Since the dawn of the Internet, entrepreneurs have been encouraged to Think Big, Start Small and Scale Fast. This mantra − particularly the last part − has been enabled by VCs awash in capital, cheered on by the business press, and further validated by Wall Street bankers increasingly inclined to underwrite IPOs with rapid growth in both revenues and losses. No wonder founders have taken to heart the belief that growth trumps profits in the race to market domination, fame, and fortune.
Over the past two decades, there has been no shortage of startups that soared to stratospheric valuations before crashing from the weight of unsustainable economics. And yet, we seem to have entered a new era where investments in unprofitable hyper-growth ventures are bigger than ever. In order to understand why the siren song of inspirational, game-changing brand promises so often crowds out a rational assessment of underlying business fundamentals, a little history is in order.
The Internet bubble at the turn of the millennium certainly had its share of epic flameouts. Remember Kozmo, eToys, and Pets.com, none of which lasted more than three years, and Webvan that went from IPO-to-bankruptcy in only 20 months? More recently, Theranos, Better Place, Fab, and Beepi each raised hundreds of millions of venture capital dollars before liquidating the crumbs of their failed enterprises. Time will tell whether Lyft, Uber, WeWork, Bird and other highly valued, massively funded, chronic money-losing ventures become the next generation of shooting stars.
While these companies span different categories and time periods, they share three traits that help explain their fundraising prowess and ignominious demise. First, each purveyed a compelling brand story that intrigued and captivated consumers, VC’s and a fawning business press. Second, none possessed the requisite know-how, processes, business model or addressable market to achieve sustainable profitability. And third, with VC help, each made massive bets they could reach market domination and profitable scale before the money ran out. Take pets.com for example. At the dawn of the Internet, pet owners marveled at the low prices, free delivery and convenience of ordering dog food and pet supplies online, not to mention an irresistibly cute sock puppet featured in pet.com’s ill-considered Super Bowl ads.
Kozmo, eToys, and Webvan also had consumers and VC’s believing that a wide range of goods could efficiently leap from their computer screens to their doorsteps. But lurking behind these compelling brand stories lay the reality circa 2000, that market acceptance of e-commerce services was still quite low, and order-to-fulfillment processes were primitive, unreliable and expensive, dooming the economic viability of these ventures from the start.
Reflecting on Webvan’s failure, the company’s former operations VP explained the challenge to me as follows.
I was sitting in my office one day when a call came through from an irate San Francisco customer, complaining that her afternoon grocery delivery hadn’t arrived. I feigned remorse and gave an empty promise that her groceries would arrive soon. But what I really was thinking was, lady, I don’t have time to worry about your goddamned grocery order; I’m up to my eyeballs racing to launch Webvan in 26 cities.
As it turned out, Webvan never did iron out the kinks in their supply chain processes, and their race to market domination turned out to be a race to oblivion, costing private and public investors $1.5 billion.
One might excuse early flameouts as the result of irrational exuberance at the dawn of the Internet. But in the years to come, other great brand stories also proved too good to be true. Take Theranos, who promised to revolutionize health care (Painless! Inexpensive! Empowering!). Better Place had us believe that we could all drive electric vehicles with swappable battery packs to eliminate range limitations. Beepi crafted a peer-to-peer used-car marketplace that took dreaded salesmen out of the loop. And Fab dazzled us with fabulous flash sale merchandise at crazy low prices. Great stories all, but in the end, none of these companies could develop the capabilities required to deliver their brand promise at prices enough consumers were willing to pay, and a cost yielding attractive profits.
We’re all suckers for a great story
Why are we perennially drawn to companies with inspirational brand stories despite glaring questions about business viability? It turns out that human beings are wired to respond emotionally to compelling stories. There’s scientific evidence to explain how storytelling triggers the release oxytocin, a hormone that boosts our feelings of trust, compassion, and empathy. Neuroscientists have found that when listening to an interesting, well-told story, our brains react as if we are experiencing the story ourselves. To wit, Theranos is how I would like to take a blood test, WeWork is where I would like to work, and riding scooters sounds like so much fun!
