With its initial public offering (IPO) scheduled to take place within months, the We Company (better known as WeWork) was about to realize the dream of technology startups everywhere: sell shares to an eager public and cash in on a sky-high valuation. WeWork promised to revolutionize the market for office space, and going public would give the company the funds necessary to make good on that promise.
That was the plan, anyway. Since its August IPO filing, WeWork’s goal to go public has given way to a series of setbacks. CEO Adam Neumann resigned, and the company’s valuation dropped to $10 billion, a far cry from the $47 billion valuation it once commanded. The company secured desperately needed financing in a last minute deal with SoftBank, though it cost Neumann his control over the company and valued the company at a relatively meager $8 billion. These recent developments have made it clear that investors no longer see WeWork as a tech company, nor do they value it as one. WeWork’s IPO debacle warrants an examination into how a company once favored heavily by private investors has since withered under public scrutiny.
A large portion of WeWork’s troubles are attributable to issues found in its financial statements, which became available to the public after the company filed a Form S-1 with the Securities and Exchange Commission. Companies are required to file an S-1, publicly disclosing information about their financial position and corporate structure to investors, before an IPO can take place. Normally, private companies are not subject to the same reporting requirements as public companies; this allows private firms to operate with less public scrutiny so long as they stay private. However, firms like WeWork can access larger pools of capital by going public, incentivizing public offerings at the cost of increased scrutiny.
This tradeoff can backfire, as it has in WeWork’s case. Prospective investors balked at WeWork’s troubling current position and the several threats to its future financial health revealed in its IPO prospectus. In 2019, the company recorded revenue of $1.5 billion but a net loss of $900 million. Even more troubling: the company’s adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA), which is used as a measure of the profitability of a company’s core business, has been consistently negative. Such large losses are not unheard of for a company on the verge of an IPO; Uber and Peloton recently went public despite recording significant losses in preceding years. Growing companies can incur large losses as they expand operations. Investors may still find IPOs for such companies attractive if they believe the firms can turn a significant profit in the future. Usually, this tolerance for losses is reserved for tech companies, which tend to burn through cash to expand their operations and take advantage of network effects.
What distinguishes WeWork from many other companies that have gone public before turning a profit is the sector WeWork operates in: commercial real estate. Commercial real estate companies are traditionally risk-averse; this risk-aversion means the sector tends to be consistently profitable and posts steady returns year after year. This is vastly different from the high-risk, high-reward returns of rapidly-growing tech companies. WeWork’s initial valuation suggested the company believed it belonged in the latter category, yet its business model does not represent a significant departure from a traditional commercial real estate company.
A deeper look into WeWork’s prospectus suggests the company’s struggles go beyond mere growing pains; the firm will likely be plagued by costly issues for many years to come. WeWork operates as a commercial real estate company: it secures multi-year leases for office properties, renovates the interiors, and then sub-leases the office space to other companies. While WeWork’s business model is revolutionary in its scale, it also acts as a significant source of long-term debt, due to the company’s contractual obligations to pay rent on the properties it leases. According to lease contract details found in the prospectus, the company has secured “free rent” periods early in the terms of its leases, along with rent increases that come into effect in future periods. Both of these conditions mean that WeWork will pay significantly more money towards its leases in coming years as generous lease terms give way to onerous ones.
WeWork has sought to downplay concerns about its future through several creative accounting strategies. In its IPO prospectus, it emphasizes its “contribution margin”, defined as the revenue it receives from its customers while subtracting costs incurred at each office space. Notably, this statistic excludes a large portion of rent costs, as it captures temporary free rent periods while ignoring future rent escalation. WeWork’s “contribution margin” may be on the rise as it continues opening new locations, also subject to free rent periods, but this upwards trajectory will eventually stall and then reverse as expansion slows and leases expenses kick in. Even WeWork admits on page 42 of its prospectus that one of its primary costs, developing leased spaces into offices, is likely to climb because its “ability to negotiate…significant tenant improvement allowances has been and is expected to continue to be impacted by [its] expansion into markets where such allowances are less common”. In other words, as it leases more properties, WeWork is less likely to be reimbursed for its primary cost of doing business.
WeWork tries to allay concern over future performance of its “contribution margin” by claiming that “higher membership and service revenue as a result of…higher-priced membership agreements” will offset future costs. However, this supposition is conditioned on the idea that its members will continue to renew their licenses and pay for the same services at higher prices. This would be possible if customers’ demand was inelastic (insensitive to price increases), an unlikely claim considering the many available substitutes in this market, including remote work and traditional offices. As it stands, investors should place little weight in the contribution margin as a marker of WeWork’s potential.
In its prospectus, the firm also chooses to present its balance sheet without adhering to a new accounting standard, ASC 842. This new rule reclassifies a large portion of operating leases, which must now be recorded on balance sheets as both an asset and a type of debt. While compliance to this standard is not mandatory yet, WeWork’s choice to base its financial statements on previous regulations paints a very different picture of its current and future financial position. In doing so, the firm keeps billions of dollars in debt off its financial statements. The fine print in WeWork’s prospectus reveals future operating lease obligations valued at a total minimum payment of almost $34 billion, the majority of which will show up on its balance sheet once ASC 842 becomes mandatory for private companies in December 2019. While these new liabilities are balanced by an increase in assets, the increased transparency around future lease obligations will impact financial statistics like debt-to-equity and debt coverage ratios.
