The last months have seen an unprecedented meltdown of one of the most valuable unicorns ahead of this year’s most anticipated IPO: WeWork went from a valuation of $47 billion to $8 billion in a matter of weeks. The IPO had to be cancelled amid lackluster demand from the public markets.
After the investment prospectus mentioned that losing its self-proclaimed messianic and self-dealing founder Adam Neumann would be one of the company’s biggest risks for future success, he has suddenly morphed into the biggest liability for WeWork’s future. So much so, that its main investor SoftBank agreed to pay him almost $2 billion just to get him to leave.
Meanwhile, the company that under his management splurged on a private jet, crates of expensive tequila and the trademark for “We”, which it conveniently purchased from him for millions, couldn’t even afford to start saving money, because it was too cash-strapped to pay the severance packages for the thousands employees it is planning to lay off. Many see this additional investment by SoftBank as throwing good money after bad, merely delaying an imminent bankruptcy for a few months.
Just weeks before, the smartest and best-paid guys in the room projected something entirely different: JPMorgan was telling WeWork’s founder and CEO Adam Neumann that it could find buyers at a company value of more than $60 billion; Goldman Sachs was floating a number over $90 billion, and Morgan Stanley speculated that even more than $100 billion was possible. How could so many experts who are being paid so handsomely for their proficiency in valuing companies be so utterly wrong?
How to determine a company’s value
While there is a lot to be said about how to value a company,¹ the principle is fairly simple: If a company is wildly profitable and growing like a weed, it will command a big multiple of the annual profits as a valuation. This is reflected in the ratio between a company’s price to its earnings (PE-ratio): At the time of writing, the companies in the S&P500 are valued at 22x their earnings on average.
The problem with this approach is, however, that new companies are rarely profitable right out of the gates and therefore have no PE-ratio. And since nobody wants to miss the next Amazon, Google or Facebook, who lost considerable amounts of money for quite some time, revenue growth or even user growth are taken as a proxy for future profits when valuing a company.
The multiple on revenue investors are willing to pay varies wildly and depends on their varying expectations of the future of the business. On revenues of $400k, Webvan was valued at $4.8 billion during the dot-com bubble — a whopping (and very unusual) 12,000 revenue multiple. WeWork in turn was valued at $47 billion on revenues of $1.8 billion — a revenue multiple of 26. This reflects that in times of optimism, market capture via exponential growth becomes the order of the day and determines a company’s value, while value capture via profits is postponed into the future.
And here’s the conundrum: While it’s not possible to buy profits or attractive unit economics, it’s possible to buy growth (users or revenues) with a lot a money at your disposal, enabling you to game the valuation system.
Why burning cash can be very profitable
Let’s say I have a business with a fairly conservative revenue multiple of 10x. My business is straightforward and wildly popular: I sell $1 bills for $0.75 cents — incredible demand, I don’t even need to spend a lot on marketing. Sure, I lose 25% on every transaction, but since my revenue multiple is 10x, every $1 I sell for $0.75 cents boosts the valuation of my company by $10. It’s a no-brainer for investors, who have recently put $1 billion into my company, boosting their stake in my business by 10x sales to a valuation of $10 billion. Every customer loves my business, the NPS is through the roof.
To keep everybody excited about the future prospects of my business, I now develop an app that digitizes the entire process, enabling me to scale my business at much lower costs as I don’t have to employ a sales team handing out the dollar bills in the streets. Also, my app uses Machine Learning to generate recommendations for the app’s users to recommend my product to their friends by pulling in data from their address book. Every transaction is securely stored on a blockchain. And voilà — I’m a tech company now. As a tech company, of course, I can command a much higher revenue multiple — let’s say the 26x WeWork was valued at, since they are totally tech and all.
