Tuesday, September 17, 2019

Insights on VC Pricing: Lessons from Uber, WeWorks and Peloton!

As a confession, I started this post intending to write about Peloton, the next big new offering hitting markets, but I got distracted along the way. As I read the Peloton prospectus, with the descriptions of its business, its measure of total market size and its success at scaling up revenues accompanied by large losses, I had a feeling of déjà vu, since other prospectuses that I had read this year from Lyft, Uber, Slack, Pinterest and, most recently, WeWorks, not only shared many of the same characteristics, but also used much of the same language. I briefly considered the possibility that these companies were using a common prospectus app, where given a bare bones description, a 250-page prospectus would be generated, complete with the requisite buzz words and corporate governance details. Setting aside that cynical thought, I think it is far more likely that these companies are emphasizing those features that allowed them to get to where they are today, and that examining these shared features should give us insight into how venture capitalists price companies, and the dangers of basing what you  pay on VC pricing. To keep my write up from becoming too long (and I don't think I succeeded), I will use only Uber, WeWork and Peloton to illustrate what I see as the commonalities in their investment pitches, when I could have spread my net wider to include all IPOs this year.

1. Unbounded Potential Markets
It is natural that companies, especially early in their lives, puff up their business descriptions and inflate their potential markets, but the companies that have gone public this year seem to have taken it to an art form. Lyft, which went public before Uber, described themselves as a transportation company, a little over-the-top for a car service company, but Uber topped this easily, with their identification as a personal mobility company. WeWork, in its prospectus, steers clear of ever describing itself as being in real estate, framing itself instead as a community company, whatever that means. Peloton, in perhaps the widest stretch of all, calls itself a technology, media, software, product, experience, fitness, design, retail, apparel and logistics company, and names itself Peloton Interactive for emphasis.   In conjunction with these grandiose business descriptions, each of the company's IPOs also lists a total addressable or accessible market (TAM) that it is targeting. While this is a measure, initiated with good sense , it has become a buzzword that means close to nothing for these young companies. In the picture below, I have taken the total market descriptions given in the Uber, WeWork and Peloton prospectuses:

If you believe these companies, Uber's TAM is $5.71 trillion spread across 175 countries, and obtained by adding together all passenger vehicle and public transport spending, WeWork is looking at $3 trillion in office space opportunities and Peloton believes that it can sell its expensive exercise bikes and subscriptions to 45 million people in the US and 67 million globally.  

It is no secret that my initial valuation of Uber used far too cramped a definition of its total market, and Bill Gurley rightly pointed to the potential that these companies have to expand markets, but defining the market as broadly as these companies makes a mockery of the concept. In fact, I will draw on a 3P test that I developed in the context of converting stories to numbers, to put these TAM claims to the test;
With Uber, for instance, my initial estimate of the car service market in June 2014, while defining the magnitude of the car services market then, was a constrained TAM and, in hindsight, it proved far too limited, as Uber's pricing and convenience drew new customers into the market, expanding the market significantly. It is a lesson that I have taken to heart, and I do try to give disruptive companies the benefit of the doubt in estimating TAM, erring more towards the expanded TAM definition.  That said, the total market claims that I see outlined in the prospectuses of the companies that have gone public this year, while perhaps meeting the possible test, fail the plausible and probable tests. That TAM overreach makes the cases for these companies weaker, rather than stronger, by making them less credible.

2. All about Scaling (in dollars and units)
All of the companies that have gone, or are planning to go, public this year are telling scaling up stories, with explosive growth in revenues and talk of acceleration in that growth. On this count, the companies are entitled to crow, since they have grown revenues at unprecedented rates coming into their public offerings. 
In short periods, these companies have grown from nothing to becoming among the largest players in their markets, at least in terms of revenues. While this focus on revenue growth is not surprising, since it is at the heart of their stories, it is revealing that all of the companies spend as much, if not, more time talking about growth in their revenue units (Uber riders, WeWork members and Peloton subscribers). 
In fact, each of these companies, in addition to providing user/subscriber members, also provide other eye-popping numbers on relevant units, Uber on drivers and rides taken, WeWork on cities and locations and Peloton on bikes sold. I understand the allure of user numbers, since the platform that they inhabit can be used to generate more revenues. That is implicitly the message that all these companies are sending, and I did estimate a lifetime value of an Uber rider at close to $500 and I could use the model (described in this paper) to derive values for a WeWork member or a  Peloton subscriber. After all, the most successful user-based companies, such as Facebook and Amazon Prime, have shown how having a large user base can provide a foundation for new products and profits. However, there are companies that focus just on adding users, using badly constructed business models and pricing products/services much too cheaply, hoping to raise prices once the users are acquired. MoviePass is an extreme example of user pursuit gone berserk, but it  had no trouble attracting venture capital money, and I fear that there are far more young user-based companies following the MoviePass script than the Facebook one.

