On track for a now-delayed IPO, SoftBank-backed WeWork’s valuation has fallen from $47 billion to somewhere in between. $10 billion and $15 billion. This precipitous fall appears to be a collective repudiation not only of WeWork’s business model and SoftBank’s valuation philosophy, but also of the reverse big-money unicorn economy with no path to profitability.

WeWork’s valuation challenges highlight potential issues that SoftBank’s other real estate investments, namely Compass and Opendoor, could face in their march to the IPO.

Strong growth, fueled by capital

WeWork shares a number of traits with Compass, a real estate agency, and Opendoor, a iBuyer: They all deal in real estate, have raised massive capital from SoftBank at multi-billion dollar valuations and are growing incredibly fast. All three are unprofitable, pay most of their revenue as cost of sale, struggle with their identity as a tech company and, in the case of Compass, have a profitable, publicly traded rival that’s a lot less valued.

The business model of Compass is fueled by capital. It has raised over $1.5 billion, which it is using to acquire brokerages and recruit agents on an unprecedented scale. It turns dollars into agents, which in turn generate revenue.

Opendoor has raised over $1 billion – more than 10 times its nearest competitor – and used that capital to fuel rapid national expansion (in addition to launching a mortgage business and acquiring a securities company). Opendoor is on track to buy around 17,000 homes in 2019.

When a company raises such large amounts of capital, there is only one possible exit: an IPO. The other route – an acquisition by another company – is left out of the equation due to the massive valuations involved; other companies cannot afford the transaction. Case in point: Compass’s $6.4 billion valuation is comparable to Zillow’s and almost four times that of Redfin.

When selling my business years ago, a trusted advisor told me that a business is worth what someone else is willing to pay for it. SoftBank is certainly guilty of testing the upper limits of private company valuations, and the WeWork episode makes it clear that what SoftBank is willing to pay for a company is quite different than anyone else’s.

Justifying an exorbitant valuation

WeWork and Compass both have profitable, publicly traded rivals that are much less valued (IWG for WeWork and Realogy for Compass). In WeWork’s case, “IWG has a lot more square footage and more customers, and has actually made a profit, but its market capitalization is only 8% of what SoftBank’s latest funding round thinks WeWork is worth. “, according to Recode.

the the wall street journal examined why WeWork is struggling to sell its story to investorsand summarizes the story as follows:

  • WeWork’s revenue is growing rapidly, but so are its expenses.
  • WeWork’s operating losses keep pace with its revenue.
  • WeWork is raising bigger and bigger sums, but has yet to report a profit.
  • And a profitable, publicly traded rival is valued at significantly less.

In 2018 (the last full year for which full information is available), Compass’s publicly traded rival Realogy had 42 times the trades, 11 times the sales volume, seven times the revenue – and actually made a profit! – but a company assessment at the same level as Compass.

WeWork, Compass and Opendoor have valuations that are tied to their impressive growth rates, but when that growth depends on having and spending large sums of money in an unsustainable way, it’s hard to justify.

Impact on Compass and Opendoor

If public market pressure continues to drive profitability, it could accelerate (or force) a shift in the operating economics of Compass and Opendoor, which so far have fueled their massive growth with massive spending.

A desire to increase revenue could lead Opendoor to increase its fees, or Compass to reduce its generous commission splits with agents; either decision would severely limit growth. Spending cuts would take the form of office consolidation (Compass has more than 250 offices in the United States), reduced employee benefits, or even layoffs.

(Uber, another SoftBank investment, recently announced a series of layoffs across its product and engineering teams: 435 people, or 8% of its entire workforce, were laid off. This comes just months after Uber, whose stock is down more than 20% since its IPO, announced it was cutting 400 employees from its marketing division.)

stock options

Those most affected at WeWork, Compass and Opendoor could end up being employees and contractors who have stock options. Compass, in particular, has used it as a key tool for recruiting and retaining agents, and a drop in valuation would make those options worth a small fraction of what was originally promised.

In addition to stock options granted as an incentive for agents to join Compass, these agents can also invest a portion of their commissions in the business. As of November 2018, over 1,000 Compass agents have invested over $20 million in stock options.

And while Compass’s valuation isn’t going down – it recently went from $4.4 billion to $6.4 billion –the rate of increase slows down.

Compass is not WeWork, nor is Opendoor. But to succeed, the three companies need unprecedented capital and a willingness to buy into a vision that is more about words than numbers and where the long-term validity of the business model is easier to assert than to prove.

The current WeWork fiasco (and to be clear, we’re talking about a 70% to 80% drop in value just from opening the books and being honest with the company) shows that valuations cannot not continue to rise unchecked by the realities of basic economics – and that investors’ patience has a limit.

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