If you think that’s unrealistic because I have a really shitty business model, wait until you hear more about WeWork’s: The company lost lost $1.9 billion on revenues of $1.8 billion. In comparison to their cash incineration, the fundamentals of my business model are really sound, as I would only be losing $450 million on the same revenue. Therefore, a 26x revenue multiple for my business is very conservative in comparison and my next funding round enables me to raise fresh capital at a multiple of 35x. My first investors love me: The stake they purchased for $1 billion in the initial round is worth over $30 billion now after dilution.
Meanwhile, my competitors are in deep trouble: In contrast to me, they run profitable businesses. How lame — and lacking the vision of the transformative nature of my business! Since it entails that their users have to work for the extra $0.25 cents on every $0.75 cent they contribute, their growth rate is much slower and the customer acquisition costs are much higher than mine where people get $0.25 cents for free on top of every $0.75 cents they invest. With the power of my multi-billion valuation I now go on a shopping spree, snapping up competitors right left and center in all-stock-deals. I change their business models to mine and the markets love me, since the NPS of the acquired companies goes through the roof and customer acquisition costs are in free fall. Magic!
My growth further accelerates and I’m on the cover of Forbes now. I’m invited as a keynote speaker to TechCrunch Disrupt, Davos and TED, giving inspiring talks about disrupting the greedy financial industry by reinventing the distribution of money while empowering and connecting people in underserved and disenfranchised communities around the world. Because that’s really what I’m all about after all: Making the world a better place. The IPO is in the works and since money is not really important to me, I decide to only sell a small percentage of my stake in the company in advance in a secondary — let’s say 10% at $5 billion?
As depicted in this description only loosely inspired by real events (Groupon, Uber, Lyft, WeWork, Sweetgreen and many more), nobody in this equation has an incentive to ask critical questions that would debunk my company for the shitty business it really is: It’s great on the side of value creation for my customers — but it sucks in the value-capture part, the second part always required in a great business, as I have no path towards turning a profit.
My investors don’t mind, though, as they can multiply the paper value of their investment, enabling them to raise additional funds from everyone wanting a piece of the fairy-dust of this king-maker investor. As long as there is an abundance of cash due to zero percentage interest rates and I as a founder don’t go batshit crazy (like selling the company’s brand name to my own company for millions, buying the majority of the $1 bills for $0.75 cents myself with money I got through a multi-million credit line from my own company, picking the size of investment rounds in accordance with my lucky number, employing my family, getting high on the company’s private jet en route to a silent retreat and yoga surf-camp with Deepak Chopra and the Chili Peppers while snorting coke off a hooker’s ass), the IPO will happen and the investors can cash out their huge profits. And if not, it doesn’t matter to me either, since I’m set for life through the secondary anyway. I can now spend my time as an investor and spiritual coach, preaching about the utter unimportance of wordly possessions on Geffen’s yacht with the $5 billion I just cashed out.
Party like it’s 1999?
That’s exactly what happened in the dot-com bubble before: It’s not that all investors were stupid and thought the valuations were justified. Many operated opportunistically: As long as people believed the story in the public markets, the road to floating shitty businesses and cashing out in an IPO remained open.
Even though many knew that most valuations didn’t make sense they invested anyway, hoping they could multiply their money before the others realized the mirage, leaving them holding the bag when the bubble burst.
Even though many knew that most valuations didn’t make sense they invested anyway, hoping they could multiply their money before the others realized the mirage, leaving them holding the bag when the bubble burst. Therefore, the available information didn’t suddenly change, just the interpretation of it. In the dot-com bubble an article by financial magazine Barron’s marked the turning point in the collective mania in March 2000 by introducing the burn-rate instead of eyeballs as a relevant metric, triggering subsequent high-profile failures.
It’s the same this time around. Although startups stayed private much longer due to the overabundance of cheap money leading to an unicorn-inflation, the majority of venture capitalists acknowledged that they considered the unicorns to be overvalued (91% of venture capitalists who don’t have any unicorns in their portfolio and 92% of the VCs who do agree). And not just by a little: Research from Stanford University suggests the average unicorn to be overvalued by over 50%.
