Business School Professors Weigh in on WeWork's Disastrous IPO

WeWork’s Precursor: How Uber Burned Investors

These days, institutional investors frequently buy stock sold by startups during IPOs. Such investors often manage large pension funds that represent a lifetime’s worth of savings for employees like teachers, who are paid less than many other occupations. Furthermore, the livelihoods of these employees during their retirement years often depends on these pension funds. These employees don’t directly buy shares of stock, but they’re indirect stock market investors because their pension funds invest in the market.

Like any investor, institutional fund managers buy into these IPOs because they believe that the stocks will increase in value. Traditionally, investment banks who underwrite these issues on behalf of startups encourage investors to oversubscribe the stock. Here’s how Investopedia (2019) explains this practice:

Share prices are intentionally set at a level that will ideally sell all shares. The underwriters of an IPO generally do not want to be left eating stock. If there is more demand for an IPO than there is supply (creating a shortage), a higher price can be charged for the securities resulting in more capital raised for the issuer. However, oversubscribed IPO shares are often underpriced to some extent to allow for a post-IPO pop and robust trading to continue to generate excitement around the issue. Companies leave a bit of capital on the table, but may still please the internal stockholders by giving them a paper gain even if they are stuck in a lock-up period.

This practice works well for IPOs when shares increase in value. But what happens in the case of a stock whose price plummets soon after the IPO? That can amount to an unfortunate result for retirees who depend on a pension fund. Granted, such funds tend to be well-diversified, such that losses from an IPO can be offset by other stocks within the portfolio. But other things equal, such a fund will nevertheless lose value if the managers buy into an IPO and that stock tanks.

For example, consider Uber, the unicorn startup with a valuation of $76 billion before its May 2019 IPO. This is a good example of a startup’s stock that badly burned investors. Uber’s stock plunged almost immediately following its introduction in May 2019 at $42 per share. By November 2019, the stock had lost almost 40 percent of its value, trading as low as $26.

Because of these losses and the threat of a continued price slide during the foreseeable future due to a suboptimal ride sharing business model, some experts argue that Uber should never have gone public. After losing $5 billion in a single quarter, Uber started bleeding cash at a rate of $400 million per month in November 2019 (NYTimes), and it’s still unclear how the firm plans to stem the losses.

Business School Faculty Speak Out on WeWork

Uber’s alarming financial performance intensified “scrutiny from investors who are calling into question the billion-dollar market caps of large companies that recently went public,” according to CNBC. With another IPO-track startup risking a market disaster worse than Uber’s, several business school faculty spoke out.

New York University’s Professor Scott Galloway: “WeWork Is the Mother of All Incinerators”

New York University Stern School of Business Professor Scott Galloway dubs newly public startups like Uber “incinerators” because they destroy instead of create value. And he knows a thing or two about creating value.

Professor Galloway holds an MBA from the University of California’s Haas School of Business. After he founded or invested in nine startups with three successful exits, Poets and Quants named him one of the top business school professors in the world in 2012.

These days, he’s now one of the most fascinating figures in graduate management education. That’s in part because of his provocative opinions and openly progressive political leanings, as well as his advocacy of an immediate breakup of Amazon, Apple, Google, and especially Facebook, whom he likens to a cigarette manufacturer.

A former member of the board of directors of the New York Times, Professor Galloway has predicted some trends and company actions with uncanny accuracy. For example, Professor Galloway gained celebrity status for predicting that Amazon would buy a national retail chain. A week later, Amazon announced their acquisition of Whole Foods Market.

In August 2019, a company Professor Galloway has vehemently criticized since 2017 and now calls the “mother of all incinerators,” signaled its plan to go public when it filed its S-1 prospectus with the SEC.

That company was WeWork. Right away, the business press began reporting on anomalies in the S-1 that resulted in an intense scrutiny that the private venture-funded startup had never before faced.

To be sure, writers like attorney Matt Levine of Bloomberg and Eliot Brown of The Wall Street Journal published critical articles on WeWork that alarmed potential investors. But it was Professor Galloway who wrote a hilarious essay that vividly spotlighted some of the more astonishing aspects of WeWork’s S-1 prospectus—an article that went viral and was quickly picked up by Business Insider.

