valued itself at a cool $47B by early 2019 and, that in fact would be its valuation leading up to its announced IPO
  • WeWork filed its S-1 and IPO paperwork in mid-Aug. 2019
  • After more than a few I-Banks and others scrutinized its financial condition and bus. model and "questioned" the proposed go-public valuation the Co. made some, shall we say, "adjustments" to its valuation
  • After some consideration, WeWork suggested it would now go public at, uh, $10B-$16B
  • Bam! A greater than 65% vaporization of its valuation in a matter days - amazing
  • Cancelled its IPO in Sept. 2019 when support waned
  • By Oct. 2019, Adam Nuemann asked to step down after discovering a few "corporate governance" problems. He received a total $1.7B golden parachute to go away.
  • Bloomberg opinion writer, Matt Levine, put it this way in a late Oct. 2019 piece, writing tongue-in-cheek suggested how the news was communicated to employees at the time: It was explained, "We had to give him a billion dollars to go away because we couldn't afford to have him stick around," So, his value to the Company was negative a billion dollars.
  • Levine continues, in other words, "We can't pay you for your good work because it was more urgent to pay your boss a billion dollars to stop doing his bad work." Sounds about right.
  • By Oct. 2019, life support was needed. The Co. accepted (as if it had a choice) a Softbank rescue pkg. where SB took control of the Co., valuing it at $8B (about $19/share, which, as it turns out, was still too high)
  • More recently (April 2020), SoftBank pulled the plug on and backed out of a planned tender offer of an addl $3B to bail out, er, I mean plan to shore up, WeWorks shareholders.
  • To a lawsuit; Following the termination of that agreement, WeWork Board voted to sue the only thing that was keeping it alive…SoftBank's money. Great strategy
  • Then came the question; Who should lead the Co. post-A. Nuemann?
  • After being led by such an irreplaceable visionary as Adam Nuemann (according to the S-1), surely a similarly disruptive, forward thinking genius would be required. Or, you could hire this guy: in Feb. 2020 WeWork announced it had named Sandeep Mathrani, a senior executive with RE Company Brookfield Properties, as its new CEO.
  • Wait, what? An experienced RE executive from one of the top companies in the field?

A sordid mess, I know…but this is what passes for reality now when you are dealing in the land of unicorns, right? Things get a little distorted

Let's get back to reality and restore some meaning to this mess:

• I told you my main objective is to cut through the hype that tends to dominate…
• With a bit of cursory, basic diligence, I'll point out and highlight a few of the basic risks of the WeWork bus. model. Something one would have expected from the analysts, I-Banks, INVESTORS, lenders and, oh yeah, the tech and financial press, to have done – but they didn't.
• It's not really that complicated to determine what WeWork is and understand its key business model characteristics.
• The First thing to point out is this; WeWork is not a tech company! News Flash. I know this may come as a rude surprise to many...and despite the narrative and musings of a truly voluminous S-1 to the contrary (> 350 pages), the WeWork vision and version of the co-working ofc. space business is not transforming our consciousness and vision on how we all work…
• What Adam Neumann and WeWork wanted you to believe, however, was that he and his firm were transforming the very way we all work and we're "building community" fostering some new form of "collaboration," and so on
• In other words, if you accept WeWork's view of the world, it's basically like saying your bus. model is the equivalent of "boiling the ocean." Doable? How does that sound as an investment opportunity?
• In the real world, renters of commercial ofc. space desire functionality, convenience and flexibility at a reasonable price – All before this nebulous creating community nonsense. It's common sense and bottom line thinking in which any business must engage. Again, not a new phenomenon or metric of the commercial ofc. space market, correct?

The WeWork Business Model in About Two and a Half Minutes:

• What is the WeWork business model at its core? How does the company actually derive/earn revenue? Let's examine the fundamentals.
• In short, WeWork creates a marketplace for commercial property that seeks to match the supply of commercial office space (from landlords, comm. Bldg. owners, prop. mgt. companies) with space users (those renting) in one place. You know, like Regus, w/o the "cool factor" and Kambuca on tap – and, oh yeah, billions from SoftBank
• So, WeWork signs long term leases on properties and also purchased some properties outright, sometimes just a floor or two in an office building—and transformed it into smaller offices and workstations with common areas, other amenities and offered a basket of shared services.
• Avg. initial lease term is 15 years, according to the S-1 Filing.
• It then rents offices and desks to individuals or groups on relatively short-term agreements, who want the benefits of a fully stocked office with some functional common areas, but without the expense of operating a full office. Sounds reasonable.
• • WeWork calls it clients "Members" and sells Memberships
  • Memberships can be On-Demand; provide access to shared workstations or private spaces as needed, by the minute, by the hour or by the day. "Space-as-a-Service platform.
  • Enterprise Memberships are signed with organizations with 500 or more employees – As of June 2019, WeWork's Enterprise Memberships accounted for 40% of all Memberships
  • Capital expenditures relates to creating Workstation Capacity + other improvements

• WeWork also has utilized the services of a few major third-party Com. RE management firms like JLL and CBRE to facilitate leasing of the space it owns or leases itself.

