For all its power, influence and capital wherewithal, if there is one bus that SoftBank--one of the world's most eccentric tech investor--continues to miss, it is the public market validation for its private market playbook.
If the underwhelming Uber IPO provided a hint for the fund to seek a course correction, the upcoming public market float of another of its portfolio company WeWork stares straight into its face, or rather mocks it. The underwriters for the co-working startup have slashed valuation expectations by nearly half to $15-$20 billion from $47 billion valuation it received in January 2019 during the last round of venture funding.
SoftBank is the largest investor in WeWork and has helped build its real estate empire. It has infused close to $10 billion into the company, including $2 billion in last round of fund raise. If the valuation stands at $15-$20 billion, SoftBank may stand to lose 42-56.5% of value in WeWork.
Shocked at the drastic reduction in valuation expectations, yet again for another portfolio, it is little surprise that SoftBank has been reportedly urging WeWork to shelve its IPO plans. On the other hand, the company, under pressure for more cash due to its high burn rate - of about $3 billion in 3 years - is reportedly moving forward with its IPO plans. A reality check on the part of the investor and a need to fund its growth plans on part of the startup has put the relationship between WeWorks and its biggest benefactor at test.
Watch - We-Works IPO: 'Greater Fool Theory' in play leaving deep-pocketed VCs, such as Softbank, stranded
Such kerfuffle, in a way, is the ultimate report card of the dissonance between private and public markets.
The rationale behind big venture funds paying irrational valuations can be explained by one of the theories of behavioural finance - “The Greater Fool Theory" that argues investors often buy into overpriced assets because they assume that there always be a “greater fool" who is willing to pay more. Clearly, SoftBank which is gearing for the second outing of its massive Vision Fund of about $108 billion does not want to end up as the last investor in line, unable to flip its investments to a ‘greater fool,’ as initial signs of unwinding of the speculative hype around large tech- unicorns emerge.
Venture Capitalists, who are still cautious about using the word "bubble" or the "B" word- as famously referred to in the private VC circles- need to be reminiscent of the fact that financial bubbles manifest three dynamics: the one we’re most familiar with is human greed, the desire to exploit a windfall, and catch a work-free ride to riches. Add a fourth layer to it: nobody believes bubbles can burst until it’s too late to get out unscathed. That reality check is now and has lessons for all.
The WeWork IPO has been headlining all week and not necessarily for all right reasons. Experts and reports suggests that the co-working behemoth had been riding on creative accounting and smart story-telling centered around explosive growth to jack up valuations, with each ensuing round, that did not seem to resonate with public market investors. Broadly, four reasons emerge which have huge lessons for startups as they build out their ventures and what do they need to be cautious of:
a) Perception matters, market signals matters, and timing is important
Public market investors work on perception and market signals, and they have a short memory. In 2019, several popular Unicorns - such as Uber, Lyft, and Slack – flopped in their public market debut that signals to an average ‘Joe’ that such start-ups are over-valued. To be fair, similar platforms (DocuSign, Elastic, FarFetch, to name a few) a year back fared well; most recent perception dictates.
Another perception issue surrounding WeWork is that investors feel its business model resembles that of real estate companies, while valuations are akin to tech-startups. If WeWork is valued using comparable in real-estate space, the tag of $47 billion will fall by a factor of 10x.
b) Math matters in public markets
WeWork valuation is based on a y-o-y revenue growth of 2x, and creative accounting measures for profitability - such as community adjusted EBITDA (that conveniently adds back large part of operating expenses to earnings) - to hide the negative operating margins. Investors, however, are not convinced at the selective number twisting when in fact, losses have ballooned y-o-y at a rate of 2x, and there seems be no clear roadmap to achieve profitability - a point outlined in the prospectus document.
c) Governance issues will reduce investor’s trust
Seasoned professionals have also been critical of the ‘poorly worded’ prospectus, released by We-Works, that reads like a cult document than a sales pitch to potential investors. It also highlights related party transactions and potential conflict of interest as business risks. In fact, there are several murky related party transactions - such as, fee of $5.9 million charged by founder Adam Neumann to use allow the use of word “We," leasing of personal properties of the founder to We-Works for a price and sale of promoter shares ahead of the IPO - all of which erodes investor confidence.
d) Investors will discount a ‘risky’ business model
All aside, investors want to invest in a business model that they could trust will succeed. The WeWork business model is perceived as being over-leveraged and risky. Company acquires properties on long term lease, with average duration of 10 years, and sub-lets spaces on short term contracts, with average duration of a year. It is a classic example of potential asset liability mismatch, and a recipe for failure in event of an economic downturn.
Successful IPOs are timed right, priced right, build on a strong business model and backed by trust-worthy promoters: WeWorks falls short on all accounts, and yet was touted as the second most valuable start-up up until recently. We-Works IPO story has deep lessons for start-ups - on things to avoid in their journey - and might encourage some behavioral shift.
Most tech unicorns that tanked in the public markets recently, have been relying on a “growth" centric story to jack up valuations with each round of VC funding. Public market investors, on the other hand, are math creatures and value “profitable growth." Opacity works for private markets but goes for a toss when one is gearing up to take his/her firm public. The story-telling remains important, but exaggeration and half-truth have to be replaced with data-backed conclusions and forecasts. Stories are important as they build narratives that drive valuations. But they will need to get sharper. In his book ‘Narrative And Numbers’, valuations guru Aswath Damodaran talks about the 3P test for business stories—whether it’s possible, plausible and probable.
One can expect that fast-growing startups will have more conversations in their board rooms, around road to profitability, consolidation and need for consistent improvement in performance, than just around growth driven by VC sanctioned cash burn. The flip side to this, however, is that startups that do not have a clear guidance towards profitability yet, can shelve their IPO plans in near term. In fact, big tech-investors that are already onboard may nudge companies to stay private longer, which may mean that deep-pocketed VCs will continue to fund their cash burning machines, till “bulls" return.
Finally, concerns are playing out on late stage funding and if that pool of capital will come under pressure. Deep pocketed VCs, have more capital than they could reasonably deploy, and thus fears of speculative valuation remain, yet repeat failures of marquee IPOs, such as Uber and WeWork, will be hard to overlook, LPs (investors in such funds) will begin to question the strategy to fund such startups, and that may force powerful investors such as Softbank to course-correct. Less capital to burn and a focus on profitability will mean startups will be expected to run a tighter ship, and focus on bottomline as much as the topline.