In that essay, “WeWTF,” published on his No Mercy/No Malice blog, Professor Galloway cited these peculiarities:

• WeWork’s ridiculous dedication that kicked off the S-1: “We dedicate this to the power of We—greater than any one of us, but inside each of us.” He also pointed out the firm’s absurd mission statement: “To elevate the world’s consciousness.” Professor Galloway’s analysis: “Maybe, but it’s clear the mission of the prospectus is to dampen our consciousness ahead of the sh*tshow that is ‘The Story of Us: We.’”
• Paying homage to Jonestown leader Jim Jones, Professor Galloway pointed out the cult-like idolatry in the prospectus. It mentioned the name of founder Adam Neumann a whopping 169 times, even though S-1 filings of other unicorn startups mentioned founders’ names only 25 times on average.
• Other strange aspects caught Professor Galloway’s attention: one was that WeWork had signed $47 billion in long-term building leases. But the company had only booked $3 billion in revenues from short-term office rental leases averaging 15 months in length. That juxtaposition meant that in a recession when many customers could not renew their co-working leases, the company likely couldn’t survive.
• Another aspect entailed the way Neumann’s attorneys had structured the firm’s corporate governance succession plan like a future interest-style family property transaction, so that “dead hands rule from the grave.” In this bizarre pseudo-will grafted onto a corporation, the board of directors and shareholders had no say in the future control of the company. But family members certainly exerted influence in this nepotistic startup, and Neumann had given several of them jobs at WeWork earning “under $200,000.” If Neumann were to suddenly die, he gave his wife a large role in picking his successor (Vanity Fair Nov. 2019). If both Neumann and his wife died, control would pass to their children.
• Neumann took out loans against his own stake in the company so he could buy commercial real estate. He then leased ten buildings back to WeWork, pocketing the handsome profit. Then, in a self-dealing tour-de-force, Neumann personally copyrighted the “We” trademark. His board of directors somehow authorized WeWork to pay an LLC corporation Neumann controlled almost $6 million for the rights to the name, “We.”

Professor Galloway also highlighted how WeWork ostensibly sold itself as a technology firm to disguise the fact that it was actually in the real estate business:

Find the hottest sector, and if you don’t have the insight, IP, genius, capital, code, skills, human capital, or a clue, then just borrow the words. SAAS firms trade at a multiple of revenues (yay), vs. real estate firms, which trade at a multiple of EBITDA (boo). So, We isn’t a real estate firm renting desks, it’s a Space as a Service (SAAS) firm. I know, use the word “technology” over and over, despite having little R&D and computers and stuff, and voilà … we’re Salesforce.

It was soon reported that the SEC had been holding discussions with WeWork repeatedly during the eight months before the S-1’s public release. That’s because upon review of an advance copy of the prospectus, the SEC believed that WeWork would mislead investors by including dishonest accounting data that didn’t comply with generally accepted accounting principles (GAAP) issued by the FASB, the Financial Accounting Standards Board. In the United States, public companies and startups planning to go public have to follow these principles during the preparation of their financial statements.

Chief among the SEC’s concerns was WeWork’s interpretation of the contribution margin, a cost accounting measure typically used to determine the relative contribution to profit of an operating unit like a subsidiary or department. WeWork called their non-GAAP version of this measure “Community-based EBITDA,” which stands for earnings before interest, taxes, depreciation and amortization. The SEC warned WeWork that if the startup reported its own “community-based” measure in the final S-1 draft released to the public, the firm would risk an SEC investigation.

WeWork published it anyway. That action triggered the SEC’s preliminary investigation, which Bloomberg first reported in November 2019. According to Professor Galloway:

GAAP accounting standards got you down? No problema at WeWTF. We have begun reporting “Community-based EBITDA,” profitability before the BITDA, but are also taking out expenses, including real estate, that comprise the bulk of cost required to deliver the service. A more honest description of the metric would be “EBEE, Earnings Before Everything Else.”

During the previous four years, the highest gross margin that WeWork ever reported was only about 10 percent. Professor Galloway’s interpretation: “Gross margins are a pretty decent proxy for how good or bad a business is. And this is a sh**ty business.”

Neumann sold three-quarters of a billion dollars worth of his WeWork stock into a secondary offering before the S-1’s release, prompting this reaction from Professor Galloway: “This is 700 million red flags that spell words on the field of a football field at halftime: ‘Get me the hell out of this stock, but YOU should buy some.’”

Is it any wonder that the New York Attorney General announced an investigation in November 2019 into Neumann for indulging in self-dealing to unjustly enrich himself? Professor Galloway’s analysis: “YOU. CAN’T. MAKE. THIS. SH*T. UP.”