3. Blurry Business Models and Flaky Earnings Measures
Most of the companies that have gone public this year have entered the public markets with large losses, even after you correct for what they spend to acquire new users or subscribers. For some investors, this, by itself, is sufficient to turn away from these companies, but since these are young companies, pursuing ambitious growth targets, neither the negative earnings, nor the negative cash flows, is enough to scare me away. However, there are two characteristics that these companies share that I find off putting:
  • Pathways to Profitability: As money losing companies, I had hoped that Uber, WeWork and Peloton would all spend more time talking, in their investor pitches, about their existing business models, current weaknesses in these models and how they planned to reduce their vulnerabilities. With Uber and Lyft, the question of how the companies planned to deal with the transition of drivers from independent contractors to employees should have been dealt with front and center (in their prospectuses), rather than be viewed as a surprise that no one saw coming, a few months later. With WeWork, their vulnerability, stemming from a duration mismatch, begged for a response, and plan, from the company in its prospectus, but none was provided. In fact, Peloton may have done the best job, of the three companies, of positioning themselves on this front, with an (implicit) argument that as subscriptions rise, with higher contribution margins, profits would show up.
  • Earnings Adjustments: As has become standard practice across many publicly traded companies, these IPOs do the adjusted EBITDA dance, adding back stock-based compensation and a variety of other expenses. I have made my case against adding back stock-based compensation here and here, but I would state a more general proposition that adding back any expense that will persist as part of regular operations is bad practice. That is why WeWork's attempt to add back most of its operating expenses, arguing that they were community related, to get to community EBITDA did not pass the smell test.
In summary, it is not the losses that these companies made in the most recent year that are the primary concern, it is that there seems to be no tangible plan, other than growth and hand waving on economies of scale, to put these companies into the plus column on profits.

4. Founder Worship and Corporate Dictatorships
Some time in the last two decades, newly public companies and many of their institutional investors seem to have lost faith in the quid quo pro that has characterized public companies over much of their history, where in return for providing capital, public market investors are at least given the semblance of a say in how the company is run, voting at annual meetings for board directors and substantive changes to the corporate charter. The most charitable characterization of the corporate governance arrangement at most newly minted public companies is that they are benevolent dictatorships, with a founder/CEO at the helm, controlling their destiny, and with no threat of loss of power, largely through super-voting right shares. In fact, most of the IPO companies this year have had:
  • Shares with different voting classes: With the exception of Uber, every high profile IPO that has hit the market has had multiple classes of shares, with the low-voting right shares being the ones offered to the market in the public offering and the high voting right shares held by insiders and the founder/CEO. It is also revealing that Uber was also one of the few companies in the mix where the founder was not the CEO at the time of the IPO, after the board, pressured by large VC investors, removed Travis Kalanick from atop the company in June 2017, in the aftermath of personal and corporate scandals. 
  • Captive boards of directors: I am sure that the directors on the boards of newly public companies are there to represent the interests of  investors in the company and and that many are well qualified, but they seem to do the bidding of the founder/CEO. The WeWork board seems to have been particularly lacking in its oversight of Adam Neumann, especially leading up to the IPO, but it is probably not an outlier.
  • Complex ownership and corporate structures: When private companies go public, there is a transition period where shares of one class are being converted to another, some options have forced exercises and there are restricted share offerings that ripen, all of which make it difficult to estimate value per share. It does not help when the company going public takes this confusion and adds to it, as WeWork did, with additional layers of complex organizational structure.
In many of the companies that have gone public this year, it is quite clear that the company's current owners (founder and VCs) view the public equity market as a place to raise capital but not one to defend or debate how their companies should be run. Put simply, if you are public market investor, these companies want your money but they don't want your input. When faced with that choice with Alibaba, I characterized this as Jack Ma charging me five-star hotel prices, when I check in as an investor in his company, but then directing me to stay in the outhouse,  because I was not one of the insiders.

Reverse Engineering the VC Game
Every company that has come down the IPO pipeline this year has been able to raise ample capital from venture capitalists on its journey, with contributions coming from some public investor names (Fidelity and T.Rowe Price, to name just two). The fact that almost every company that went public this year framed its total market as implausibly big, emphasized how quickly it has scaled itself up, both in terms of revenues and users/subscribers, glossed over the flaws and weaknesses in its business model, and had shares with different voting rights suggests to me that this is behavior that was learned,  because venture capitalists encouraged and rewarded it. Bluntly put, the pricing offered by venture capitalists for private companies must place scaling success over sound business models, over-the-top total addressable markets over plausible ones and founder entrenchment over good corporate governance.