Risk Assessment:

• So, let's step back for a moment and summarize: WeWork incurs rent liabilities and payment liabilities for its properties that are fixed pmts. and long term. Its revenue, on the other hand, is generated from the short-term contracts it signs with clients, many month-to-month.
• Let's stop here and identify one of the major risks that becomes very obvious in the WeWork business model, has always existed, and is potentially huge? The possibility for a significant C.F. timing mismatch between the long term, fixed payment liabilities WeWork carries on its balance sheet vs the short-term agreements with clients that represent its primary source of revenue and cash flow. (to pay those property liabilities and cover bus. expenses)
• More specifically, the risk I have identified is renewal risk and/or non-payment risk. I don't know the avg. term that clients have signed up for; i.e. renting monthly, for 6 months or a year (to obtain the flexibility they desire)?
• SO, renewal rates are directly dependent upon a firm's ability to provid great service, Completely independent of the mission of "transforming the way we all work, collaborate, etc.
• Presents the classic CF squeeze that can occur if things do not go as planned
• The rent or loan payments are due every month, fixed, for many years. (Avg. 15 years)

• My diligence questions upon reviewing this business risk would include the following:
• • What is the avg term of your rental agreements? i.e. – how long are clients signing up for space on avg? (allows one to see a schedule of lease renewal dates)
  • What is the historical renewal rate experience? (After all, WeWork has been operating under this model since 2014 – it's not new – should be readily available data)
  • Alternatively, What's the churn or non-renewal rate?
  • This analysis, with the historical experience, provides one with a semblance of margins generated and whether there is EVER a path to profitability – and ability to service the lease/debt payment obligations.

• So, that is the WeWork business model in a nutshell – Providing flexible ofc space with some common area, amenities and services...
• How should such a company be valued? Well, like most any company – by the cash flows that it generates from operations…right?

• A basic "smell test," that should have been a reality check, a wake-up call evident to anyone analyzing WeWork was presented by Professor Ilya Strebulav's (Stanford valuation model creator and author) from his June 2016 presentation to the SVOD.
• • Again, please refer to the Show Notes for a link to the video. I highly recommended you watch it.

• Link to Video:

Presentation at SVOD (Sil. Valley Open Doors Conf.), June 19, 2016 by Ilya Strebulav, author of the Study and Professor, Stanford Univ. Grad. School of Business: https://youtu.be/k4OtGWZ3iYI

• Link to Stanford University Study:

Squaring Venture Capital Valuations with Reality - Downloadable pdf found here: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2955455

(Social Science Research Network – SSRN)

• Here is what Professor Strebulav points out in his presentation regarding WeWork:
• • On March 1, (2016) WeWork closed a $430MM round of capital at a post-money valuation of $16B. That is the valuation that the WSJ and others printed and reported the next day as the "value" of the Company
  • He notes that, At this valuation, WeWork would have represented the 3rd most valuable publicly traded ofc landlord (if it were publicly traded). Even though it controlled only small fraction of the sq. footage compared to the leading companies in the sector.
  • Remember, by the time WeWork filed for its IPO, it represented that it was nearly triple that ($47B)
  • Such a valuation makes no financial or intuitive sense…based on what we know of the business model, as practiced by its "peers" in the sector (Regus) – And, set against the sq. footage it operated.

• This valuation it obviously what investors and some I-banks thought they could get leading up to Sept. 2019 when WeWork was indicating a $47B valuation go-public offering.
• A reading of WeWork's S-1 filing, if you could stomach it, is mostly an exercise in fantasy-land thinking.

• What are some of those "other" public firms that WeWork's valuation mirrored or exceeded at the time of its S1?
• • Brookfield Asset Management - CAN (> 152M retail s.f.; 300M s.f. ofc, hotel, apt.; Mtk Cap - $51B; highly profitable)
  • As of June 1, 2019, WeWork's location pipeline included approximately 40 million "usable" square feet, which it estimates could accommodate approximately 724,000 workstations. Again, this is "Pipeline" of "Useable" s.f. not actual rented and under management square footage.

How VCs Make Final Investment Decisions:

• Ask any associate or partner at a VC firm to divulge one of the key criteria they evaluate before making a decision to invest in a tech company – The answer you will receive most often, if not unanimously, is; Quality of the Management Team. Can this team move this co. forward to success?
• I know this b/c I've been asking VCs this question as part of my investor diligence for more than 15 yrs – it's required understanding before our venture debt group would approve making a loan to the companies we considered…VCs bet on management teams in the end…
• It seems this key tenet of the VC decision process was thrown to the wind in the case of WeWork…and many other unicorns.
• Perhaps it was the lure of all the SoftBank dollars pouring in through a firehose? Either way, the process was tainted and distorted.