After a lackluster IPO-performance of star-unicorn Uber, the exit-via-IPO story of companies without any path to profitability started to crack. WeWork might have been too late to the party already or might have significantly contributed to jamming the IPO-window shut with its hilarious paperwork so blatantly over the top that it can only have been penned while in an elevated state of consciousness.
“We dedicate this to the energy of We — greater than any one of us but inside each of us. […] Our mission is to elevate the world’s consciousness.” WeWork’s S-1
Popping the bubble: Margins matter
What Barron’s “Burning up” article was to the dot-com bubble, influential VC Fred Wilson’s blog post “Public Market Reckoning” might turn out to be to the private-market unicorn-inflation of the recent years. Inspired by WeWork’s failure to complete its IPO as planned, he mused about the benefits of gross margins and their correlation to a company’s performance post IPO.
The profound observation that — gasp! — capturing value in the form of margins might actually matter and not just growth without any path to profits apparently took quite a number of experts in the industry by surprise and made them change course. As reported by the New York Times, at Eniac Ventures the partners combed through their companies and identified the “gross margins” for each one, said Nihal Mehta, general partner of the firm. This was not something the firm regularly looked at, he said, but they were inspired by Mr. Wilson’s cautionary blog post.
Just like after the Barron’s article hit, nothing was different in terms of the information available to the markets after Fred Wilson’s post and both just stated very basic economic axioms, yet everything was suddenly interpreted differently. That growth and margins are key for determining a company’s value certainly isn’t anything new. But over the last couple of years these two numbers became decoupled: Growth became the measurement for the valuation as the markets were awash with cheap money and optimism, that a profitable business model would present itself either way somewhere down the line. Amazon, Google and Facebook had set a precedent that VCs lacking the imagination to see the unfathomable riches behind these initially money-losing companies would end up paying dearly for their inability to identify tomorrow’s visionaries. The problem: You can buy growth just in the way I did in my glorious dollar-bargain-business above without ever having any prospects of turning a profit.
Winner takes all
If basic economic principles like margins are crucial for a company’s viability and profitability, why do they keep getting overlooked time and time again? The answer is simple: Focusing on profits too early can limit a startup’s potential, as it would result in throttling its growth. Competitors not burdened by these considerations would be enabled to swoop in with money to spend and grab the market. Also, when a business model isn’t clear from the start and no revenue whatsoever is initially generated, as it was the case with Google and Facebook, there are no margins or unit economics to measure yet.
That’s why Blitzscaling, the mantra of outspending any competitor once an exponential growth-trajectory (profitable or not) has been hit, became the order of the day. Its most prominent advocates Peter Thiel and Reid Hoffman see it as the only way to reach the escape velocity required in a networked market to propel the company to the number one position on a global scale. This singular winner tends to dominate the market in terms of valuation, leaving the second-placed with only the leftovers. It’s Amazon vs. Barnes and Noble, Google vs. Bing, WhatsApp vs. Kik, Uber vs. Lyft. And who wants a set of steak knifes when he can have the Cadillac Eldorado?
While this enables companies to grow at an unprecedented pace with a bottomless stash of VC-money as rocket fuel, it can also result in a massive misallocation of resources if the company’s product turns out to be just a fad without a path to profits.
To prevent this from happening, it helps to determine whether the founder’s appeal is based on her thought leadership or a cult of personality — which, given the examples of Elizabeth Holmes (Theranos) and Adam Neumann (WeWork), seems to be very easy (in hindsight…). It also helps to understand whether a company’s product actually exhibits the characteristics of a tech-product that justifies the insane revenue-multiples or whether it’s just masquerading as one to maximize the cash-out.
How supermoney is driving innovation — and inequality
Why stories of an eccentric founder like Adam Neumann, who essentially lit $10 billion of SoftBank’s money on fire and was still able to go back to them to successfully demand a commission of 10% for doing so while his employees get nothing, elicit calls to throw out capitalism and market economics as a whole, is understandable. It also misses the bigger picture.