In almost every IPO this year, the basis for at least the initial estimate of what the company would get from the market was the pricing at the most recent VC round, about $66 billion for Uber, $47 billion for WeWorks on the Softbank investment and about $4.2 billion at Peloton. The strongest sales pitch that the company and its bankers seem to be making is that venture capitalists are smart people who know a great deal about the company, and that you should be willing to base your pricing on theirs. This is not very persuasive, because, as I noted in this post, VCs price companies, they don't value them, and the pricing ladder, while it can lead price up, up and away, can also bring price down, when the momentum shifts.  

This is not meant to be a broadside against all of venture capital. As with other investor groups, I am sure that there are venture capitalists who are sensible and unwilling to go along with these bad practices. Unfortunately, though, they risk being priced out of this market, as a version of Gresham's law kicks in, where bad players drive out good ones. In fact, since VC pricing takes its cues from public markets, it will interesting to see if the WeWork fiasco works its way through the VC price chain, leading to a repricing of companies that emphasize revenue scaling over all else. 

A Peloton Valuation
Since I started this post intending to value Peloton, I might as sell include my valuation of the company, especially since the company has released an updated prospectus with an estimated offering price of $26 to $30 per share. The company posits that there will 277.76 million shares outstanding (across voting share classes), but it also very clearly states that this does not include the 64.6 million options outstanding.

Business Model and Accessible Market
The Peloton product offerings started with an upscale exercise bike, but has since expanded to include an even more expensive treadmill; the bike currently sells for about $2,250 and the treadmill for more than $4,000. In fact, if that is all that the company sold, it would have been competing in  a constrained fitness product market with other exercise equipment manufacturers (Nautilus, Bowflex, NordicTrack, Life, Precor etc.). The company's innovation is two fold, first focusing on the upper end of the market with a very limited product offering and then offering a monthly subscription to those who bought, where you can take online classes and access other fitness-related services, with a monthly subscription fee of $40/month. In 2018, Peloton expanded its subscription service to non-Peloton fitness product owners, charging about $20 a month, with a membership count of 100,000 in 2018. The growth in the subscription portion of the business can be seen in the graphs below:

The fitness market that Peloton is going after is large, but splintered, currently with gyms, both local and franchised, and fitness product companies all competing for the pie. In 2019, it was estimated that the total market for fitness products was $30 billion in the United States and close to $90 billion globally.  That said, harking back to our discussion of probable and plausible markets, Peloton is trying to draw people into this market who may otherwise have stayed away and getting existing customers to pay more, hoping to expand the market further. 

Valuation Story and Numbers
I am way too cheap to own a Peloton, but my conversations with Peloton owners/subscribers suggests to me that they have created a loyal customer base, perhaps unfairly likened to a cult. They rave about the online classes and how they keep them motivated to exercise, and while I take their praise with a grain of salt, it is quite clear that the company's online presence is not only polished but looks amazing on the high resolution TV screens that are built into their bikes and treadmills. In my story, I assume that the total accessible market will grow as Peloton and other new entrants into the subscription model draw in new customers, and that Peloton's allure will last, allowing it to grow its revenues over time to make it one of the bigger players in the fitness game. In my base case valuation, I see Peloton's subscription model as their ticket for future growth, pushing revenues by year 10 for the company to just above $10 billion, a lofty goal, given that the largest US fitness companies (gyms and equipment makers) have revenues of $2-$3 billion. I also believe that the shift towards subscriptions will continue, allowing for higher margins and lower capital investment than at the typical fitness company. My valuation is pictured below:
Download spreadsheet
My equity value is $6.65 billion, but in computing value per share, I have to consider the overhang of past option issuances at the company; there are 64.6 million options, with an average strike price of $6.71, outstanding in addition to the 277.76 million shares that the company puts forward as its share count. Valuing the options and netting them out yields a value per share of $19.35, about 20% below the low end of the IPO offering. That does bring me closer to the initial offering price than I got with either my Uber or WeWork valuations, though that is damning Peloton with faint praise. The magnitude of options outstanding at Peloton make it an outlier, even among the IPO companies, and I would caution investors to take these options into account, when computing market capitalizations or per share numbers. For instance, this Wall Street Journal report this morning, after the offering price was set at $26-$29/share, used the actual share count of 277.76 million shares to extrapolate to a market capitalization of $8 billion, at the upper end of the pricing range. That is not true. In fact, if you pay $29/share, you are valuing the equity in this company at more $9.5-$10 billion, with the options counted in.