Another concern has been brewing among potential investors for some time: a lack of confidence in the company’s leadership. Co-founder and now-former CEO Adam Neumann has been singled out for several questionable actions carried out during his time as head of the company, including the involvement of his wife, Rebekah Neumann. Mrs. Neumann was heavily involved in the production of WeWork’s S-1, and was largely responsible for the unorthodox presentation of the document. Her involvement was a point of contention among executives; as one put it, “The traditional approach to producing an S-1 is bankers and lawyers hashing this out, but the process was continually usurped by Rebekah’s involvement.” It was also reportedly emblematic of the company’s leadership under Neumann, as one employee told New York Magazine, “The thing that’s so damning about all that is that it’s just not the point of the document… That’s the thing about WeWork: You’re spending all this time working on the surface of it instead of the actual truth of the thing.” SoftBank has since taken control, but it is still searching for a new CEO for WeWork.
Potential investors also disagreed with the prospectus’ outline for the company’s voting structure, specifically the allotment of super-voting shares to Mr. Neumann. Super-voting shares give holders extra votes in corporate matters, allowing them to wield a disproportionate amount of control relative to the number of shares they hold. WeWork’s original IPO filings listed Neumann’ shares as worth 20 votes per share, compared to the one vote alloted to each publicly-offered share. Later amendments to the prospectus lowered this ratio to 10-to-1. Following Neumann’s resignation, his shares held extra voting power of only 3-to-1. It is not surprising that prospective investors balked at the original voting structure outlined in the prospectus. IPOs are not just a different way to raise capital; they are an opportunity for investors to secure a stake in the company’s ownership. This ownership stake takes on a greater importance (and value) when investors lack confidence in a company’s current leadership, as it allows investors to push the firm to make better decisions. Without sufficient voting rights, investors may be unable to ensure that company leaders are acting in their best interest. SoftBank ultimately bought out Neumann, but control of WeWork came at a steep cost.
With the extent of WeWork’s questionable corporate governance and uncertain financial future, the public had good reason to be wary of WeWork’s IPO. However, several questions remain. Why would private investors look past these issues for so long? If they did, why did they let these issues come to light by attempting to go public?
The answer to the first question depends in large part on the type of stake private investors hold in the company. Since private companies do not sell shares on public exchanges, the ways in which investors stake a claim in such companies is a little more complicated. The most basic form of investment would be to simply loan funds to the private firm, with a return on investment comprised of interest earned on the loan. This strategy has limited upside, however, as the lender is only entitled to return of the loaned amount with interest.
Investors can also secure an equity stake in the private company, which gives them a way to cash in on the firm’s future growth. The private investor may invest in the company by purchasing different types of shares, such as preferred (non-voting) stocks or voting shares. The drawback of this approach is the smaller pool of available buyers compared to stock listed on public exchanges, which can easily be bought and sold. Another strategy is investing in warrants, which give the private investor the right to buy shares at a set price on a later date.
In the leadup to WeWork’s IPO, the company’s biggest private investor, SoftBank, had over $10 billion invested in WeWork via a variety of financial instruments, including preferred stock, warrants, convertibles, and joint ventures. Together, these investments gave SoftBank a 29% stake in the company. However, the vast majority of this stake was tied to preferred stock or the right to own preferred stock in the future, neither of which gave SoftBank voting rights. Perhaps it was this lack of direct control that prevented Softbank from stepping in to improve WeWork’s corporate governance and financial woes.
Still, SoftBank held the purse strings for a large portion of WeWork’s available capital, thus it holds significant influence over the direction of the company. It was SoftBank officials that supposedly pressured Mr. Neumann to step down following the frigid reception toward WeWork’s IPO. SoftBank again wielded its financial influence when it bought out Neumann’s stake in the company, providing WeWork with a vital injection of capital in return for a controlling interest in the company. Many analyses lay blame at SoftBank’s feet for not acting sooner. They claim the investor simply misjudged WeWork’s potential profitability, doubling down on a bad investment by allowing the IPO to proceed as far as it did.
Hindsight is 20/20. While it may have miscalculated on its assessment of WeWork’s value, even now SoftBank faces additional risk the longer the IPO is postponed. As mentioned earlier, WeWork’s future prospects are shaky to say the least; a serious revision of its business model is necessary to become profitable. Softbank needs an exit strategy if WeWork’s performance does not improve. IPOs make it easier for private investors to cash out on their investments by selling their stake in the company on public exchanges. Even with clauses in place to prevent the sale of shares too soon after an IPO, the ability to liquidate its stake in WeWork will be a valuable option for SoftBank in coming years. While WeWork is now taking time to address corporate governance concerns before its next IPO attempt, its financial position may worsen as time goes on, especially in the absence of capital injections from an IPO.
SoftBank also made sure to protect itself in the event of a poor IPO performance. While the majority of its WeWork investment is in the form of non-voting equity shares, a clause in WeWork’s amended IPO reveals that owners of preferred shares can convert their holdings to common (voting) shares at a predetermined ratio if WeWork’s IPO underperforms. Known as an anti-dilution provision, this clause would give Softbank up to $400 million in additional common shares. While not protecting against losses entirely, this would dampen the blow to SoftBank’s multi-billion dollar investment in WeWork.
However, measures like the anti-dilution provision and an early liquidation of its WeWork investment would only serve to turn SoftBank’s paper losses into realized losses. Now that it has control of WeWork, SoftBank surely hopes to find a way to regain investor confidence in the startup. The ideal situation would be for WeWork to reel in its losses, demonstrating that it can translate its incredible growth into profits. Like the superstar firms in Silicon Valley, it must tap into the gold mine of network effects, in which growth directly improves the quality and profitability of the services it provides. If WeWork can convince investors that it can not only talk like a tech superstar, but operate like one too, it may still salvage its IPO and its future.