The Cautionary Tale of WeWork

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The Cautionary Tale of WeWork

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Touring The Office

First it’s a #hustle poster. Then it’s your freelancer friend raving about the free beer and table tennis tournaments. Next thing you know, three vegan food trucks are parked outside and the building next door is emblazoned with the now-familiar logo: WeWork.

In the last decade, WeWork went from a small coworking startup to a global office space behemoth – and the biggest corporate office tenant in London and New York – valued at a whopping $47 billion. But shortly after reaching its peak valuation, issues came to light at WeWork that even kombucha on tap couldn’t solve: a governance dispute crushed that $47 billion price tag, ousted its rockstar CEO, and canceled its initial public offering (IPO).

How come? WeWork entered the market in the right place at the right time: in 2010, the financial crisis left a bunch of landlords with prime office buildings in New York City empty. At the same time, lots of unemployed 20 and 30-year olds were starting life anew as freelancers. With its inspirational neon signage and flexible short-term leases, then, WeWork looked like a good place to hunker down.

Then-historic low interest rates and booming private investment markets also helped, as investors were on the lookout for the next unicorn 🦄 So-called venture capitalists had a big appetite for disruptive startups – even ones like WeWork, which at one point was losing over $200,000 every single hour. Although as we’ll later see, the stark and rapid reversal in WeWork’s valuation might have embarrassed the eager financiers some of whom competed to give them cash.

Why should I care? The story of WeWork – a startup that got too much money too fast without enough effective oversight on how to spend it – encapsulates an era of easy money and laissez-faire rules among startups and startup investors. Such stories usually begin with a sound idea that requires scale to succeed. Fast-growing firms then “blitzscale” – raising fortunes to acquire users and disrupt an industry before anyone else does.

WeWork rise and fall coincided with shifting investor perceptions of wannabe unicorns – especially those without the profits to sustain their ambitions. In fact, Uber’s CEO said in February 2020 that the era of growth at all costs is over.

“The ‘brute force’ of capital can let a start-up scale so fast that no rival can catch it, but if its spending outruns the money coming in, that can create its own variety of ‘brute force’.”

– Jeffrey Rayport, Harvard Business School

How WeWork Works

What’s WeWork’s business model? It’s pretty simple: WeWork takes out long-term rental agreements with real estate owners, agreeing to lease a big chunk of a building. It then works its magic: renovating the offices, adding amenities, and using space more efficiently (the average square footage per person in a WeWork is five times smaller than in a normal office) 🕴

It then sublets desks in the swanky new space on a monthly basis to startups and entrepreneurs, who hopefully find the flexibility and #vibes more attractive than a traditional water cooler and striplight environment. This is called “rent arbitrage”, and it’s similar to what some of your savvier friends might do with Airbnb: by subletting the property for more than it pays to its own landlord, WeWork should make money.

In reality, things haven’t worked out that way, and that’s not just because of the coronavirus-induced lockdown. Despite having over 600,000 members across 120 cities (paying an average of $6,360 annually for the privilege), WeWork lost $1.93 billion in 2018 and $690 million in the first half of 2019. The company says that’s because it was still expanding: each completed location apparently makes much more than it costs to run. But it’s still true that WeWork’s core business relies on it being able to charge people more rent than it pays itself – and if it can’t find people to fill desks, it’s on the hook for gigantic rental payments 😬 WeWork’s business model is therefore especially fragile in an economic downturn, as several companies simply cannot afford to pay rents and can walk away thanks to the flexible lease contracts.

How did the company sustain these losses? WeWork was a key beneficiary of the billions of dollars of venture capital money floating around. Its losses so far have largely been funded by investors like SoftBank, which pumped $10 billion into the company between 2017 and 2019, and even agreed to a $9.5 billion bailout after its failed IPO. WeWork’s also a debt devotee – a 2018 bond sale raised $700 million – and unsurprisingly, WeWork’s bonds were trading at roughly a third of what they’re worth on paper in June 2020.

Anything else? For the past ten years, WeWork has been a commercial landlord’s best friend. Not only does the company often guarantee them an income for a decade or more, it also funds much of the renovation works – and claims to make other floors and neighboring properties more attractive to tenants. A cynic’s view, however, is that WeWork’s spent a decade using investors’ money to make landlords better off...

The takeaway: WeWork tries to make money by subletting offices for more than it pays, but expanding into new areas caused its losses to widen.

Community-Adjusted Losses

Why do people criticize WeWork? The biggest red flag is the company’s financial health. In 2018, it brought in $1.8 billion in revenue – but its costs were so large that it still managed to lose more money than Uber.