Is there a great deal of uncertainty embedded in this valuation? Of course! While some argue that this is reason enough to either not invest in the company, or to not do a discounted cash flow valuation, I disagree. 
  • First, at the right price, you should be willing to expose yourself to uncertainty, and while I would not buy Peloton at $26/share, I certainly would be interested at a price lower than $19.35. 
  • Second, the notion that the value of a business is a function of its capacity to generate cash flows is not repealed, just because you have a young, high growth company. If your critique is that my assumptions could be very wrong, I completely agree, but I can still estimate value, facing up to that uncertainty. In fact, that is what I have done in the simulation below:

In terms of base numbers, the simulation does not change my view of Peloton. My median value is $18.30, with the tenth percentile at close to zero and the ninetieth percentile at $38.42, making it still over valued, if it is priced at $26/share. The long tail on the positive end of the distribution implies that I would buy Peloton with a smaller margin of safety than a more mature company, because of the potential of significant upside. (I have a limit buy, at $15/share. Given the offering price of $26-$29, there is little chance that it will execute soon, but I can play the long game).

A Requiem
The flood of companies going public, and their diverse businesses, has made for interesting valuations, but there are also more general lessons to be learned, even for those not interested in investing in these companies. First, our experiences with these IPOs should make it clear that it is the pricing game that dominates how numbers get attached to companies, and that is especially true for IPOs, not just on the offering day, but in the VC rounds leading up to the offering, and in the post-offering trading. Second, to the extent that the pricing game becomes centered on intermediate metrics, say revenue growth or on users or subscribers, it can lead companies astray, as they strive to deliver on those metrics, often at the expense of creating viable business models, and the pricing players (VCs and public investors) can get blindsided when the game changes. As I noted in my long-ago post on Twitter, these companies will face their bar mitzvah moments, when markets shift, often abruptly, from the intermediate users to the end game of profits, and many of these companies will be found wanting.

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Links
  1. Valuation of Peloton (September 16, 2019)
Posts on IPOs this year
Posts on Venture Capital

  1. Venture Capital: It is a pricing, not a value, game!

Monday, September 9, 2019

Runaway Story or Meltdown in Motion? The Unraveling of the WeWork IPO

In a year full of high-profile IPOs, WeWork takes center stage as it moves towards its offering date, offering a fascinating insight into corporate narratives, how and why they acquire credibility (and value) and how quickly they can lose them, if markets lose faith. When the WeWork IPO was first rumored, there was talk of the company being priced at $60 billion or more, but the longer investors have had a chance to look at the prospectus, the less enthusiastic they seem to have become about the company, with a news story today reporting that the company was looking at a drastically discounted value of $20 billion, which would make Softbank, the biggest (and most recent) VC investor in WeWork, a big loser on the IPO. Before I set my thoughts down on WeWork, I will confess that I have never liked the company, partly because I don't trust CEOs who seem more intent on delivering life lessons for the rest of us, than on talking about the businesses they run, and partly because of the trail it has left of obfuscation and opaqueness. That said, I don't believe in writing hit pieces on companies and I will bend over backwards to give WeWork the benefit of the doubt, as I wrestle not only with its basic business model but also with converting that model into a story and numbers.

The WeWork Business Model: A Leveraged Bet on Flexibility
The WeWork business model is neither new, nor particularly unique in its basic form, though access to capital and scaling ambitions have put that model on steroids. That said, most traditional real estate companies that have tried the WeWork business model historically have abandoned it, for micro and macro reasons, and the test of the WeWork model is whether the advantages it brings to the table, and it does bring some, can help it succeed, where others have not.

The Business Model
Most businesses need office space and the way in which that office space is created and provided has followed a standard script for decades. The owner of an office building, who has generally acquired the building with significant debt, rents the building to businesses that need office space, and uses the rent payments received to cover interest expenses on the debt, as well as the expenses of operating the building. As economies weaken, the demand for office space contracts, and the resulting drop in occupancy rates in office buildings exposes the owner to risk. Prudent real estate operators try to buy buildings when real estate prices are low, and sign up credit worthy tenants with long term leases when rental rates are high, thus building a profitability buffer to protect themselves against downturns, when they do come. Even with added prudence, commercial real estate has always been a boom and bust business and even the most successful real estate developers have been both billionaires and bankrupt (at least on paper), at different points of their lives.

