The WeWork Debacle Is Just A Symptom Of A Much Larger Problem

When I first arrived in Poland in 1997, it seemed like the entire country was being rebuilt out of the Marriott hotel. Multinational companies looking to set up shop in the formerly communist country would rent temporary offices at the Regus Center there to get operations rolling. Later, they would move into more conventional space.

It was a good model that provided a useful service, but I was surprised to see that 20 years later that same model, in the form of a company called WeWork was being given a $47 billion valuation for an upcoming IPO. I was somewhat less surprised to see that valuation crash and burn almost as soon as the prospectus came out.

This is becoming a common tale of woe. Theranos, once the darling of Silicon Valley, was exposed as a fraud. Uber, the poster child for the sharing economy, saw its stock price collapse after it once again posting massive losses. It’s time to face facts. These are not isolated incidents but indicative how Silicon Valley investors misjudge the physical economy.

The WeWork Business Model

The WeWork business model is essentially the same as I saw in Poland two decades ago. The company acquires space from building owners using long term leases and then rents that same space out to businesses and entrepreneurs in the form of individual desks or offices. By charging more for the space in pieces than it pays for the whole, it can earn a profit.

A look at the financials of IWG, the parent of Regus, shows how this model can make for a decent business. In 2018, the company earned an operating profit of 154 million British pounds on 2.5 billion in revenues. That translates into 6% margins, which is respectable for a real estate business. So WeWork was, in a sense, following a tried and true path.

The problem comes when you start comparing IWG’s business with WeWork. While IWG had revenues of almost $7000 a desk and expenses just over $6000, WeWork had revenues of just over $4000 a desk but expenses of more than $8000. So While IWG was making a few hundred dollars per desk, WeWork was losing thousands!

What makes the comparison between the two companies even more curious is that while IWG, which is slightly bigger than We Work in terms of square footage is valued in the public markets at just under $4 billion, WeWork, as noted above, was privately valued by its venture funders at $47 billion?

How can a company that’s losing money hand over fist be valued more than ten times higher than a similar business that’s already profitable? Apparently, all it takes is a little Silicon Valley pixie dust.

The New Economy Promise Of Network Effects And Increasing Returns

One of the oldest principles of economics is that of diminishing returns. As you produce more of something, supply costs tend to increase while customers become less enthusiastic and demand less. While there are also positive returns to scale, such as improved efficiencies and reputation, the forces of diminishing returns tend to limit growth.

However, under certain conditions, such as when network effects are present and high upfront expenses combined with low marginal costs, instead of diminishing returns you get increasing returns. That completely changes the way a business makes money and how it’s valued.

Consider the case of Microsoft Windows in the 90s. As the dominant operating software, everybody wanted to use it because everybody else was using it. Customers were hesitant to go to the trouble of learning new software to switch and the marginal copy of the software cost Microsoft nearly nothing. That’s what made the business so valuable.

Today, companies like Google, Facebook, and Apple enjoy similar advantages from increasing returns. They are worth more than ordinary businesses because they function, at least to some extent, as platforms. That’s why today, if you’re an entrepreneur looking to impress investors, it helps if you can make a case that your business is, in fact, a platform.

The Platform Fallacy

As noted above, the coworking space business model is fairly straightforward. You lease space for a certain amount, rent it out to others for another amount and pocket the difference. It’s not exactly rocket science, but not terribly profitable either. The 6% operating margins that IWG earns is solid, but not stratospheric.

Yet WeWork argued, in great Silicon Valley fashion, that it was something more. Rather than just a real estate play, WeWork convinced investors that the offices were, in fact, “a platform for creators that transforms buildings into dynamic environments for creativity, focus, and collaboration.” It would also collect and analyze data to optimize its revenue machine.

The key to the strategy, of course, was to leverage network effects. As more and more tenants signed up, the more valuable a desk at WeWork would be because the company was offering more than just office space, but a place for cool, hip entrepreneurs to collaborate with other, cool, hip entrepreneurs.

This is, in effect, the platform fallacy, the idea that a platform business is inherently more profitable than any other kind of business. Amazon struggled for years to become profitable and, even today, makes most of its money from cloud computing, not its retail platform. Uber may never hit break even. Sure there have been some tremendous successes, such as Facebook, but platform-based companies fail all the time.

The Silicon Valley Myth

In hindsight, the WeWork debacle looks ridiculous. Deep pocketed investors pumped billions into a decades-old business model that has a history of mediocre margins in the hopes that it would somehow miraculously become something different. Yet if we dismiss the whole story as simply a tale of foolishness and hubris, we lose sight of an important lesson.

WeWork investors have had great success with this investing approach in the past. Softbank, for example, which was the company’s largest investor, also bought early stakes in Yahoo!, Alibaba and Slack. However, those were software companies and applying the same investing approach to real estate was a serious error.

That, in essence, is the Silicon Valley myth, that a model that has largely been successful in digital technology can be applied to any business, anywhere. As we begin to enter a new era of innovation that will driven more by physical atoms and less by virtual bits, we’re likely to find that the Silicon Valley approach becomes less viable and relevant.

As Mark Twain is reputed to have said, “It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” WeWork’s investors thought that by pumping tons of money into a conventional business they could transform it into a super-profitable platform. They were terribly wrong, but they won’t be the last ones to try.

– Greg

Image: Wikimedia Commons