We’re all suckers for a great story, and that includes consumers, investors and especially the business press who have obvious incentives to promote compelling storylines with widespread reader appeal. Just think about how much glowing press coverage welcomed the launch of Bird scooters, Snapchat and Tesla, each of whom had compelling brand stories to tell, if not proven economics.
Which brings us to the current generation of ventures with stratospheric valuations, supported by VCs making big bets on companies with inspirational brand stories, rapid growth, but deeply negative cash flows. And the bets are getting bigger than ever.
Capital investment by US VCs reached an all-time high of $130 billion in 2018, driven by a spike in mega-rounds (defined as $100 million or more). These outsized investments rose 90% YOY, more than doubling mega-round deal value, and accounting for nearly half the total venture capital invested last year.
The emphasis on growth over profitability is extending into public capital markets as well. During the first three quarters 2018, an all-time record 83 percent of U.S.-listed companies lost money in the 12 months leading up to their debut. The prior dubious record for the propensity of investors to welcome money-losing companies into public markets was set in 2000, just before the Internet bubble burst.
These trends suggest we may be witnessing yet another round of irrational exuberance towards ventures with a great brand promise but little evidence of sustainable economics.
WeWork’s meteoric rise… and fall?
Take The We Company for example, better known by its original brand name WeWork. The company was founded in 2010 to provide shared workspaces for entrepreneurs, freelancers, small businesses, and more recently, large company employees as well.
Recent reports suggest that while WeWork has been growing at a breakneck pace, with revenues approaching $2 billion in 2018, losses have been mounting at an even faster rate. To fund its rapid growth, WeWork has been a prodigious fundraiser, attracting nearly $13 billion in venture capital since inception, with the most recent cash infusion valuing the company at $47 billion.
By any measure, WeWork’s valuation is exceptionally high.
- Approaching its tenth anniversary, WeWork has never been profitable, and losses have been accelerating. By comparison, tech company superstars Facebook, Google, Airbnb and Salesforce were solidly cash flow positive by the time they reached WeWork’s age.
- WeWork’s underlying business model is intrinsically risky, as it is arbitraging decades-long lease commitments for flexible, short-term rentals (often as short as one month). WeWork’s bet arguably could pay off in a bull market, but it hasn’t yet despite the fact that demand for flexible office space has grown every year since WeWork launched.
- WeWork’s occupancy rate declined in 2018 as perhaps a leading indicator of expected softer global market conditions to come over the next two years
- We’ve already witnessed the effects of a boom/bust cycle in this sector with WeWork’s closest comparable, IWG (operating under the brand name Regus). Regus launched in the late 1980s, and expanded rapidly to become the world’s largest provider of temporary workspace. But in 2003, Regus was forced to file for Chapter 11 bankruptcy in the US after the dot.com bubble collapsed, sharply reducing office space demand. After reorganizing and continuing its global expansion, Regus experienced weak demand again in the wake of the 2008 recession, which cut Regus’ operating profits in each of the ensuing two years by 52% and 66% respectively. In contrast, with a weaker balance sheet, WeWork has yet to experience, let alone demonstrate how well it could weather an economic downturn
- Regus doesn’t trade at anywhere near the valuation premium that WeWork enjoys. Regus’ parent IWG is about the same size as WeWork, and has grown its topline and net profit over the past two years by respectable annual growth rates of 11% and 17%, respectively. Nonetheless, IWG’s market cap is currently trading at only about one times revenue, whereas WeWork is valued at >20X revenue. What could possibly explain such a disparity?
Granted, WeWork is growing considerably faster than Regus, but the company hasn’t proven that it can earn attractive margins on its burgeoning topline.WeWork does have the advantage of reducing its tenant space requirements relative to traditional office layouts. And it is efficient in converting newly acquired (or leased) buildings into rentable space. But these are marginal improvements over competitive norms in this space that don’t justify a 20X valuation premium over Regus and others. There has to be something fundamentally different in how investors view WeWork’s business potential.
What drives shooting star valuations?
Three interrelated factors appear to be at play, which sound hauntingly similar to prior tech industry shooting stars that ultimately failed.
