WeWork failed IPO – What are the lessons for investors?

WeWork failed IPO – What are the lessons for investors?
 
As the global economy slows and asset valuation rises, it is getting harder to find good investment opportunities in some asset classes such as real estate where there are less value dispersion. Many individual investors are now looking for their next 10x baggers in the venture capital world. Startups and technology companies often grow by taking market share away from larger traditional players, and therefore are less dependent on a growing economy for sales growth. For example, Google experienced its hyper growth period after the tech bubble burst in 2000 by taking share from traditional TV/newspaper media players during the economic downturn in 2001-2004.    
 
Lately, I have been quite active in venture investing and startup advisory. So far this year, I have evaluated tens of venture investment opportunities (both VC funds and startups) around the world (US, Canada, Hong Kong, UK, India, Latam) for clients in various industries including enterprise software, cannabis, quantum computing, autonomous drones, property tech, medical device, biotech and education.
 
I observed that there are many types of high growth companies. These companies are very different from one another in many respects – technology vs. business model innovation, market opportunity, team quality/energy/integrity, customer stickiness, demand cyclicality and valuation. Let’s use a well-known example WeWork for illustration. The recent failed IPO of WeWork is a showcase of a high growth company that investors should avoid. While WeWork has pioneered the new co-working business model and addresses a huge market opportunity, it was clear to me that it was not an attractive investment at $47bn valuation for the following few reasons:
 

1. Capital intensive and unsustainable growth – While WeWork has strong revenue growth (100% y/y in 1H2019) since founding, it was fueled by massive capital investment that is not sustainable. WeWork could also lose these rental revenue stream fairly quickly. WeWork takes long-term lease of office space from landlords and then sub-lease it for the short term. Many WeWork tenants are on a month-by-month lease (non-sticky customers) and can easily rent with another cheaper/better co-working company at any time (low switching costs).
2. Cyclical demand – Commercial office demand tends to be very cyclical in nature especially for the small medium business sub-segment that Wework targets. If a major economic downturn comes, WeWork will be stuck with a very high vacancy rate and lease obligations that it cannot back out of.
3. Corporate governance nightmare – Founder Adam Neumann engaged in numerous activities to profit himself through his control of WeWork. To me, an intelligent person with high energy but low integrity is a toxic combination. WeWork investors and board members (Softbank, Benchmark, Goldman Sachs, Hony Capital, Legend Holding, Benchmark) clearly did not perform their oversight duties over the CEO letting these behaviors proliferate as the company expands over the years. Naumann’s questionable activities include:
   1. Neumann charged WeWork $5.9 million in order to use the “We” trademark that he personally owns when the company rebranded as the We Co. in 2018.
   2. He and his team use WeWork’s Gulfstream private jet to travel the world
   3. He hired many friends/relatives into senior roles or used them as vendors/contractors selling to WeWork.
   4. He has taken loans from WeWork directly. He used the proceeds of these loans to buy properties, which he subsequently leased back to WeWork.  
4. WeWork had inflated private market valuation driven by SoftBank – WeWork’s similar-sized but profitable London-listed competitor IWG has a valuation of US$4.3bn which is <1/10 of WeWork’s $47bn private valuation. Because a startup only needs one lead investor to set the valuation/terms of a financing round, their valuation sometimes does not reflect the view of the rest of the market and can be easily manipulated with a small size investment. Furthermore, private valuations are often inflated due to venture capital investors’ use of protective clause in their preferred shares investments. In the case of the WeWork’s parent company, it was a “partial ratchet” disclosed on page 115 of its S-1 filing. If the stock price comes in below a certain price in the IPO, venture capital investors like SoftBank will receive additional shares as compensation. The issuance of these new shares at the IPO will dilute the ownership of existing common shareholders such as founders and employees. While these protective clauses are fairly common in venture capital investing, they are never discussed as the company would never disclose them until the IPO. Back in January, the media reported that WeWork received a $1bn direct investment from Softbank at an $47bn valuation but never mentioned that Softbank was granted a partial racket. As a private company, WeWork can always selectively disclose information about its financing in order to burnish its image and valuation. 

As the WeWork saga shows, investing in high flying late-stage startups backed by well known VCs does not guarantee a positive return. In fact, many of the high flying unicorns (Uber, Lyft, Slack, SmileDirectClub) that went public this year are now trading below their IPO price.  My takeaway is that it is easy for private investors to pump up unicorn valuation as these are private transactions involving a small number of professional investors only. On the other hand, it is much more difficult to do so in the public markets as listed stocks are traded daily by thousands of professional and retail investors. Listed stocks have a much higher corporate governance standard and information disclosure requirements than private securities. The marketing and trading of listed stocks are restricted and monitored by global regulators to protect the interests of minority shareholders and the public. Private securities have much fewer restrictions as they can only be sold to “accredited investors” i.e. high net worth individuals who are supposed to know what they are doing. 

The Bottom Line

To succeed in venture capital investing as an angel investor, it is important to have a thoughtful methodology to separate the wheat from the chaff among thousands of startups out there all with strong growth potential.  As an ex-engineer and licensed investment professional with 20 years of experience, I have the required science/engineering knowledge and financial market experience to evaluate both startups and listed companies.
 
If you are presented with an attractive investment opportunity to invest in a high growth startup and need to get a second opinion, I would be happy to assist you in your due diligence and investment process.