The WeWork business model puts a twist on traditional real estate. Like the conventional model, it starts by identifying an attractive office property, usually in a city where office space is tight and young businesses are plentiful. Rather than buying the building, WeWork leases the building with a long term lease, and having leased it, it spends significant amounts upgrading the building to make it a desirable office space for the Gen-X and Gen-Y workers, brought up to believe in the tech company prototype of a cool office space. Having renovated the building, WeWork then offers office space in small units (you can rent just one desk or a few) and on short term contracts (as short as a month). For a given property, if things go according to plan, as the building gets occupied, the excess of rental income (over the lease payment) is used to cover the renovation costs, and once those costs get covered, the economies of scale kick in, generating profits for the company. The steps in the WeWork business model are captured in the picture below:
If you buy into the company’s spin, as presented in its prospectus, the strengths it brings to each stage in the process are what sets it apart, allowing it to win, where others have failed before. In fact, the company is explicitly laying the foundations for this argument with two graphs in its prospectus, one of which maps out its time frame from signing to filling a location and the other which presents a picture, albeit a little skewed, of the profitability of each location, once stable.
Prospectus: Pages 
Note that all we have is the company's word on the timing and its definition of contribution margin plays fast and loose with operating expenses. To illustrate how the WeWorks model works, consider 600 B Street in San Diego, which is an office building that WeWork acquired, renovated and opened in 2017:


In 2019, WeWork claimed that the building was mostly occupied, which should mean that the renovation costs are being recouped, but since the company does not reveal per-building numbers, it is impossible to tell what the company's financials are just on this building. 

The Model Trade off
The model's allure is built on three factors. The first is the WeWork look, with open work spaces, cool lighting and lots of extras, that the company has worked on building over its lifetime and presumably is able to duplicate in a new building, with cost savings and quickly. The second is the WeWork community, where the company supplements its cosmetic features with add-on services that range from business networking to consulting services and seminars. The third is its offer of flexibility to businesses, especially valuable at young companies that face uncertain futures but increasing becoming so even at established companies that are experimenting with alternate work structures. Presumably, these businesses will be willing to pay extra for the flexibility and WeWork can capture the surplus. The model's weakness lies in a mismatch that is at the heart of the business model, where WeWork has locked itself into making the renovation costs up front and the lease payments for many years into the future, but its rental revenues will ebb and flow, depending upon the state of the economy. In fact, the numbers in WeWork’s own prospectus give away the extent of this mismatch, with lease commitments showing an average duration in excess of 10 years, whereas its renters are locked into contracts that average about a year in duration, which I obtained by dividing the revenue backlog by the revenue run rate. This mismatch is not unique to WeWork. You can argue that hotels have always faced this problem, as do the owners of apartment buildings, but WeWork is particularly exposed for four reasons:
  1. Own versus lease: There is an argument to be made that owning a property and leasing it is less risky than leasing the property and then sub-leasing it, and it is not because buying a property does not give rise to fixed costs. It does, in the form of the debt that you take on, when you buy the property, but borrowing & buying comes with two advantages over leasing. First, when buying a property, you can decide the proportion of value that comes from equity, allowing you to reduce your financial leverage, if you feel over exposed. Second, if the property value of a building rises after you have bought it, the equity component of value builds up implicitly, reducing effective leverage, though if property values drop, the reverse will occur.
  2. Explosive growth: As we will see in the next section, WeWork does not just have a mismatched model, it is one that has scaled up at a rate that has never been seen in the real estate business, going from one property in 2010 to more than 500 locations in 2019, adding more than 100,000 square feet of office space each month. This global growth has given rise to gigantic lease commitments, which combined with its operating losses in 2018, make it particularly exposed.
  3. Tenant Self-selection: By specifically targeting young companies and businesses that value flexibility, the company has created a selection bias, where its customers are the ones most likely to pull back on their office rentals, if there is a downturn.
  4. Lack of cost discipline: Companies that have historically been exposed to the mismatch problem have learned that, to survive, they need to have cost discipline, keeping fixed cost commitments low and adjusting quickly to changes in the environment. While it is possible that WeWork is secretly following these practices, their prospectus seems to suggest that they are oblivious to their risk exposure.
It is worth noting that the WeWork business model has been tried in real estate before, with calamitous results. As Sam Zell, a billionaire with deep roots in real estate, noted on CNBC, on September 4, 2019, not only did he lose money investing in a business model like this one in 1956, but every company in the office space subletting space that existed then went out of business.

The Back Story
To understand where WeWork stands today, I started with the prospectus that the company filed on August 14. While this filing may be updated, it provides a basis for any story telling or valuation of the company.