- WeWork has created a unique and compelling brand story
To their credit, a decade ago, WeWork’s founders recognized the unmet needs of workers yearning for a more fulfilling workplace environment that could enhance social interaction, well-being, productivity, creativity and happiness. And the founders further reasoned there could be opportunities to extend WeWork’s brand promise to enhance how We Live, We Party, We Network, We Exercise, We Learn, We Care For Our Children, We Design Office Space, etc.
This vision underscores WeWork’s intriguing brand story, which the company’s CEO describes as a “state of consciousness“ rather than as a stodgy real estate company. As the Financial Times noted:
WeWork’s vast valuation premium is only justified if it can prove that it is far more than a provider of flexible office space. That may be why it has expanded into ancillary services. These include social network Meetup, coding trainer Flatiron School and soon a kindergarten in New York called WeGrow, where tuition will be $36,000 a year. Synergies with Spanish wave pool company Wavegarden, in which WeWork bought a stake in 2016, are harder to imagine.
In essence, WeWork has positioned itself as a “lifestyle platform” arguing that its collective value far exceeds the value of its individual businesses. But there is little evidence that WeWork’s underlying business model justifies the kind of valuation multiple normally seen only in true technology platforms, which enjoy exceptionally high margins, strong scale economies, customer lock-in, and robust network effects. In contrast, WeWork is a capital intensive, cyclical business, with inherently modest operating margins, high customer churn, limited economies of scale and unproven network effects.
Moreover, it is unclear whether WeWorks’ nascent and materially insignificant ancillary services – WeLive (furnished apartments), Rise by We (wellness centers) and WeGrow (schools) – can capture additional share of wallet from WeWork office space renters, or yield attractive returns in their own right. WeWork’s core and ancillary services primarily cater to a distinct consumer lifestage – tech-savvy, upwardly mobile millennials – who are likely to outgrow WeWork’s services if they are successful, or will no longer need or be able to afford WeWork’s services if they are not.
WeWork is thus likely to face chronic high customer churn, cyclicality, and the need for ongoing expensive sales and marketing efforts to maintain high occupancy rates in its core business, and memberships in its ancillary services.
- The business press has often highlighted the human interest angles of WeWork’s brand story, without questioning the viability of WeWork’s business model
Earned media is immensely valuable for companies trying to create a distinctive brand image, and in this regard, the press has been a valuable ally in reporting WeWork’s intriguingly different business tactics, from its lavish annual bacchanalia for thousands of employees (dubbed Summer Camp), to unlimited craft beer at many of its workspaces to its ever-expanding range of new services to its recently enacted vegetarian policy for employee meals.
Has WeWork succeeded in creating the image of delivering a truly unique culture as a service? The New York Times certainly seems to think so in its recently published essay on WeWork’s customer experience.
WeWork is right to perceive that it provides its members with a heightened sense of social organization. To join WeWork is to feel gently buoyed along in a strange kind of substrate, neither fully adrift nor fully anchored, loosely bound to others by novel waveforms. These ties alternately resemble deals between independent contractors, collaborations between colleagues, flirtations between strangers and intimacy between friends — and insofar as they muddy the boundaries between these things, they ultimately feel like none of them. There is a near-imaginable WeWorld in which all human endeavor outsources itself to associations of WeNodes that in an eternal churn arise as spontaneously as they disperse. If a very clever combination of architecture, technology and hospitality serves as an analgesic for the disaggregated, it can just as easily function as a solvent for the institutions that remain.
Now that is not your run-of-the-mill temp office space rental company!
- A mega-VC, Softbank, has doubled and tripled down on its investments, enabling WeWork to pursue its bold vision
A new breed of mega-VC’s and sovereign wealth funds has emerged in recent years, dramatically ramping up the scale of private capital invested in tech startups. Softbank’s Vision Fund is by far the biggest player in this new game, as evidenced by its recent investments in Uber ($9.3 billion), SoFi ($1 billion) and ten other ventures receiving investments in excess of $1 billion. Softbank has even invested $300 million in a US-based dog walking service (Wag) from its $100 billion war chest.
Unprecedented investments of this scale enable — indeed require — ventures to grow rapidly, often before the underlying business model has been validated, key operational processes have been built, customer behavior is fully understood, or competitive resilience is properly gauged.
