WeWork has had a tough time as of late. Since it shared its IPO prospectus on August 14th, the company has:
Pushed out its founder and CEO Adam Neumann
Reduced Neumann’s voting powers and sold Neumann’s private jet
Had its publicly traded debt fall to an all time low price of 84.5 cents on the dollar
Discussed layoffs affecting 5,000 employees
Postponed a $6 billion dollar loan deal
Had investment bankers recommend a $10 billion price target for the company, down 80% from its last $47 billion private valuation
Officially withdrew its initial public offering
And that’s all in less than 2 months.
But what’s more surprising than the downward spiral for WeWork, is how the fall began in the first place. WeWork didn’t have any sudden controversy. There wasn’t a scandalous case of impropriety. There wasn’t a competitor that made a hugely threatening move. There wasn’t a change in customer behavior or a shift in the regulatory environment or some other unexpected market force. WeWork’s core business, financial performance, customer satisfaction, company culture, mission, vision, and leadership were exactly the same before the fall as they were after the fall.
There was really only one thing that happened: WeWork asked investors the question “what are we worth?”. And from there, everything changed.
To price or not to price
“When the stock is up 30% in a month, don’t feel 30% smarter — because when the stock is down 30% in a month, it’s not going to feel so good to feel 30% dumber.”
Jeff Bezos, founder of Amazon
On August 8th, 2017, The Walt Disney company announced they would be pulling their content off of Netflix in 2019 in preparation for launching its own subscription streaming service Disney+. Disney’s stock fell 5% the next day, one of the worst single-day declines in years for the media giant as many investors questioned the risky strategy to forego hundreds of millions in licensing revenue from Netflix for an unproven new product. Fund manager Michael Browne said about Disney’s move to try to enter the subscription arena: “I think it’s late and it’s probably arrogant”.
18 months later on April 12th, 2019, Disney made another Disney+ related announcement and disclosed that the price for their subscription product would be $6.99, two dollars cheaper than Netflix. Disney’s stock surged 11.5% that day, its biggest one day rise in a decade. Cowen & Co. analyst Doug Creutz said about the news: “We believe Disney+ is positioned to see very fast early adoption”.
Here were two separate Disney+ announcements with wildly different influence on the stock price. But the two announcements were similar in this important regard: there was no change in Disney’s actual business on either of those days. In the first announcement that erased billions of dollars of market capitalization from the Walt Disney Company, Disney didn’t lose a penny of licensing revenue from Netflix. In fact, they are still collecting revenue from Netflix even now as their licensing deal doesn’t expire until the end of this year. In the second announcement that created billions of dollars in enterprise value for Disney, they didn’t earn a single penny of revenue from Disney+ as the service hasn’t even launched yet.
In both cases, Disney+ had the same measurable impact on Disney’s current finances, which was zero. Yet the stock price, the market cap of Disney, and the overall value of the company changed so dramatically. Why? Not so much because the value should change, but rather because the value could change. Because Disney must ask the question “what are we worth?” every single day.
As a public company, investors get to answer that question of “what is Disney worth” every day through the act of purchasing their stock at a given price. Disney stock gets priced on good news, it gets priced on bad news, it gets priced all the time and Disney has no control over this. Disney can’t choose to not sell their stock when they end an important partnership, or only sell their stock when they generate excitement for a new product. But you know who can? A startup.
Startups don’t have to price every day because their stock isn’t available for purchase every day. It’s only available to purchase when the startup decides to make it available through the process of raising capital and selling shares to investors. Beat your revenue plan or exceeded your user growth target? That startup can choose to fundraise. Lost some key customers or had to delay a big product launch? That startup can choose to postpone investor meetings.
This is an important structural advantage that startups have over public companies. In the public market world, investors control when the company prices. But in the startup world, the company controls when they price. And control means that startups only have to ask the question “what are we worth?” when they think the time is right.
So when is the right time?
“…running a startup is also the way I think about raising money — it’s a process of peeling away layers of risk as you go.”
Marc Andreessen, founder of Andreessen Horowitz
The journey of startup fundraising can be described as a process of risk removal. At the very beginning when a startup is just formed, the entire company is a collection of risks as there are no assets, no products, no customers, nothing but risks. These risks are generally consistent for all startups and fall into these groupings:
Team Risk: can the founder(s) recruit a team to carry out their vision for the company?
Implementation Risk: can the team build the product they need to fulfill the company vision?
