In recent weeks, the news has grown steadily worse for WeWork. The company postponed its planned IPO amid concerns from the investment community over its financials. Revenue doubled to $1.5bn in the first half of this year, but net losses increased 25% to -$904m over the same period of time. Its valuation dropped from $47bn to $8bn.
Last week, WeWork laid off 2,400 workers and will outsource 1,000 more. The contracts for the newly outsourced employees will reportedly remove a year of pension contributions, refuse severance pay if they do not agree to the status change and perhaps even freeze wage levels until 2021.
Meanwhile, Adam Neumann, the chief executive and founder, left the company in exchange for a nearly $1.7bn payout. Quite the contrast.
In the coming years, WeWork will be taught in business schools as the primary example of the irrational exuberance that underpinned today’s inane high-tech startup philosophy that fictitious ‘growth’ matters more than actual profit.
That mentality benefits only startup founders and the venture capitalists who invest in them – in other words, the one percent of the one percent. Everyone else gets a lot less – if anything at all.
Welcome to the new Guilded Age. It all starts with predatory pricing.
The return of predatory pricing
My definition of late-stage capitalism: use predatory pricing, lose money, and survive off of loans and VC funding until you can grow large enough to defeat all competitors and gain a monopoly in a market. Then, raise your prices. It is a winner-take-all system that – when successful – benefits already rich VCs and few others.
Predatory pricing is the act of intentionally setting low prices to eliminate competitors and create a monopoly. The practice has generally violated US antitrust law since the late 19th century, but violations are difficult to prove in court.
A 2015 US Department of Justice paper goes through various US Supreme Court rulings and determines that pricing is illegally predatory if it meets two conditions. First, a company sets low prices with the specific intention of driving out competitors and creating a monopoly. Second, the price must be lower than the seller’s cost.
“Pricing below your own costs is also not a violation of the law unless it is part of a strategy to eliminate competitors and when that strategy has a dangerous probability of creating a monopoly for the discounting firm so that it can raise prices far into the future and recoup its losses,” the US Federal Trade Commission also states.
WeWork underpriced competitors. In the US, Netflix is $13 a month compared to a minimum of $50 for cable television. The company may have a popular product and a 2018 net income of $1.2bn on $5.8bn gross profit. But the company has total liabilities – including long-term debt – of $15.4bn despite raising $3.1bn over 10 investment rounds.
And what has Netflix been doing now after going deep into the hole to become the top streaming broadcast entertainment platform in the world? Raising prices.
In the words of Matt Stoller, a fellow at the Open Markets Institute and the author of the forthcoming book Goliath: The Hundred Year War Between Monopoly Power and Democracy, is it fair that Hollywood is being killed by a company that can afford to lose billions of dollars?
It is not just Netflix. Uber raised $24.7bn and has become the top ride-hailing platform in the world, but it still loses money on every ride. So, what has the company been doing now? Increasing prices. Spotify became the most popular streaming music platform by raising $2.6bn and losing money every year – as much as -€1.2bn in 2017. Now, the company is looking to raise prices.
Many high-tech companies are textbook examples of predatory pricing, and I have no idea why antitrust regulators in countless countries are not breathing down their necks. But I doubt the founders and VCs are worried. If you can get enough funding, teams of expensive lawyers are just costs of doing business.
Still, companies that need continuous loans or VC funding to offset huge losses would not exist in a natural and fair economic market. They need the constant influx of cash for a reason – to save themselves from bankruptcy. In a VC-driven world that encourages predatory pricing, the companies that win are those that obtain the most cash – not those with the best products or promotional campaigns.
“Many investors I’ve spoken to and most who write about the field believe this is the only way early-stage startup investing can work,” Rand Fishkin, the Moz co-founder and former chief executive who now runs SparkToro and has become a vocal critic of venture capital, wrote earlier this year.
“They’re convinced that new companies always have high failure rates, and so to beat the market’s returns, you have to invest in a lot of them and find the few that turn into monopolies or near-monopolies. I think that’s bullshit.”
The historical view of profit and valuation
During my MBA studies in the 2000s, one of the first things I learned in finance class was that the value of a company is typically based on its profits. In one example, the P/E ratio is the ratio of a company’s share price to its earnings per share. (And ‘earnings’ refers to net profit, not revenue.)
Of course, value is relative and does not exist in a vacuum. Just remember what Publilius Syrus wrote 2,000 years ago: “Everything is worth what its purchaser will pay for it.” A single P/E ratio means little unto itself. Rather, the figure is used in context and in comparison to the company’s history and other businesses in the same industry.
But the fact remains that profit underpins all. Any company with no profits usually has little actual value. Today, the high-tech startup world uses figures from investment rounds to create nonsensical valuations based on its own convoluted methodologies.
Here are two simplified examples. I can borrow $2m, sell the cash for $1m and then say that I have a startup with $1m in revenue. Or I can sell 0.005% of my business to someone for $100 – and thereby have an immediate valuation of $2m based on the investment maths. Yes, it is complete and utter nonsense. But those are simplified versions of some of the private valuation methods that VCs and high-tech startups often use.
