WeWork’s Aftermath: Success as a Momentum Bet

Well, that was interesting. WeWork, which was once valued at $47bn (this was not a real number), and whose bankers touted IPO valuations of up to $60bn (this was, if anything, an even less real number) is likely to be recapitalized by SoftBank at a valuation of closer to $8bn.

This is not the outcome I expected a few months ago, when I wrote up WeWork at length. My thesis then:

  • WeWork as a business not as disastrous as everyone thinks. However, they’ve obscured their unit economics, so it’s hard to say. What we can say is that WeWork has demonstrated the ability to get tenants to pay top dollar for very little space, so if — a big “if” — they can get other costs under control, the underlying business has a competitive advantage.
  • WeWork’s corporate governance is weak, but mostly because tech companies’ corporate governance is pretty good; for a commercial real estate operator, it’s not crazy.
  • A bet on WeWork is a bet on Adam Neumann, specifically a bet that his ability to negotiate good deals on behalf of WeWork’s shareholders exceeds his ability to negotiate deals at their expense.

I was sort of right. Per the latest updates, Adam Neumann remains a good negotiator:

Like other famous flame-outs, WeWork’s has prompted a rapid reshuffling of blame. Tech people point out that it’s more of a real estate company than a tech company; West Coast people note that it’s very much an East Coast firm. Alex Danco wrote a great Girardian analysis of Neumann’s defenestration, which he happened to post a few hours before we got the first stories about Neumann stepping down as WeWork’s CEO.

This has also prompted a stream of I-told-you-sos, most vociferously from Scott Galloway. Galloway uses a rhetorical technique familiar to anyone who went to an all-male high school: a semi-charismatic authority figure yells things you already believed, and he even swears. Wow! This guy gets it!

Eh, I’m over it.

You can fit WeWork into two patterns:

  1. Basically fraudulent companies that continue to grow in the hope that they can grow their way into a real business model. Think of AOL: once the stock was sufficiently overvalued, the best exit opportunity was to pump it up further and then merge with Time Warner, a company with real assets.
  2. A high-risk company with uncertain economics, high variability in profits, and extremely high variability in market value.

Possibility #1 is the consensus view right now. And there’s plenty of evidence for it. On the other hand, there’s less evidence than we might expect. WeWork has said that their locations typically take two years to achieve steady-state occupancy, and they’ve also said that adding additional locations in a given city tends to raise occupancy at existing WeWorks in the same city. And of course their growth costs are front-loaded. So WeWork’s present financials present a highly misleading view of their long-term viability. They have lots of one-time costs that are expensed rather than capitalized, and 100% annual growth means that fully 75% of their locations are performing below their long-term potential.

If you were the CEO of a company that was a structural money-loser but could still raise money, you’d be tempted to grow full speed ahead and take money off the table, as Adam Neumann did. On the other hand, if you were the CEO of a company that had great long-term unit economics and was constrained only by how fast it could grow, you’d want to max out growth even if it meant reporting high losses in the short term — exactly as Neumann did.

Taking capital out of the business sounds like a tiebreaker here, but it’s not necessarily. Neumann sold stock in earlier rounds, but he also took out margin loans — which raised his exposure to WeWork’s performance.

(And now, he’s selling stock and extracting “consulting” fees, indicating that he’s not so bullish after all. Perhaps Neumann is making the reasonable bet that WeWork without a messianic CEO is worth a lot less. Perhaps he’s piqued. Or perhaps he wanted to sell all along and this was his first opportunity.)

WeWork is not the first growth company to run into this kind of difficulty. Lyft is worth about $12bn right now, but two and a half years ago they were close to bankruptcy. The only thing that saved them was a lucky coincidence — their biggest competitor ran into one problem after another, mostly self-inflicted. At this point, Lyft’s long-term viability is still debatable, but you can make the case that it will grow into sustainability. If Uber hadn’t stepped on a series of rakes in the first half of 2017, though, Lyft would be a cautionary tale: charismatic founders, negative margins, too much capital chasing too few ideas. I mean, really: investing billions of dollars in a taxi company?

Most growth companies today can’t fund their growth entirely from internally-generated funds. The economic low-hanging fruit has largely been picked, so if you’re going to build a business worth a lot in twenty years, you should expect to lose a lot in years one through ten. This turns growth companies into momentum plays: if the company is doing well, it can recruit employees with compelling stock grants, raise funds from big investors, and commit to bold bet-the-company moves. But when one of those bets goes poorly, the entire model can unwind.

The more ambitious the company, the fewer people naturally believe in its success. This leads to the pattern Scott Galloway pointed out: a single investor leading a series of higher and higher-priced rounds. But other people more familiar with the business world noted that Scott is missing the many, many examples of that pattern leading to outsize gains. As it turns out, an idea that’s only compelling to a few people is an idea that leads to a monopolistic business. The risk is that it’s an expensive-to-build monopoly on a nonviable business, but that’s rarely apparent early on.

You can think of cynicism as a strategy of writing reputational call options. Make a list of hyped companies, and it’s a safe bet that 90% of them are, at present, overhyped. The problem with that bet from a financial perspective is that the under-hyped companies are under-hyped by an order of magnitude. So you’ll be right almost every single time. But if you’re investing in high-growth companies, a massive error rate is okay. You only need to be right once.

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I write about technology (more logos than techne) and economics. Newsletter: https://diff.substack.com/

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