RIP WeWork - Time to Rebrand?

Adam Neumann turned over $10bn of equity into an $8bn company. Where to now?

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Now the dust is well and truly settled on WeWork’s attempted IPO, and its rescue refinancing is more or less locked down, let's debunk some of the myths around the company and look at where its future – and true value – lies.

A great deal of nonsense has been written about both WeWork and its founder Adam Neumann, including comments in the Financial Times that the failed IPO was “a severe setback… for visionaries everywhere” and indeed that it posed significant questions for many other technology start-ups.?Truth is, the WeWork story has almost no implications for visionaries or tech entrepreneurs, unless they are castle-in-the-air builders.?Here’s why.

Let’s start out with a dose of reality, and five things that WeWork is not:

1. It’s not a technology company: Unlike Uber or AirBnB, for example, WeWork is not a technology business. WeWork’s core business is entering long leases for bare floors with property owners and renting fitted-out offices on short-term contracts to individual tenants and companies.?This is more like timeshare holiday accommodation than a technology business.??
2. It’s not a platform company:?Again, unlike Uber or AirBnB, WeWork isn’t really a platform business.?Those companies orchestrate the use of third-party assets (cars, accommodation), whereas WeWork takes on the leases for most of the property that it rents out itself, making for much more capital and risk-intense operations.
3. It’s not a design-leader: Never mind the hype – the physical design of the typical WeWork office is hardly inspirational, let alone cutting-edge.?I visit a lot of different office spaces through my work around the world, and WeWork’s design language is far from memorable.?It may have led the sector in its early years, but it’s hard to say it does now.
4. It did not create a new “sector” Yes, WeWork did not invent the idea of providing fitted-out offices on short term leases. Regus has been in this market since 1989 and has some 2.5 million customers (quite a few more than WeWork).?Meanwhile Australia’s, Servcorp has operated at the premium end of the market since 1979, forty years ago this year.?
5. It does not have a new business model: There’s also nothing new in the way that WeWork does business.?Most of its revenue derives from office rentals, just like any other office leasing business.?It has, according to some reports, been offering very high incentives to tenants for committing to longer leases (one to two years, rather than month to month), though this is hardly an attractive feature from an investor’s perspective.?And free beer isn’t a business model, it’s a just marketing.

So, what is WeWork, and why has it been so successful in growing its revenues??And yes, we’ll come back to profits later.?

The essence of WeWork’s attraction to both the landlords from whom it leases property and the tenants that are its customers is that it addresses the need for flexibility.?Traditional landlords are not currently well set-up to manage short-term leases, as their marketing, lease terms and lease execution processes focus on large, long-term contracts.?Moreover, banks and building valuations both favour the security of long-term leases, dis-incentivising innovation by property owners.?Meanwhile, tenants increasingly demand flexibility as their own industries and corporate futures become less certain.?In appraising WeWork’s prospects, don’t ever forget the latter, as it has profound implications for inherent risks.

Though WeWork is the front man in the flexibility parade, landlords are still taking on nearly all the risks through the back door, by leasing their properties to WeWork.?

Though WeWork is the front man in the flexibility parade, landlords are still taking on nearly all the risks through the back door, by leasing their properties to WeWork.?Indeed, most of the underlying risks remain with the landlords, as WeWork’s leases are executed through individual special purpose vehicles with very little recourse to the parent in the event of financial distress.?In other words, in a downturn, WeWork can simply allow these entities to fail, and consolidate its customers back into a reduced number of office locations, some of which it owns directly.?Landlords will be left holding the baby – or empty stroller in this case.

This is not to say that the shared office model isn’t attractive – far from it.?WeWork provides tenants with flexibility and, even without the aggressive discounts that have been on offer, attractive value for money too.?There are significant efficiencies in sharing communal spaces such as kitchens, break-out areas, meeting rooms and receptions, which are typically massively under-utilised in the average office.?There are also hidden savings in some of the shared services, such as meeting room management and mail delivery.?

We’ve experienced this firsthand, as we relocated our Australian HQ a couple of years ago, reducing our direct footprint and outgoings significantly, but gaining access to significantly more space overall.?Incidentally, we did not choose WeWork, as other operators offered both better design and office ambience.?