1. Operations
The financials reported in a company clearly paint a picture of growth in the company, as can be seen on almost every operating dimension (cities, locations, tenants, revenues).

While the growth represents the good news part of the story, there is bad news. Accompanying the growth in locations and revenues are losses that have grown to staggeringly large amounts by 2018.
EBITR= EBIT + Lease Expense, EBITR&PO = EBITR + Non-lease pre-opening expenses
One argument that the company may make for its losses is that they are after operating lease expenses (which are financial expenses, i.e., debt) and pre-opening location expenses (which are capital expenses). Adjusting for these expenses make the losses smaller, but they still remain daunting.

2. Leverage: The Leasing Machine
The WeWork business model is built on leasing properties, often for large amounts, with a long-period commitment, and not surprisingly, the results are manifested in lease commitments that represent a mountain of claims that the company has to cover before it can generate income for equity investors. The graph below captures the lease commitments that WeWork has contractually committed itself to for future years, and how much these commitments represent in equivalent debt:
Prospectus
Brought down to basics, WeWork is a company that had $2.6 billion in revenues in the twelve months ending in June 2019, with an operating loss of more than $2 billion during the period, and debt outstanding, if you include the conventional debt, of close to $24 billion. Note that this leverage is built into the business model and will only grow, as the company grows. The hope is that as the company matures, and its leaseholds age, they will turn profitable, but this is a model built on a knife’s edge that, by design, will be sensitive to the smallest economic perturbations.

3. Issuance Details
To value an initial public offering, you need three additional details and at the moment, information on at least two of the three details is not fully disclosed, though it will be made public before the offering.
  • Magnitude of Proceeds: While the company has not been explicit about how much cash it plans to raise in the IPO, rumors as recently as last week suggested that it was planning to raise about $3.5 billion from the offering. Of course, that was premised on a belief that the market would price their equity at about $45-$50 billion and that may change, now that there are indications that it may have to settle for a lower pricing.
  • Use of Proceeds: In the prospectus (page 56), the company says that it intends to use the net proceeds for general corporate purposes, including working capital and capital expenditures. In effect, there seem to be no plans, at least currently, for any of the existing equity owners of the firm to cash out of the firm, using the proceeds. 
  • Dilution: There will be additional shares issued to raise the planned proceeds, and the offering price will determine the share count. There will be circularity involved, because the proceeds, since they will stay in the firm, will increase the value of the firm (and equity) by roughly the amount raised, and thus the value per share, but the value per share itself will determine how many additional shares will be issued and thus the share count.
I will do my initial valuation with the rumored $3.5 billion proceeds amount and use the estimated value per share to adjust share count, but these numbers will need to be revisited, once there is more concrete information.

4. Corporate Governance: Founder Worship and Complexity
In keeping with what has become almost standard practice for companies going public in the last decade, WeWork has muddied the corporate governance waters by creating both a complex holding structure and share classes with different voting rights. Let's start with the holding structure for the company:
Prospectus: Page
In particular, note the carve out of a separate company (ARK) which will presumably buy real estate and lease it back to We and the region-specific joint ventures, where the company collects management fees. I am not quite sure what to make of the partnership triangle at the center, where it looks like the company will be partnering with it's own managers (with the founder/CEO presumably leading the way) to run WeWork Company. I have to compliment the company's owners and bankers, and it is a back-handed compliment, for managing to create more complexity in a couple of years than most companies can create in decades. Some of this complexity is probably due to tax reasons, in which case the company is behaving like other real estate ventures in putting tax considerations high up on its list of decision-drivers. Some of the complexity is to protect itself from the downside of its own lease-fueled growth, where the company can maintain the argument that since its leases are at the property-level, and the properties are structured as nominally stand-alone subsidiaries, it is less exposed to distress. That is fiction because a global economic showdown will lead to failures on dozens, perhaps hundreds, of lease commitments at the same time, and there is no protective cloak for the company against that contingency. A great deal of the complexity, though, has to do with the founder(s) desire for control and potential conflicts of interests, and investors will have to take that into account when valuing/pricing the company.

On the governance front, the company’s voting structure continues the deplorable practice of entrenching founders, by creating three classes of shares, with the class A shares that will be offering in the IPO having one twentieth the voting rights of the class B and class C shares, leaving control of the company in the hands of Adam Neumann. In fact, the prospectus is brutally direct on this front, stating that “Adam’s voting control will limit the ability of other stockholders to influence corporate activities and, as a result, we may take actions that stockholders other than Adam do not view as beneficial” and that his ownership stake will result in WeWork being categorized as a controlled company, relieving it of the requirement to have independent directors on its compensation and nominating committees.