This has certainly been the case with Softbank’s $10+ billion investment in WeWork over the past two years, which has enabled the company to expand operations to over 550 buildings, in 92 cities, spanning 32 countries, serving over 270,000 members − as losses continue to mount.
In fact, Softbank had planned to invest $16 billion last October to acquire a majority stake in WeWork, but had to back down, after facing unusual pushback from its limited partners. As a result, WeWork had to settle for a Softbank cash infusion of “only” $2 billion in January, which boosted its valuation by $8 billion from the prior Softbank funding round only two months earlier.
But mega-VC investments can have downside consequences. By becoming WeWork’s sole source of equity capital over the past two years, Softbank has put the venture and itself in a vulnerable position.
- WeWork will undoubtedly need additional cash over the next few years to offset its annual burn rate of over $1 billion, and to cover $18 billion in long-term lease commitments coming due in stages through 2023.
- Softbank’s LP’s have already signaled their reluctance to commit additional capital to WeWork, forcing the company to look elsewhere for financing. In fact, only half of Softbank’s last investment was new capital; the rest was to buy out existing shareholders at a lower valuation.
- Since there has been no independent validation for WeWork’s lofty $47 billion valuation, VC’s may well resist providing fresh capital without a lower valuation and/or other investor-friendly terms.
- WeWork’s last bond sale about a year ago was rated as junk, and has underperformed the corporate high yield index ever since, signaling investor worries with WeWork’s mounting losses and weak balance sheet.
- A number of economists have expressed concerns about the stability of the global economy amid rising debt levels and slowing GDP growth. Obviously, WeWork’s fundraising prospects would be further constrained by a global recession.
With a lot of help from a magnanimous mega-VC, an intriguing corporate vision widely covered by the business press, and an abundant supply (for now) of satisfied customers, WeWork has become the second-highest valued private tech company in the US (behind Uber).
But the founders’ soaring ambition to run the company on a hyper-growth/mega-fundraising treadmill has forced WeWork to consistently prioritize global expansion over profitability, putting the company at risk, with a weak balance sheet, deep and chronic operating losses, uncertain future funding prospects, and the looming possibility of having to face its first-ever downturn in temporary workspace demand. Past experience with other companies that jumped on a hyper-growth/fundraising treadmill suggests that the endgame can be ugly.
WeWork is not alone in zealous pursuit of hyper-growth
Uber raced to global market share leadership in the rideshare sector on the strength of over $9 billion of investment from Softbank’s Vision Fund. But its hyper-growth strategy was based on six critical assumptions that have all proved to be false or yet to be proven.
- Uber’s asset-light business model and strong network effects would allow it to achieve huge economies of scale and an unassailable first mover advantage in each of the markets it entered.
- Uber’s prodigious fundraising success would give it ample reserves to drive competition from the market and establish global monopoly control and pricing power.
- Uber’s scale advantage and sophisticated AI algorithms would power a superior service offering, translating into shorter wait times for passengers and drivers and improved driver productivity, which in turn would allow Uber to achieve the trifecta of low fares, attractive driver compensation and corporate profitability.
- With consumers on its side, Uber could run roughshod over municipal governments, who would be unwilling or unable to restrict its ever-expanding operations, even after recognizing that Uber’s business priorities often conflict with public policy goals for sustainable, efficient public transportation, reducing congestion, and adequate compensation for a large and growing sector of city employment.
- Uber’s urban mobility platform and large installed base of rideshare drivers would provide numerous opportunities to expand into other last-mile businesses that would drive profitable growth
- Longer term, the combination of available funds from capital markets and retained corporate earnings would fund a seamless transition to autonomous vehicle operations, promising an even more utopian corporate future.
While Uber has indeed become the largest rideshare company in the world, it has also earned the dubious distinction of losing more money, faster than any startup in history. As it approaches its tenth year anniversary, Uber is planning what would be by far the largest public offering in history, on the heels of operating losses of nearly $4 billion last year, slowing growth and increasing regulatory concerns. Moreover, Uber CEO Dara Khosrowshahi recently acknowledged that in his US core ridesharing business “I’m not optimistic that market is going to be profitable any time soon.”