But WeWork argued it didn’t matter: it shunned the popular profitability metric of EBITDA (“earnings before interest, tax, depreciation, and amortization”), already a controversial accounting technique, in favor of something really wacky called “community-adjusted EBITDA”. This measurement, unique to WeWork, strips out marketing expenses, executive salaries, sweetheart initial rent discounts it offers startups, and a bunch of other costs – and purportedly shows how much the office spaces alone make. That was positive in the first half of 2019, at $340 million (up from $467 million in the whole of 2018). But the company’s been widely derided for using a profitability metric that ignores essential ongoing costs 👀

That’s not the only sneaky thing WeWork’s done with its accounting. When it agrees to lease a new property, it typically gets a discount for the first few months – meaning its rent bill now may look a lot smaller than it really is. WeWork smooths out those rental payments in its financial statements to better reflect the financial reality over time – something called “straight-lining”. That’s prudent – it would be weird to pretend that current rental payments accurately reflect the business.

Yet when calculating its community-adjusted EBITDA, WeWork doesn’t straight-line the rent. According to its financial statements, WeWork’s 2018 community-adjusted EBITDA excluded the impact of straight-lined rent expenses, which inflated the measure by more than twofold.

The takeaway: Even before its attempted IPO, WeWork’s financials looked pretty bleak.

Big Is Beautiful

Why would anyone invest in WeWork? We’ve painted a pretty negative picture so far, but there are a lot of reasons why investors thought backing WeWork would be an excellent bet. The company’s fans say it’s more than just a rental arbitrage business: it’s got a bunch of unique and defensible capabilities that warrant a massive valuation.

What makes WeWork special? One thing investors point to is the company’s technology. WeWork’s pretty advanced: it makes 3D models of buildings, uses machine learning to figure out how many meeting rooms a given number of employees will need, and even puts sensors in offices to track exactly how they’re being used. WeWork’s not the only firm to have this kind of tech in place, but its scale gives it an advantage – it’s always going to have more data than its rivals. WeWork says that its tech improves space efficiency by up to 20%, and saves 10% on building costs 😋

Tech and scale also make WeWork extremely efficient. On average, once a lease agreement for a building has been signed, WeWork begins accepting tenants within nine months. That may be especially attractive for clients used to long waits before they can move into new office space.

Compared to coworking competitors, meanwhile, WeWork likes to highlight the power of its community. It thinks the events and network of like-minded people you get in a WeWork make it much more than just an office – and it thinks people are willing to pay extra for the privilege.

That ties into a key idea of WeWork: leveraging its scale to become more than just an office provider. WeWork already upsells its members on products: it runs a services store where members can get discounts on everything from restaurants to Microsoft Office; it bought coding school Flatiron in 2017; and started to sell special loans from SoFi to its members. These, combined with the gyms and homes, add up to WeWork’s vision of becoming the Amazon of the workplace – a one-stop-shop for everything.

So can investors ignore the financials? They can’t! But they’ll point to Amazon’s history: it too made negative (or tiny) profits for years in the relentless pursuit of expansion, and is now one of the most valuable companies in the world. And investors also believe that WeWork will succeed in making changes that improve its business.

One key trend is WeWork’s gradual shift away from small startups with short leases towards bigger corporate clients with longer commitments (the average is now 21 months). That, in theory, takes a lot of risk out of the business model.

WeWork fans have another argument for the company’s resilience: in a recession, for example, they claim it’s too big to fail. Because WeWork is the main player in the New York and London property markets, its demise would likely decimate real estate prices. That would be a nightmare for all property investors – which includes individuals like you, who probably have a stake in the market through your pension pot. Research firm CB Insights suggests governments might therefore step in to avoid a collapse. Though people said the same about several now-defunct banks back in 2008…

Now you’re familiar with the cases for and against WeWork, it’s time to see what investors actually thought about it – and why its long-awaited IPO was a dud.

The takeaway: WeWork’s technology, community, and efficiency make it unique – and it might simply be too big to fail.

Why Didn’t WeWork’s IPO Work?

What happened? At the start of September 2019, WeWork stood tall with a whopping $47 billion valuation. But its grand stock market debut never actually happened: by the middle of the month, its long-awaited IPO was postponed. And shortly after that, WeWork’s controversial CEO (we’ll explain why in a second) Adam Neumann stepped down.