Valuing WeWork
As I mentioned at the top of this post, I fundamentally mistrust the company, but I am not willing to dismiss its potential, without giving it a shot at delivering. In creating this narrative, I am buying into parts of the company’s own narrative and here are the components of my story:
  • WeWork meets an unmet and large need for flexible office space: The demand comes both younger, smaller companies, still unsure about their future needs, and established companies, experimenting with new work arrangements. There is a big market, potentially close to the $900 billion that the company estimates.
  • With a branded product & economies of scale: The WeWork Office is differentiated enough to allow them to have pricing power, and higher margins.
  • And continued access to capital, allowing the company to both fund growth and potentially live through mild economic shocks. That access, though, will be insufficient to tide them through deeper recessions, where their debt load will leave them exposed to distress.
This story translates into three key operating inputs:
  1. Revenue Growth: I will assume that revenues will grow at 60% a year, for the next five years, scaling down to stable growth (set equal to the riskfree rate of 1.6%) after year 10. If this seems conservative, given their triple digit growth in the most recent year, using this growth rate results in revenues of approximately $80 billion in 2029.
  2. Target Operating Margin: Over the next decade, I expect the company’s operating margins to improve to 12.50% by year 10. That is much higher than the average operating margin for real estate operating companies and higher than 11.04%, the average operating margin from 2014-2018 earned by IWG, the company considered to be closest to WeWork in terms of operating model. For those of you persuaded by the company’s argument that its locations make a 25% contribution margin, note that that measure of profitability is before corporate expenses, stock-based compensation and capital maintenance expenditures.
  3. Reinvestment Needs: The business will stay capital intensive, economies of scale notwithstanding, requiring significant investments in new properties and substantial ones in aging properties to preserve their earning power. I will assume that each dollar of additional capital invested into the business will generate $1.68 in additional revenues, again drawing on industry averages. (Currently, WeWork generates only 11 cents in revenues for every dollar invested, but in its defense, many of its locations are either just starting to fill or are not occupied yet.)
From my perspective, this seems like an optimistic story, where WeWork generates pre-tax operating income of 10.07 billion on revenues of $80.5 billion in 2029, generating a 26.61% return on capital on intermediate capital investments. Allowing for a starting cost of capital of about 8%, the resulting value for the operating assets is about $29.5 billion, but before you decide to put all your money in WeWork, there are two barriers to overcome:
  1. Possibility of failure: The debt load that WeWork carries makes its susceptible to economic downturns and shocks in the real estate market, and the cost of capital, a going concern measure of risk, is incapable of capturing the risk of failure embedded in the business model. I will assume a 20% chance of failure in my valuation, and if it does occur, that the firm will have to sell its holdings for 60% of fair value.
  2. Debt load: As I noted in the last section, the company has accumulated a debt load, including lease commitments, of $23.8 billion. 
Adjusting for these, the resulting value of equity is $13.75 billion, and with my preliminary assessment of shares outstanding, translates into a value per share of about $26/share.
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I am sure that I will get pushback from both directions, with optimists arguing that the unmet demand for flexible office space in conjunction with the WeWork brand will lead to higher revenue growth and margins, and pessimists positing that both numbers are overstated. In response, here is what I can offer:
If you are puzzled as to why the equity value changes so much, as growth and margins change, the answer lies in the super-charged leverage model that WeWork has created. To the question of whether WeWork could be worth $40 billion, $50 billion or more, the answer is that it is possible but only if the company can deliver well-above average margins, while maintaining sky-high growth. That would make those values improbable, but what should terrify investors is that even the $15 or $20 billion equity values require stretching the assumptions to breaking point, and that there are a whole host of plausible scenarios where the equity is worth nothing. In fact, there is an argument to be made that if you invest in WeWork equity, you are investing less in an ongoing business, and more in an out-of-the-money option, with plausible pathways to a boom but just as many or even more pathways to a bust.