Market Risk: if the product gets built, will anyone use it?
Monetization Risk: if people are using the product, will anyone pay for it so the company can earn revenue?
Scale Risk: if a few people are using the product and there’s a little revenue being earned, can you grow to lots of people using the product and lots of revenue being earned?
Profitability Risk: once you have a lot of revenue, can you turn that into profits that can sustain the company?
Entrepreneurs then go raise financing to remove each of those risks, one group at a time. These startup financings fall into discrete moments (with their own class of stock) which we commonly refer to as Series: Series Seed, Series A, Series B, Series C, and so on. Not only are these Series fairly universal across all startups, the risk expectations for these series are also fairly consistent across investors. In other words at each Series, investors are actually expecting to see certain risks specific to that series — that's why they call it "venture capital". You’re a brand new startup just getting underway? It’s expected that all 6 risk groupings are present. But as your startup matures, investors will expect fewer remaining risks. By the time you’re a unicorn startup preparing to go public, Profitability Risk is probably the only remaining risk grouping that investors will tolerate (if that).
Visually, that risk removal process looks like this:
Series Seed startups have the most risk, but Series Seed investors also get to buy in at the lowest price as risk and company value are inversely correlated. That seed capital is then used to remove risks to get to the Series A, at which point investors are typically expecting Team Risk (you’ve recruited a capable group of builders) and Implementation Risk (you’ve built a product that works) to be removed. The Series A company is also partly through removing Market Risk — so they have some early adopters using their product but it may not be clear yet if those adopters are representative of broader customers, or if their usage is representative of broader behavior. Again, investors aren’t expecting all risks to be removed at the Series A, just some of them. Since there are less risks, the company has grown more valuable and the Series A price is greater than the Series Seed price.
At the Series B, investors expect Market Risk to be removed and the company on its way to figuring out Monetization. But the number of customers and amount of revenue can still be small at the Series B, (i.e. Scale Risk is still unremoved) and the company can still be unprofitable (i.e. Profitability Risk is still unremoved). At the Series C, Monetization Risk is also removed and the company is working on Scale, with still no expectation of profitability. And so forth for the Series D and beyond. At each Series, certain risks are expected by investors, others risks get removed, and the company gets more valuable as they do. Rinse and repeat.
Put it all together and startups actually have an advantage over investors during fundraising. The startup controls when they price, and they know what risks they need to remove before they ask investors the question “what are we worth?”. So a startup can not only wait to price on good news, they can even wait to price on exactly the right type of good news the investor is looking for at their stage.
But there’s an important scenario we haven’t considered yet: what happens when the startup can’t afford to wait? What happens when it’s forced to price?
“If your business is the right business, then money will never be an issue.”
Adam Neumann, founder of WeWork
There are many factors that contribute to a startup succeeding or failing. But here’s one sure path to failure: run out of money. In the infinite wisdom of Y Combinator founder Paul Graham:
Startup funding is measured in time. Every startup that isn’t profitable (meaning nearly all of them, initially) has a certain amount of time left before the money runs out and they have to stop. This is sometimes referred to as runway, as in “How much runway do you have left?” It’s a good metaphor because it reminds you that when the money runs out you’re going to be airborne or dead.
A company’s runway is therefore the ultimate deadline as there is no future beyond that date. Even if a company had well laid plans around when would be the best time to fundraise, those plans get superseded if their runway is coming to an end. In other words, when a company is out of runway, they lose control over when they price.
In WeWork’s IPO prospectus, the company reported having $2.4 billion in cash as of June 30th, which was forecasted by analysts to fund operations into Q2 of next year. But there have been a slew of recent rumors that spending is actually significantly more than forecasted and that the company only has runway through November. If true, WeWork may not have been choosing to price in August with their IPO filing. Instead, they may have been forced to price before they had removed the risks they wanted to.
And that’s an important lesson that applies to startups of all sizes. Again, controlling when you ask investors the question “what are we worth?” is a key structural advantage that startups have. Investors only get to answer that question when startups decide to ask it. Unlike with publicly traded companies that price every day, startups can pick whatever moment they want to price themselves, when they’ve removed all the right risks and there’s nothing but good news to share. But control over when you price requires that a startup has the runway to maintain control in the first place.
So perhaps the real lesson here is that before you ask the question “what are we worth?”, make sure you can answer the question “where is my runway?”…