Adam Neumann’s ability to pull this stunt is based on the fact that investors imagined a future in which WeWork might become really valuable. They were willing to take a bet on it, supplying the company with ample resources to build out this vision. In return for their money they received a share in the company based on the imagined future value.
Being able to be valued on expectations, hopes and dreams rather than actual profits or even revenues, is a powerful driver of innovation, as it enables the investments required to bring new ideas to life. Without it, Google would not have been able to develop a search-technology so far superior to anything that was around at that time without any clear idea how they would make money from it. The business model of selling ads in the search results would only later evolve and turn the company into a money-printing machine. Tesla would not have been able to put pressure on giant, profitable automotive incumbents to pursue the development of electric vehicles and Uber would hot have been able to radically improve the user experience of urban transportation without the investors willing shoulder huge losses in turn for a stake in their shared dream of turning them into future profits.
Often, these bets don’t pan out and startups don’t end up creating the value they and their investors intended them to. Economist Carlotta Perez makes the case that every technological revolution has been accompanied by a financial bubble, resulting in over-investment in the specific sector: Railroads, electrification, automobiles, the internet. The rubble of many failed attempts, however, builds the foundational infrastructure for the underlying technology to be deployed at scale, transforming the entire economy with it.
Investors placing bets on the potential of a new technology enable this technology and all the applications human ingenuity can dream up to be built out, even though most of them will fail. While this process is not very efficient, as a lot of money will be allocated to ideas that don’t work out, it is very effective, as it creates the financial incentives of rewarding the creativity that brings innovation to life.
As Tim O’Reilly points out in his excellent book “WTF — What the Future?”, this mechanic also has a downside, however, that goes far beyond just losing investor money. Valuing a startup company by applying a hefty multiple on its revenues — in WeWork’s case 26x the $1.8 billion — creates a hypothetical value of the company ($47 billion). This process creates what financial writer George Goodman calls “supermoney”, as it turns the company’s stock into a very powerful currency, providing the upstart with an unfair advantage over companies with access only to the ordinary currency used in the markets of goods and services.
The impact of this hypothetical value becomes very real: If I only have my profits to spend on investments like employee compensation, marketing and acquisitions — as regular companies without access to supermoney do — I can’t compete with a company like WeWork with zero profits, which has $47 billion in their own stock to spend.
A financialized company — i.e. a company valued in supermoney — can operate at huge losses for years, enabling it to disrupt older companies not just by offering a superior product, but by effectively subsidizing its product and destroying their business without a path to building something sustainable in its place.
A financialized company — i.e. a company valued in supermoney — can operate at huge losses for years, enabling it to disrupt older companies not just by offering a superior product, but by effectively subsidizing its product and destroying their business without a path to building something sustainable in its place. Competitors in this vein can be forced to copy what Matt Stoller calls “their fraudulent competitors” in such a counterfeit capitalism.
Indeed, the last couple of years under the Blitzscaling-mantra have seen a vast number of celebrated money-losing-unicorns with terrible unit economics and without any plausible path to profitability emerge. While some of them have succeeded in improving a product or service experience in a meaningful way, the main advantage of many others is limited to their access to capital, enabling them to grow exponentially by creating what Kevin Roose called a millennial lifestyle subsidy: “If you wake up on a Casper mattress, work out with a Peloton before breakfast, Uber to your desk at a WeWork, order DoorDash for lunch, take a Lyft home, and get dinner through Postmates, you’ve interacted with seven companies that will collectively lose nearly $14 billion this year.” The money I spent on these services as a user falls short of these $14 billion to cover the costs of providing them. It therefore effectively amounts to a wealth transfer from the investors to the pockets of these services users.
While Uber just like WeWork may very well turn out to never make any money, it doesn’t matter to the founders and early investors if they get the timing right to collect their potential future profits today. The transfer of future expectations into the present through the exit of the company via sale or IPO converts their multiple-based-supermoney into regular money, making them wealthy beyond imagination.