Storytelling's Dark Side: The Meltdown of Runaway Stories
Valuation is a bridge between stories and numbers, and for young companies, it is the story that drives the numbers, rather than the other way around. This is neither good nor bad, but a reflection of a reality which is that bulk of value at these companies comes from what they will do in the future, rather than what they have done in the past. That said, there is a danger when stories rule, and especially so if the numbers become props or are ignored, that the pricing that is attached to a company can lose its tether to value. In 2015, I used the notion of a runaway story to explain why VC investors pushed up the price of Theranos to $9 billion, without any tangible evidence that the revolutionary blood testing, that was at the basis of that value, actually worked. In particular, I suggested that there are three ingredients to a runaway story:
With Theranos, Elizabeth Holmes was the story teller, arguing that her nanotainers would upend the (big) blood testing business and in the process, make it accessible to people around the world who could not afford it. Investors, Walgreens and the Cleveland Clinic all swooned, and no one asked questions about the blood tests themselves, afraid, perhaps, of being viewed as being against making the world a healthier place. For much of its life, WeWork has had many of the same ingredients, a visionary founder, Adam Neumann, who seems to view the company less as a business and more as a mission to make the business world a little more equal by giving the underdogs (young start-ups, entrepreneurs and small companies) a base, at least in terms of office space and community support, to fend off bigger competitors. It is no surprise, therefore, that the company describes its clients as community and members and that the word "We" carries significance beyond the company name. Along the way, the company was able to get venture capitalists to buy in, and the pricing of the company reflects its rise:
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The list of investors includes some big names in the VC and money management space, indicating that the runaway story’s allure is not restricted to the naïve and the uninitiated. Note also that one of the last entrants into the capital game was Softbank, providing a capital infusion of $2 billion in January 2019, translating into a pricing of $47 billion for the company's equity. In sum, Softbank’s holdings give it 29% of the equity in the company, larger even than Adam Neumann’s share.

As we saw with Theranos, in its rapid fall from grace, there is a dark side to story companies and it stems from the fact that value is built on a personality, rather than a business, and when the personality stumbles or acts in a way viewed as untrustworthy, the runaway story can quickly morph into a meltdown story, where the ingredients curdle:
Once investors lose faith in the narrator, the same story that evoked awe and sky-high pricing in the runaway model starts to come apart, as the flaws in the model and its disconnect with the numbers take center stage. With WeWork, the shift seems to have occurred in record time, partly because of bad market timing, with the macro indicators indicating that a global economic showdown may be coming sooner rather than later, and partly because of its own arrogance. In fact, if you were mapping out a plan for self-destruction, the company has delivered in spades with:
  1. CEO arrogance: For someone who is likely to be a multi-billionaire in a few weeks, Adam Neumann has been remarkably short sighted, starting with his sale of almost $800 million in shares leading into the IPO, continuing with his receipt (which he reversed, by only after significant blowback) of $6 million for giving the company the right to use the name “We”, and the conflicts of interest that he seems to have sowed all over the corporate structure. 
  2. Accounting Game playing: WeWork’s continued description, with more than a 100 mentions in its prospectus, of itself as a tech company is at odds with its real estate business model, but investors would perhaps have been willing to overlook that if the company had not also indulged in accounting game playing in the past. This is after all the company that coined Community EBITDA (https://www.bloomberg.com/opinion/articles/2018-04-27/wework-accounts-for-consciousness), an almost comically bad measure of earnings, where almost all expenses are added back to derive arrive at earnings. 
  3. Denial: Since even a casual observer can see the mismatch that lies at the heart of the WeWork business model, it behooves the company to confront that problem directly. Instead, through 220 pages of a prospectus, the company bobs and weaves, leaving the question unanswered.
While these are all long standing features of the company, I think that if pricing is a game of mood and momentum, the mood has darkened during this period, and it came as no surprise when rumors started a couple of days ago that the company was considering slashing its pricing to $20 billion a lower. That is an astounding mark down from the initial pricing estimate, but it suggests that the company and its bankers are running into investor resistance.

What is the end game?
As WeWork stumbles its way to an IPO, with the very real chance that it could be pulled by its biggest stockholders (Neumann and Softbank) from a public offering, the question of what to do next depends upon whose perspective you tak.
  1. If you are a VC/equity owner in WeWorks, your choice is a tough one. On the one hand, you may want to pull the IPO and wait for a better moment. On the other, your moment may have passed and to survive as a private company, WeWork will need more capital (from you).
  2. As an investor, whether you invest or not will depend on what you think is a plausible/probable narrative for the company, and the resulting value. I would not invest in the company, even at the more modest pricing levels ($15-$20 billion), but if the price collapsed to the single digits, I would buy it for its optionality.
  3. If you are a trader, this stock, if it goes public, will be a pure pricing game, going up and down based upon momentum. If you are good at sending momentum shifts, you could take advantage. 
  4. If you are a founder/CEO of a company, the lesson to be learned from this IPO is that no matter how disruptive you may perceive your company to be, in a business, there are lessons to be learned from looking at how that business has been run in the past. 
The saying that those who do not know their history are destined to repeat it seems apt not just in politics and public policy, but also in markets, as companies rediscover old ways to make money, and then find anew the flaws that put an end to those ways.

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