So, how has WeWork managed to grow its global footprint and revenue base so much more rapidly than Regus or Servcorp??The short answer is money.?WeWork has been able to raise huge amounts of external capital at what now is viewed as a vastly inflated valuation.?Remember the last mooted valuation for the whole company was $10bn, less than total amount of money the company has raised to date..

This money has been spent on promoting the company’s brand, and on offering extremely high incentives to customers who commit to leases of a year or more.?In some cases, I have heard that these have been as much as twelve months rent free on a two-year lease - or 50% off the rent, if you prefer to think about it that way.?

WeWork’s massive risk is that it may be attracting the most price-sensitive tenants

This equation goes some way to explaining why WeWork’s rental income falls short of rental outgoings.?Over anything other than the short term, this level of incentive is entirely unsustainable.?WeWork’s massive risk is that it may be attracting the most price-sensitive tenants, and/or those who know that their demand for office space may well contract dramatically in any down-turn.?Regus has previously filed for bankruptcy, as most large landlords will recall.?

WeWork has also been able to spend a huge amount of money promoting its brand and office locations, something that longer-established competitors run with at least one eye on profitability could not match.?Quite likely both Regus and Servcorp could achieve similar growth if they were prepared to sustain such massive losses.?But both have focused on bottom line profits rather than top line growth, and both have seen their share prices move up significantly over recent months.

What does the future hold?

WeWork’s challenge is that, under its current business model, the company does not appear to have a clear path to profitability, even if it slows its growth dramatically to cut down on the costs of expansion.?There are only a handful of practical solutions to this problem and all of these would be needed to justify its current valuation (even in the US$10bn to US$15bn range):

• Retain customers at substantially higher net rents;
• Continue to attract new customers and grow revenues without offering large incentives;
• Weather the next downturn without materially contracting its footprint; and
• Find ways to create additional value for customers that they will pay for – ie provide services to customers that help improve their efficiency and reduce associated costs in other areas of their businesses.

The numbers here are, however, very challenging, as all high-growth superstars eventually return to earth-bound valuation metrics in the end (as Facebook and Google did long ago).?To justify a valuation of $10bn or so (the last number mentioned before the IPO was pulled), WeWork would need to double revenues with virtually no change in operating costs – assuming it was then valued on similar metrics to Regus or Servcorp.?This is a tall order for most businesses.?

To justify a valuation of $10bn or so, WeWork would need to double revenues with virtually no change in operating costs

And this brings me to one other critical point – WeWork has little in the way of a scale advantage.?It is incredibly easy for competitors to open co-working spaces, as thousands of small operators have done, often offering a much better product at a competitive price.?Our own business has leased space with several smaller operators, as well as Servcorp and Rent24 over the last couple of years.?And large landlords are beginning to enter this market directly, a further threat to WeWork’s future growth.?

As an aside, it’s worth noting that Servcorp has already cracked the profitability conundrum faced by many co-working spaces.?It remained profitable through the last downturn, and – despite a massive increase in competition over the last decade – has managed to continue to expand its footprint slowly whilst maintaining occupancy rates.?In part, this has been achieved through a strong service proposition, with services accounting for a roughly a quarter of all revenues.?The company also has an operating platform which allows it to achieve dramatically higher operational efficiency than WeWork.?

Where to from here?

There’s no doubt that the future of the flexible office leasing sector is bright.?When I wrote the first version of this piece, Servcorp’s share price was up around 60% from its recent low of $2.66 to $4.37.?Regus (or IWG as it’s now known) had seen its share price more than double since December 2018 to ￡4.12. As at 23rd October, Servcorp's price had held more or less steady, and Regus was up a further 20% to ￡4.90.

Meanwhile, larger companies are shifting progressively more of their overall office space to flexible office arrangements.?Smaller companies are increasingly shifting their entire operations into dedicated suites within shared offices.?As these trends continue, the best operators (whether they run a single floor or a million workstations) will offer a broader array of services, helping their tenants to reduce their overall outgoings, whilst capturing more value themselves.?In a sustained economic downturn, short leases will be the first to be cut back.?So, there are substantial downside risks too, and we would expect many operators to fail if and when the next recession unfolds.?