WeWork’s shenanigans: Investors were already familiar with WeWork’s questionable metric for measuring its profitability – “community-adjusted EBITDA” – but in mid-August 2019, analysts and investors were able to peel back the curtain and see the company’s financials laid bare. That was thanks to its “S-1 document” – a company prospectus that’s filed with financial regulators ahead of an IPO. Prospective investors pored over the document which revealed WeWork made a loss of $690 million in the first six months of 2019, bringing its total losses between 2016-2019 to almost $3 billion. That meant it had lost more than $5,000 per customer between 2016-2019.

The S1 also revealed issues with WeWork’s corporate governance. For instance, lucrative tax benefits that accrued directly to CEO Adam Neumann, as well as shares that gave him 20-times the voting power of other shareholders. What’s more, he appeared to have personally purchased the trademark “We” and then sold it to the company for almost $6 million. Add to that Neumann’s personal investment company, which owns stakes in a bunch of buildings that WeWork rents 🙃 and you might begin to see why some investors were more than a little skeptical.

What happened next? Investors grew cynical of WeWork’s $47 billion valuation after seeing the detail of its spending and governance practices, which made several worry the company might never generate a profit in the manner investors traditionally like to see. By early September, WeWork slashed its valuation below $20 billion – and less than a week after that, it reportedly considered proceeding with an IPO that valued it at $10 billion, 80% lower than the valuation it was originally looking for. By this point, WeWork only had $2.5 billion cash left and without an IPO or cash infusion from elsewhere, would run out of money in just two months. The company did have a $6 billion loan agreed with investment bank JPMorgan, but it was contingent on WeWork raising $3 billion via an IPO, which seemed increasingly unlikely. At the end of September 2019, Adam Neumann resigned as WeWork’s CEO, and the company officially postponed its IPO indefinitely.

SoftBank to the rescue: By October 2019, WeWorks $47 billion valuation had plummeted to $8 billion and its $700 million worth of bonds (due to be repaid in 2025) were in free-fall, pushing their yields above 11%. Caught in between a rock and a hard place, WeWork turned to SoftBank again, and the Japanese tech conglomerate ultimately bailed it out. SoftBank pulled together a rescue package worth $9.5 billion – but it was forthcoming on the condition that Adam Neumann leave the company completely (he was still chairman at the time). It cost $1.5 billion, by way of a compensation package, to get rid of him, mind you.

The aftermath and Covid-19: After its failed IPO and SoftBank’s bailout, WeWork has been cutting costs by doing whatever it can; by laying off employees and shedding assets. In November 2019, WeWork laid off 2,400 employees globally and let go another 250 in March 2020 after taking a hit from coronavirus. Furthermore, it sold Managed by Q – which it bought for $220 million in April 2019 – for just $25 million, and also sold 2017 purchase Meetup in the same month. WeWork’s “whatever it takes” cost-cutting strategy didn’t convince Softbank as it cut down WeWork’s valuation again from $8 billion to $2.9 billion in May 2020. Softbank’s tech unicorns – WeWork and Uber – had fallen into the valley of the coronavirus, leading to its biggest annual loss in history.

Naturally, for a business that relies on people leaving home, WeWork’s revenue stream was at risk of coming to an abrupt halt as coronavirus-induced lockdowns forced office workers around the world to stay home. As some experts warned, WeWork’s “rent arbitrage” business model meant most of its tenants were on short-term leases, allowing them to quickly and easily walk away when the economic tide turned. As a result, WeWork was forced to skip some of its own rental payments in April 2020, which had knock-on effects on investors in “commercial mortgage-backed securities” (CMBSs), whose income is composed of payments from the likes of WeWork.

Whether WeWork will weather the crisis is to be seen. Some analysts reckon several “zombie firms” – companies that are unable to pay the interest on their debts from the profits they generate – that might’ve been potential WeWork customers will go bust, and the companies that do survive may not return to offices in the near future. On the other hand, advocates think the pandemic won’t have changed how we view our workspaces or the property market at large. And if it does, WeWork might be able to offer a unique value proposition due to its flexible and open office space. And with the Federal Reserve’s promise of purchasing corporate bonds, there’s yet another lifeline that could keep WeWork going.

The takeaway: WeWork’s dubious accounting and corporate governance led its ambitious IPO to flop, resetting its valuation from $47 billion to $3 billion, while the global pandemic revealed a weakness in its business model.

In this Pack, you learned:

🔹WeWork is a once-upon-a-time unicorn worth $47 billion that lost 90% of its value

🔹Despite its continuous gigantic losses, it attempted to launch an IPO and failed

🔹WeWork has been selling assets and laying off employees to fund lease obligations and other expenses

🔹Its story might work as a cautionary tale for venture capitalists and wannabe unicorns

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