To paraphrase the immortal words of Jerry Maguire, show me the profit. Private valuations are one thing. But as WeWork has discovered, it is the public markets that will determine your true worth. And the public markets usually want actual profit.
Of course, many businesses lose money at the beginning – and there is nothing wrong with that. Take the stereotypical people in their garages who spend a lot of cash trying to create and promote something new. They will lose money until it takes off.
But when companies still lose money years later, that means there is something inherently wrong in their marketing mixes. Something in the product, price, distribution or promotion desperately needs fixing. But no one in the high-tech startup world seems to care, and we are now seeing the results.
Uber’s stock is down 43% from its IPO price. Lyft’s has fallen from $72 to $37. SmileDirectClub has sunk 60%. All have lost untold amounts of money. Further, Lemonade, an Israeli startup in the insurance industry, indefinitely postponed a planned IPO because the company has high revenues but is still losing money.
Somewhere, my finance professor is shaking his head.
The whole mentality goes back to Amazon – the first internet company to use VC funding and (some posit) predatory pricing to grow rapidly. (Luckily for Jeff Bezos, online platforms have been unregulated in the US since the passage of the 1996 Telecommunications Act.) Later, Mark Zuckerberg created a free and unregulated Facebook, also securing investment.
Both companies are now hugely profitable, and everyone today wants to do something similar. Even Gary Vaynerchuk has told his millions of deluded followers that top-line revenue and growth are more important than profits.
But what separates the successes of Amazon and Facebook from the failures of Uber, Lyft and SmileDirectClub? Actual profit. Amazon created its highly successful Amazon Web Services division, and Facebook became really good at convincing advertisers to fork over a lot of money.
“Three of the six manias in my lifetime featured profitless companies roaring to great heights. Each time, investors forgot there’s no such thing as an investment that’s good at any price,” investment analyst Dan Ferris wrote in 2017. “Losses may be the new black, but you’ll freeze to death if that’s all you’re wearing when the weather changes.”
What WeWork can teach us
If you do not want to freeze to death, remember these lessons from the story of WeWork.
There is no such thing as a ‘tech company’.
Facebook and Google are personal data collection and targeted advertising platforms. Apple sells luxury consumer electronic products. (I have to pay $125 every time my cat chews through my Macbook’s charger cable.)
Netflix is an entertainment media company that licenses or creates programming and then stores it on servers that are owned by someone else (which is all the ‘cloud’ really is). Amazon is a retail product distributor, web host and advertising platform.
Technology is not something that you are. Technology is something that you use to do something. In March, McDonald’s bought personalisation platform Dynamic Yield for its outdoor digital drive-thru menus. But that does not now make McDonalds a tech company – it is still a fast-food business that uses a specific technology to sell fast food.
In the same way, WeWork is a glorified office space subletter that laughably tried to convince future investors that it was a ‘tech company’. Everyone should be wary of such attempts to create unwarranted hype in the future.
Stop getting people hooked on cheap prices.
To lose money and grow quickly, companies will initially offer a product for free or at a low price – with the goal of eventually charging more or finding another ‘path to profitability’.
Getting people hooked on a product through cheap prices and then trying to charge more later is not a good pricing plan – it is how you sell drugs. (“The first one is free!”) The reason is similar to the logic that says marketers should rarely do discounts or sales promotions. Once people pay a low price for something, they never want to pay more in the future.
Pizza Hut in Israel offers coupons for NIS 45 ($13) large cheese pizzas every few months. (The regular price is NIS 70 – or $20.) I buy one during a sale and at no other time. The company actually called me once to ask why I do not purchase their pizza more often. I told them: “I’m never paying more than NIS 45 for a pizza.”
Companies that would not survive in a natural market continue to exist only because VCs throw more and more money at them. And predatory pricing only leads either to ‘surveillance capitalism’ – when we give our personal information as the payment because the platform is free – or monopolies in more and more industries.
Be very cautious of cult followings.
Supposedly, B2C promotions should be fun and emotional while B2B ones should be dry and rational. And there is nothing more ‘B2B marketing’ that selling your business idea to potential investors.
But Neumann used his cult of personality to convince Masayoshi Son, chief executive of venture capital firm Softbank, to invest $9bn in a company with dubious financials. There is no better – and no more ludicrous – example of Neumann’s cult of personality than this week’s news that he had been working on America’s forthcoming Middle East peace plan. Seriously.
Softbank’s investment agreement was the perfect example of how B2B marketing is actually very similar to B2C – in the end, human beings who are emotion-driven are always making the decisions. To WeWork’s credit, the company and its creative agency, Johannes Leonardo, did create good ads that appeal to emotion (PDF). (And that is rare in the B2B world.)
Forget about fictitious ‘growth’
Chief marketing officers are starting to last as long as Spinal Tap drummers and are being replaced by positions such as ‘chief growth officer.’ But this is a grave mistake. A relentless focus on ‘growth at all costs’ leads only to the fates of Lyft, SmileDirectClub, Uber and WeWork.
The adults need to return to the C-suite, reclaim the CMO title and build real companies with real profits. Stopping the use of ‘growth hacks’ and predatory pricing would be a good start. And it might be a good sign that more marketers are dropping venture capitalists as well.