This article delves into the Space-as-a-Service (SPaaS) business model, valuation growth and its journey to initial public offering (IPO). We will analyse the importance of corporate governance, non-financial metrics and behavioural bias impacting start-up valuation as the financial metrics, such as cost of capital estimates, DCF and pre-revenue valuation, are heavily scrutinised.

The Rise & Fall

WeWork had its humble beginnings as a New York-based real estate arbitrage firm that offered flexible, community-focused co-working spaces for entrepreneurs that became the world’s largest company by private market capitalisation servicing global real estate solutions for Fortune 500 firms. Established in 2008, WeWork became the world’s largest privately-held company by market capitalisation within a decade. It achieved unicorn status with a $1.59B valuation in 2014 and reached $47B by January 2019.

It transformed the commercial real estate sector through its innovative technology and IoT to track office space usage and optimise energy consumption while enhancing design through usage analysis. This drew massive investment from top private equity firms and significant funding from SoftBank, JP Morgan, Goldman Sachs, and others. Pre-IPO private valuations ranged from $43B to $104B, according to Morgan Stanley and Goldman Sachs. In Aug 2019, WeWork filed for an IPO with the SEC and faced intense scrutiny of its finances and leadership from the media, leading to investor scepticism about its high valuation. WeWork’s complex structure, lack of corporate governance, ongoing projected losses, and controversial transactions with CEO Neumann, including trademarking the word “We”, led to the failed IPO and Neumann’s departure. SoftBank funded the company and brought in new leadership.

Under new management, WeWork went public in Oct 2021, with its stock opening at $10 on the NYSE under ticker WE. It has raised a total of $21.9B over 22 rounds, with its latest funding in May 2022 from a post-IPO debt round. Despite the pandemic’s impact on global commercial real estate, WeWork has sustained growth and changed its business strategy. SoftBank, despite heavy write-downs, continues to invest in the company with the belief that the business will eventually break even and become profitable, but this was far from the truth. 

Business Model Analysis

WeWork’s core business model is real estate arbitrage, not technology. It pioneered technology usage to enhance physical spaces, offering flexible co-working spaces and disrupting the commercial rental industry. During its growth phase, it secured low-interest, long-term leases in prime locations, transformed the room, and subleased it to members for shorter periods.

The company generated revenue from membership fees and higher aggregate rent from its densely-designed co-working spaces. Its unique value proposition of lower cost per desk and short-term rentals facilitated rapid customer acquisition in high-demand commercial locations. WeWork also incurred ongoing expenses for communal facilities such as design, technology, baristas, and other communal costs.

Riskiest Assumptions

Blinded by growth extrapolation and overconfidence, WeWork may have underestimated the risks involved in its business model.

• Fixed Cost Risk – By committing to long-term real estate leases, WeWork increased its right-of-use liabilities and costs without holding assets. Short subleases expose WeWork to the risk that tenants may leave on short notice, leaving the company with mounting lease obligations and exposed to SME credit risk.

• Real Estate Market Risk – Betting on a bullish real estate market, WeWork factored in future fee revenue growth based on demand and economic growth while keeping leasing costs and technological and operational expenses. A market downturn fueled by macroeconomic factors would significantly vary the cost of capital. 

• Customer Segment Risk – the company’s initial customers were a young early-stage start-up, individuals, and SMB segment who are often in a bootstrapped venture, and conversion to a longer-term commitment through customer loyalty was not viable. 

Key Takeaways:

Market capture and growth from early adopters should not necessarily indicate exponential growth in future. Consistent marketing and customer acquisition costs should be factored into the valuation. Noticeably the company also campaigned on revenue-sharing arrangements without thoroughly analysing the cost of operations down to the workstation level. Flexibility comes at a higher price, as seen in Options – WeWork underestimated the financial cost of ‘Option’ it provided to its customer in terms of pricing while operating a lock-in business model.

Behavioural Bias in Capital Budgeting

“Our valuation and size today are much more based on our energy and spirituality than it is on a multiple of revenue” quoted Adam Neumann, the former CEO of WeWork. 

Despite the best efforts of sophisticated investors and underwriters, cognitive bias still exists when assessing an investment, as the WeWork debacle demonstrated. The massive fall in valuation in a matter of weeks was due to the impact of various behavioural tendencies, including information processing and emotional biases.

1. Anchoring and Confirmation Bias

Morgan Stanley pitched the valuation of WeWork pre-IPO upwards of $104B in 2019, reflecting the anchoring bias of conglomerate investors such as SoftBank and the high valuation provided by internal investors such as JPMorgan, which also allowed a debt facility. Even with independent modelling, confirmation bias amplified by trust in the validity of the assumptions likely led to such a high valuation.

2. Loss-Aversion and Endowment Bias

From the perspective of investors who have continued to suffer losses due to the WeWork failure, loss aversion and endowment biases could be to blame. SoftBank’s Masayoshi Son is a well-known investor in high-risk, hyper-growth private ventures. Despite the collapse of the 2019 IPO, SoftBank continued to bail out WeWork, leading to a significant write-down on its investments in the company.

3. Representativeness Bias

The fair value of private entities in unobservable markets is largely impacted by the benchmarking data available. WeWork was an amalgamation of technology and real estate, with a combination of hyper-growth tendencies and consistently bullish property. The reliance on best-fit approximation to determine the factors influencing valuation could have impacted the results.

4. Overconfidence, Planning Fallacy, and Illusion of Control

From the inside, the ‘cult-like’ following of Neumann, boosted by the grandiose plan instilled by Son, likely led to the Dunning-Kluger effect of overconfidence in the business model and growth projections. Start-up growth at an early stage is not an indicator of future trends, and the illusion of control likely caused oversight in corporate governance issues, while the planning fallacy impacted the underestimation of operational costs.

Mitigating Bias Risk in Capital Budgeting

A pre-designed valuation model is a pathway to overcoming behavioural bias in evaluation and making a sound investment decision, especially for entities in unobservable markets and privately held start-ups in the pre-revenue stage. The evaluation techniques used in assessing the return on investment in capital budgeting are consistent across industries, but the surveyed results indicate that DCF and CAPM models with assumptions about associated risks are the most common. An arbitrary adjustment and wide assumptions can lead to volatility in financial modelling results.

Adding a layer of capital decision bias metrics to validate the possible outcome of the analysis, and critically applying solutions such as aggregating input from a broadened scope, determining a portfolio of relevant metrics, and forecast-actual trend analysis are suggested approaches to mitigating the risk of behavioural biases.

However, recent developments have shown that more than applying such techniques may be required to overcome behavioural biases fully. As such, it is crucial for investors and underwriters to keep themselves informed of the latest developments in the field and to seek out external content to update their knowledge continuously. This will help them make better investment decisions and avoid costly mistakes like those made in the case of WeWork.

Corporate Governance failure:

The failure of corporate governance in the case of WeWork can be attributed to several factors, including:

1. Lack of accountability and oversight from the board of directors and Insufficient checks and balances in the company’s management structure.
2.  Conflicts of interest between the CEO and other stakeholders.
3.  Inadequate risk management, financial controls, transparency in the company’s financial reporting and decision-making processes.

These factors contributed to a culture of unchecked growth and mismanagement, ultimately leading to the downfall of WeWork.