The University of Michigan’s Professor Erik Gordon on WeWork’s Five Lessons for Entrepreneurs

Professor Galloway, however, hasn’t been the only business school faculty member to offer opinions on WeWork.

The second is Professor Erik Gordon, faculty member at the University of Michigan’s Ross School of Business, the first top-ten school to introduce an online MBA program. Professor Gordon, who holds a law degree, features five lessons on WeWork in his venture capital course for second-year MBA students. He has already disclosed this information to the business press:

Lesson One: Expect Disclosures About the Corporate Culture

Plan in advance that the corporate culture will become known to the press and public. Venture capitalists like WeWork’s funder SoftBank might not care about some of these behaviors, but potential institutional investors might consider them deal-breakers and pull out. That’s because many investors believe that behaviors like those displayed by Neumann reflect poorly on the founder’s capability to lead. Some investors may consider the founder unsuitable years later and seek to remove that figure before an IPO, which is exactly what happened to Neumann.

Lesson Two: Distribute Control Among Experienced Leaders

Don’t cede complete control of a public company to a founder with no experience running one. The result may be Uber’s Travis Kalanick or Elizabeth Holmes of Theranos. The Theranos board of directors could not remove Holmes, and venture capitalists had threatened to stop funding Uber if Kalanick didn’t relinquish control. Frequently, the board or investors will kick founders like these out of CEO roles and into board chair or less powerful chief technical officer positions.

Lesson Three: Treat Valuations with Skepticism

WeWork’s $47 billion valuation collapsed once potential investors reviewed nearly 30 pages of investor risk disclosures included in the S-1. After a short-term cash infusion from SoftBank and 2,400 layoffs, a bankruptcy reorganization remains likely.

Professor Gordon told Business Insider that “when investors got past all of the hype about ‘we’re raising the consciousness of the world’ and ‘look how fast we’re opening these [new sites],’ when they looked carefully at the business model, they saw a business model that they actually didn’t like.”

Lesson Four: Carefully Screen for Counterfactuals

Look for “counterfactuals,” that is, evidence within the S-1 that the business model may not work as the founders describe. Blue Apron’s S-1 provides a good example, because the cost data presented contradicted the founders’ model. That stock has lost about 94 percent of its value.

Lesson Five: Fear of Missing Out (FOMO) Doesn’t Justify Venture Funding

Venture capitalists should fear investing recklessly more than missing out on the next world-changing company. With a highly questionable CEO, says Professor Gordon, WeWork turned into a regrettable investment by backers simply afraid of missing out.

The University of Chicago’s Dr. Steven Kaplan: WeWork Drives Down Startup Valuations

A third faculty member with an opinion on WeWork is Dr. Steven Kaplan. He teaches at the University of Chicago’s Booth School of Business, and is an expert on new venture finance and entrepreneurship.

During a CNBC interview in October 2019, Professor Kaplan suggested that WeWork probably progressed as far as the firm did because the SoftBank Vision Fund may have been propping up the startup despite lackluster financial performance. He believes that with an IPO window now closing in Silicon Valley, later stage deals will be affected sooner than early stage deals—with valuations in late stage deals decreasing.

New York University’s Dr. Aswath Damodaran on SoftBank’s Screwed-Up WeWork Valuation

Another New York University faculty member has raised questions about WeWork’s valuation by SoftBank. Dr. Aswath Damodaran, a finance professor and author of four books on valuing businesses, explained to Bloomberg (November 2019):

WeWork is not just a mistake, it is a signal of weakness in the whole model. If you screwed up that valuation so badly, what about all of the other companies in your portfolio? If I’m an investor, I want to know how they are coming up with these numbers. Otherwise, you can’t believe any of the valuations. The more they talk about accountants the less I would trust the numbers.

Bloomberg claims that the Vision Fund’s multiple WeWork funding rounds may have driven up those valuations in ways that also boosted SoftBank’s profits on paper. If so, the possibility exists that not just Neumann but the otherwise well-respected Vision Fund might have also engaged in a form of self-dealing.

According to NYU’s Damodaran, “Markets are telegraphing that the trust is gone.” But how can firms like WeWork and SoftBank rebuild that trust? And what indications will signal the integrity of the financial metrics and the strength of the business models driving upcoming IPOs?

These are but a few of the questions that academics like Professors Galloway, Gordon, Kaplan, and Damodaran should address in the coming months.