In its IPO prospectus, WeWork stated that it’s guiding mission is “to elevate the world's consciousness” – hot-air drafting that is unlikely to inspire the calm, cold minds of investment analysts.?

In its IPO prospectus, WeWork stated that it’s guiding mission is “to elevate the world's consciousness” – hot-air drafting that is unlikely to inspire the calm, cold minds of investment analysts.?If WeWork makes a second run at a listing at some point in the future, it's a safe bet that the yogic musings of its founders will be banished from the lexicon and the focus will be squarely on the company's pathway to profitability (assuming that it has found one).

Let's spend a moment thinking about what the future for WeWork holds. In doing so, it is instructive to follow through how the company crashed from mooted valuations of us much as $100bn to just $8bn this week.

#1 - Crazy Valuations: Various media outlets eventually got their hands on the pitch documents used by investment bankers trying to secure a piece of the IPO. The valuations put forward were truly mind-boggling, even by the uber-frothy standards of Wall St.

• JP Morgan: $46bn to $63bn
• Goldman Sachs: $61bn to $96bn
• Morgan Stanley: $18bn to $52bn (down from $43bn to $104bn in 2018)

Remember, there are no "new valuation metrics". To sustain its value, every company eventually needs to generate reasonable levels of profit - the market will only let you stay ten seconds ahead of your own bullshit for so long... With Regus valued at only a small fraction of these numbers - indeed it's valued at only a modest fraction of the $10bn tag attached to WeWork before its value disappeared off the bottom of the charts - it's unlikely these figures will ever be achieved, at least in my own lifetime.

#2 - Neumann's toast: WeWorks' board was placed under huge pressure to attempt to rescue the listing ship. Co-founder Adam Neumann was been pushed upstairs from the CEO role to non-executive Chairman, with significantly reduced influence. His super-voting shares were cut back to 3:1 power (from 20:1) and he lost majority control of the business. His wife and co-rounder Rebekah's role was also trimmed substantially - and then completely eliminated.

Whilst these changes cleared the air a little for the newly-installed Co-CEOs Artie Minson and Sebastian Gunningham, they id nothing of themselves to address the huge profitability chasm that yawns in front of WeWork. The company's cost base is still more than double its revenues, meaning that these two must engineer a decent increase in revenues (ie charge customers more) and take a deep knife to the cost base to reach a credible P&L. So these changes were little more than a corporate governance amuse-gueule.

#3 - First round rationalisation: 24 hours into the new co-CEOs' tenure, and there was already talk of a swinging cost-cutting exercise. There were reports of honesty-based snack carts being shut down (due to rampant customer dishonesty) and doubtless the Prosecco taps in the kitchen's won't be far behind.

On a more serious note, there was also talk of a significant rationalisation of the company's workforce. But here's the thing. Even if WeWork fired all it's employees, it would I think still be making losses, as its other costs alone are greater than revenues. Now that's unsustainability, man!

#4 - Further write-downs, rescue ReFi: A couple of weeks on, and the outlook for WeWork looked as bleak as ever. The company's bonds were trading at a discount of around 14%, with dire implications for the value of equity. Media reports began to appear that the company would run out of cash as soon as November - implying implicitly that it probably couldn't afford to make redundancies, as it wouldn't have been able to afford the payments.

Meanwhile, there was also talk about a multi-billion dollar rescue refinancing at an equity value of $8bn or less. This would significantly dilute existing shareholders, and at least give the company time to explore whether a profitable business could be carved out of the massively over-inflated cost base. For the first time in this sorry tale, voices of reason appeared to be entering the conversation.

Bankers were appointed and were understandably working through the lease portfolio with a fine tooth comb, with the implication that any property that cannot be turned to profit fairly rapidly may be axed. This would trigger some cost for WeWork, but most of the pain would be borne by landlords. The latter will be watching this part of the story with both interest and concern, I am sure.

#5 - The Svengali is dead: After reports that JP Morgan was attempting to build investor support for a debt-based rescue package, on 22nd October WeWork's board accepted an alternative proposal from Softbank, WeWork's largest investor, and indeed the only party to have invested money in recent years.