Bird also fits the profile of a mega-funded venture with a compelling brand story – adult scooters that will transform urban mobility! — that became the fastest startup ever to exceed a $1 billion valuation. Founded in September 2017, Bird became a unicorn in less than 9 months, after closing a C-round that brought its total funding to over $.5 billion at a valuation of $2 billion.
Bird used its venture capital to expand at breakneck speed. Within the company’s first 14 months, Bird launched in more than 120 cities, from Russellville, Arkansas, to Los Angeles in the US, and farther afield in Paris, Antwerp, Tel Aviv, London, and Mexico City.
But like many prior ventures that expanded far faster than they could validate key business assumptions, Bird soon faced troubling and unanticipated operating problems across its global enterprise.
Durability and Cost
During its first year of operations, Bird found that the majority of its $550 per unit scooters were lasting less than two months in heavy shared use. Both these key operating metrics turned out to be far worse than originally assumed, crippling the company’s financial performance. In order to break even going forward, Bird will have to double scooter service life, reduce unit acquisition costs by one-third, raise prices, or some combination of all three. In the meantime, the company recently announced layoffs for 5% of its workforce.
In their breakneck race to establish first mover advantage, scooter companies have experienced a troublingly high rate of rider injuries and maintenance-related safety problems. The Centers for Disease control just launched a first-ever study of electric scooter safety after growing reports of trauma center admissions from scooter accidents, involving lacerations, broken bones, severe head injuries and fatalities. Early indications suggest that the majority of accidents resulted from falls (as opposed to collisions with other vehicles) and that 98% of victims were not wearing a helmet. At the scale Bird hopes to operate, the company is likely to face growing calls for safety-related regulation in the years ahead.
Bird’s first-mover launch, high initial growth, and rosy financial forecasts sparked a VC frenzy which quickly gave rise to numerous scooter competitors, including Lime, Scoot, Skip, Spin, Jump (owned by Uber), and Lyft. In fact, Bird is no longer the global market leader in scooter ridership or revenue, ceding that money-losing honor to Lime.
Taking a page out of Uber’s playbook, Bird’s CEO Travis VanderZanden (a former Uber and Lyft executive) raced to launch scooter operations without asking for city government permission. Bird’s launch-first, explain-later policy backfired in San Francisco, when city officials banned scooters, pending the creation of a licensed pilot program, which initially excluded Bird. While Bird ultimately did secure an operating license in SF, it now must compete against three other operators all of whom face supply caps. A similar story unfolded in Bird’s hometown of Santa Monica and in Denver, while other municipalities have banned scooter operations outright (e.g., Beverly Hills, New York). So much for first-mover advantage.
In light of these adverse developments, the early euphoria surrounding Bird’s explosive launch has given way to a more sober outlook on the business, where market share leadership is no longer the CEO’s top priority. Bird has slowed its expansion plans and pivoted to a new business model where it will license the use of its brand and platform to independent contractors who assume responsibility for scooter acquisition, charging, and maintenance. While Bird’s new asset-light, Uber-like business model may not ultimately solve the business model challenges in this category, at least for now, the company has jumped off the hyper-growth/ fundraising treadmill.
As CEO Travis VanderZanden explains:
What matters the most is getting the economics dialed, meaning losing less money per ride… If you’re growing recklessly without good economics, you lose control of your destiny. You might be able to ride some venture capital in the short term, but at the end of the day if you don’t build a good business, who knows where that will take you.
Next-generation entrepreneurs with compelling brand stories and access to seemingly unlimited VC investment would be well advised to heed VanderZanden’s advice.
Each of the cases cited above illustrates that first-mover advantage is usually not all it’s cracked up to be, particularly in the vast majority of cases where scale economies and network effects are minimal and IP is easily replicable. FOMO pressures in the VC community often drive a herd mentality that creates too many competitors, with too much money, chasing unproven markets before the operating realities of the new ventures are well understood. And Wall Street is now eagerly awaiting a raft IPOs, starting with Lyft, seeking public capital at inflated valuations to cover ongoing money-losing operations.
Before queuing up later this week to add more capital to Lyft’s unfulfilled brand promises, investors should seriously rethink whether the multiple reasons for the company’s deep losses to date are likely to change any time soon. The same holds true for Uber and other shooting star ventures, whose investor-fueled race for global domination may turn out to be a race to oblivion.