The founders of both of these companies — and many others — are billionaires a few times over in spite of their companies not having a business model with a clear path to profitability. The bill will be footed by the investors who got in too late (dumb money) and the employees who saw the value of their shares or options collapse. Therefore, even if your company ends up destroying real economic value, you can end up a billionaire just by being on the lucky end of a failed acquisition, making timing and luck the most important component by a long shot.
While the irony of — in WeWork’s case — transferring Saudi billions via SoftBank’s Vision Fund to an Israeli entrepreneur unfortunately has been lost on most commentators, the wealth transfer enabled by this financialization is at the heart of the rising wealth inequality we experience today: While most of us are operating with the power of regular money, a few lucky ones get paid in supermoney. By reinvesting this money in new companies with a similar multiple and in real estate, they can multiply their wealth even further: All but one of the wealthiest tech figures have seen their net value grow by billions of dollars in 2019. Meanwhile, real estate prices are crushing those who make their living in the real economy, prompting companies like Apple, Amazon, Facebook, Google, Microsoft and Salesforce to try to put a bandaid on the housing crisis.
The deeper systemic problems at play won’t self-correct and are threatening to undermine the very foundations of prosperity: Infrastructure, trust in governmental institutions and democracy. Being able to borrow from the future by dealing in supermoney is essential for enabling innovation to flourish. But, as Tim O’Reilly puts it, it comes with the obligation to pay back this debt by creating a better future. More and more billionaires and companies seem to be starting to get the message.
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 To determine a company’s value, it certainly doesn’t hurt to take a company’s profits into consideration: If a company has $1 million in profits this year, it’s safe to assume you would be willing to pay this amount for the company, as you will be able to get your investment back this year already. Any future profits would therefore be a bonus. Now, taking only this year’s profits into account for valuing the company wouldn’t be very fair to the seller, however, since all things equal it’s safe to assume, that this company will proceed on more or less the same trajectory in the coming years, generating a multiple of your investment with a very limited risk. Therefore, the most common way to value traditional business takes these future profits into account and calculates their value today (Discounted cash flow, DCF-method).
Or the other way around: Whether or not a company is priced fairly takes the relation of its price to earnings into account: Dividing the current valuation (number of shares * price per share) by the amount the company earned gives you the number of years the company would need to deliver these earnings to amount to the current value of the company (Price-earnings-ratio, PE-ratio). For instance, Apple’s PE-ratio is currently at about 20, meaning the company’s profits would pay for my investment in twenty years if I purchased the company today. Depending on the expectations of future profits, this ratio varies considerably by industry and company. For example, a company like Amazon is currently valued at 72x of its earnings, whereas General Motors trades at barely 6x earnings. This reflects the expectations of the market, that Amazon will see much stronger growth than General Motors and therefore significantly more profits down the line. Although this introduces quite some leeway in setting the right price as expectations may vary, this method is still tied to some solid numbers: The profits of the company.
This approach of evaluating the fair price, however, creates a problem when valuing companies that don’t have any profits yet. Google and Facebook — now profitable beyond most peoples’ wildest dreams — were initially losing money for quite some time (and many didn’t see how this could ever change). If you would have refrained from investing in these companies because their assumed value would be zero for lack of profits, you would have missed out on the investment opportunity of a lifetime.
It might therefore make sense to take a company’s revenues as an indicator for future profits into consideration: If the company is able to generate considerable revenues and these revenues show strong growth, apparently it is providing a product or service the market wants and it should be possible to generate profits from it down the line. The degree of freedom of what a fair value is, however, becomes even bigger, as the company has not proven that it can actually turn a profit.
Keeping in mind that revenue is only an indicator for future profits, two factors are the most relevant for gauging this profit potential: Growth and gross margins. The higher the both, the brighter the prospects of the business and in turn the valuation, usually measured as a multiple of revenues for lack of profits.
And here’s the catch: While revenue growth always has a major impact on a company’s valuation, the second part — gross margins or unit economics — often gets dropped from this valuation in phases of exuberant optimism, as everybody is convinced the company will eventually get there anyway if they have the growth engine going.