Given the huge challenges in turning WeWork into a profitable company, the terms of the deal look generous, not least for its co-founder Adam Neumann:

• $1bn for Adam Neumann's shares, plus a 'consulting fee' of $185m and a $500m line of credit (and remember Neumann has already sold several hundred million dollars of shares). His remaining shares lose their preferential voting rights, and with a residual stake of under 10%, his board role is reduced to observer;
• $2bn for a partial buy-out of other investors. Early investor Benchmark bought in at a valuation below $100m, so the FT reports that it will book a cool 40x return on its investment (allowing for dilution along the way). Later investors will not fare so well;
• $1.5bn injected into WeWork's equity. This is sufficient to cover operating losses for six months or so;
• $5bn of new debt facilities. This will provide the company with runway for several years, and indeed longer if operating losses can be slowed or stopped;
• Apparently tens of millions will be paid to JP Morgan for its role in running the IPO process and attempting to arrange a debt package.

Is Softbank making a well-timed investment, or catching a falling knife? Only time will tell. On the positive side, it is close to the business, having been a repeat investor over recent years. On the other hand, it remains unclear how well Softbank really understood the business, as evidenced by the stratospheric valuations ascribed to the business in earlier financing rounds. My instinct tells me that there are more write-offs ahead in 2020 and 2021. At the time of writing, its bonds are trading at 85 cents on the dollar, suggesting there's a decent chance that the equity is worth nothing at all.

Others may see that turning more than $100 into $80 or less does not equate to a brilliant return on investment.

Prior to this deal, Softbank had invested more than $10bn in WeWork. Adam Neumann has turned that investment - together with several billion dollars in debt - into a business worth just $8bn on paper, and much less if you believe our own analysis, or the FT's Lex. Some will no doubt say that Neumann "built an eight billion dollar value business, so he deserves his 25%". Others may see that turning more than $100 into $80 or less does not equate to a brilliant return on investment.

Meanwhile, in all this there is little talk of employees. Despite all the pain the company has been through, by and large morale appears to be reasonably strong within the business. This may change after what are likely to be large headcount reductions, cut-backs in benefits and a much more stringent approach to cost control.

Where to from here?

As I'd already outlined, turning the WeWork cash-chewing machine into a profitable business remains a real challenge. Some sense appears to have emerged - most of the talk of WeWork being a 'tech company' or a 'platform company' has been tossed in the shredder.

Like most turnarounds, the best plan will be a simple one:

1. Bring in new leadership - it seems fairly likely that Artie Minson and Sebastian Gunningham (the internal candidates who replaced Neumann and became joint CEOs) will resign and be replaced in due course. Further changes will flow down the organisation.
2. Establish a new strategic destination - It's imperative that WeWork identifies clearly what a profitable end-state business model looks like, and works back from there. The right approach will factor in what's required for the business to be profitable, and will assume that it is then valued more or less in line with listed peers IWG and Servcorp.
3. Align every action with achieving that end state - This will mean a much more cost-efficient operating model, as well as finding new ways to generate income from services that customers value, and which offer them better value for money than their current suppliers.
4. Think long term - though there will be much pressure to slash costs to control WeWork's monstrous burn rate, it needs to take care to retain and motivate the people that are key to its longer term success.

All this is easy to say, but much harder to do in practice. Most companies focus on 'strategic direction', without clarity of end-objectives. Faced with an operational and financial firestorm, WeWork may well do the same.

In the meantime, the WeWork name has been dragged through the mud in 2019 - in terms of leadership, financial performance and governance - and many potential customers will be more aware than ever of the plethora of competing options. So it would not surprise me at all if WeWork rebranded itself in the next six to nine months, whilst simultaneously carving out one or more new brands to apply in individual segments, including premium locations and corporate services.

Finally, as I said at the start, nothing in this flopped IPO should create any worry for visionaries or tech entrepreneurs.?Innovative businesses that create value for their customers and have a sustainable business model will continue to thrive.?If there is one old lesson for today’s founders to (re)learn, it’s this. Don’t dump your own stock in private trades before a public market offering.?Unless, of course, you’ve seen the valuation writing on the wall…

Nigel Lake is Executive Chairman of Pottinger, a global advisory business headquartered in New York and London