• Thus, we cannot lose sight of the unmistakable role of SoftBank in fueling this craziness – and the related poor VC decision making – in light of the bankrolling on steroids in which SB engaged – driving up the "on-paper-only" valuations of the companies in its portfolio.
• While examining SoftBank's Vision Fund activities is worthy of an episode of its own… one can certainly read all the commentary and articles on your own…

Failure of the Tech Media:

• Yet, in May of 2019 only a few months before WeWork pulled its IPO, here was PitchBook, with another fawning piece expressing total amazement at the killer valuation growth of some of the most bad-ass unicorns, including WeWork. They were so giddy they could hardly contain themselves..
• In another Weekend Pitch edition, "When your valuation is growing by nearly $1 billion a month, you must be doing something right." [They were referring to DoorDash]
• "It calls to mind a stretch experienced a few years ago by WeWork. Today, WeWork is reportedly worth $47 billion, making it the most valuable VC-backed company in the US."

Amazing, isn't it? Again, no supporting analysis, no bus. model assessment, no risk assessment – just sheer amazement at valuation growth based upon a faulty measure of Value – the post-money valuation!

• And from my last Episode, this is worth repeating - PitchBook Weekend Pitch from Nov. 3, 2019:

"For a long while in and around Silicon Valley, unprofitability was what every startup hoped to achieve. And if losing hundreds of millions of VC dollars was cool, then Adam Neumann was Miles Davis."

• Really? Are you kidding me? This is post-IPO cancellation, post Andy Neumann is toast and post-SoftBank rescue package!
• This is your expert analysis that PitchBook is charging for?
• PitchBook continues, "But these days, in the wake of WeWork's sudden fall from grace, investors are feeling differently. All those years of red ink are finally adding up."

• Again, the only redeeming thing I could take from such a ridiculous statement is that the writer even knows who Miles Davis is. But then I realize, the whole thing is an insult to Miles Davis and our intelligence. Miles Davis was a musical/jazz genius, a master artist. Adam Neumann was a fraud. And the VCs in the WeWork deal should have known this through their diligence.

• Hey, I've got another survey question or two for the VC community that I would ask; 1) is losing 100's of millions of VC dollars a cool thing? 2) Do you agree that every startup hopes to achieve this "unprofitability" status?
• That's what PitchBook suggests…as recently at Q4 2019

• e.g. - CB Insights CEO, Anand Sanwal, opined in an August 2019 piece that it (unicorn status) is often used as a scheme to attract top talent in a very tight hiring market for key tech talent…
• Of course, Sanwal also said this in a June 25, 2019 presentation he gave to partners, investors, supporters: "Blockchain is a buzzword looking for a problem…" Another example of the disconnect…

My Takeaways/Conclusions:

• What can we deduce and learn from all of this?
• This is a bubble in private co. tech stocks – it's an artificial inflation of valuations due primarily to a non-standard, faulty method of applying valuations – the Post Money valuation -
• Bubbles can only be created and progress toward a bursting point if they are embellished and fueled by those perpetuating the non-market, non-fundamentals approach to value. There is no more disconnected phenomenon today in private tech than the post-money valuation.
• Enter SoftBank Vision Fund: They provided the fuel necessary
• Disappointments to share value after tech unicorns go public will be the norm, not the exception.
• Luckily for investors in public companies – we don't have to suffer through trail of tears on WeWork – they didn't make it that far and with good reason…as outlined in this Episdoe.
• Not so lucky, however, for WeWork employees with worthless stock options…

• My Recommendation/proposal: All private tech company valuations should be run through the Stanford Univ. Valuation Model prior to any kind of exit – I believe it should be made an integral part of the S-1 filing process. Or any time the value of a private tech company needs to be certified for audit or other purposes. These companies owe it to their employees who are provided, in many cases, with near worthless Common stock or options for common.

Thank you for joining me for this edition of DVC. I hope you found the topic interesting and useful. I am currently working on the DVC website. In the meantime, Please send questions and your comments regarding today's episode to: bill@ccs.capital

Again, check the links in the Show Notes for the Stanford Valuation Model Study and the video of Prof. Strebulav's 2016 presentation to SVOD…

Stanford University Study - Summary of the Findings – From Study Abstract:

• Developed a valuation model for venture capital-backed companies and applied it to 135 US unicorns - private tech companies with reported valuations above $1 billion.
• Valued unicorns using financial terms from legal filings, finding that reported unicorn post--money valuations average 48% above fair value, with 14 being more than 100% above.
• Every Company reviewed and valued, (100% of the Sample) was overvalued to some degree – that means not one company came in at the post-money valuation utilized by the VC industry
• Values were calculated for each share class, which yields lower valuations because most unicorns gave recent investors major protections such as initial public offering (IPO) return guarantees (15%), vetoes over down-IPOs (24%), or seniority to all other investors (30%).
• According to the authors, "Overvaluation arises b/c the reported valuations assume all of a company's shares have the same price as the most recently issued shares." Even though each new round of funding effectively sucks the value out of prior rounds through seniority and superior rights, among other preferences.