WeWork’s Failure is SoftBank’s Day Of Reckoning

In the wake of WeWork’s failed IPO last month, schadenfreude fans had a lot to cheer from Adam Neumann’s fall from grace. The once high-flying CEO lost his job, his corporate jet, over a billion dollars of liquidity, and voting control over the company he founded a decade ago.

It would be easy to write off this humbling experience as the inevitable result of Neumann’s singular avaricious, impulsive, and sometimes just plain weird behavior. But that misses the broader point that WeWork reflects only the most recent and extreme example of irrational exuberance and fantastical thinking that has transformed private equity markets in recent years, spearheaded by SoftBank’s $100 billion Vision Fund.

Since Vision Fund’s launch in May 2017, VCs have engaged in a race to the top, raising and spending unprecedented amounts of capital. Over the past two years, VCs have closed two to three “hypergiant” funding rounds—more than $250 million—every week, mostly in unprofitable ventures with unproven business models. In contrast, VCs closed only seven hypergiant rounds in all of 2014. What accounts for this nearly 25-fold increase in pursuit of “blitzscaled” growth?

Masayoshi Son, the charismatic and self-proclaimed visionary CEO of Japanese holding company SoftBank and its Vision Fund VC arm, is blitzscaling’s enabler-in-chief. His investment entities alone have led or participated in nearly 11 percent of the total global value of VC investments in 2019 to date. Most notably, over the past two years, Son has poured over $10 billion into WeWork, which went from being the highest valued US private company to a distressed asset in just six weeks, and a like amount into Uber, which has lost more money faster than just about any startup in history, and has shed over 35 percent of its market value since its IPO in May. Wall Street’s wakeup call has put SoftBank’s investments in Uber and WeWork underwater.

The Vision Fund has also backed numerous other ventures, from hotels to dog-walking services, whose losses have reportedly compounded since receiving hypergiant investments. To understand the method behind this seeming madness, one needs to know more about Masayoshi Son’s background and investment philosophy.

Masa, as Son is popularly known, has always lived life in the fast lane. The son of Korean parents who emigrated to Japan in search of prosperity, Son himself moved to California at age 16, reportedly graduating from high school in just three weeks by passing all the requisite exams. While at UC Berkeley, he started and sold several businesses and became a dorm-room millionaire.

Upon graduation, Son returned to Japan and started and invested in several successful tech companies. In 1981, the then 24-year-old launched a software distribution company with two part-time employees in a cramped office in Fukuoka. Lore has it that one morning he stood on a makeshift podium to deliver an impassioned speech to his “staff” about how his company would eventually grow to be among the world’s giants. Fearing their boss was delusional, the story goes, the two part-timers quit soon thereafter.

After the dot-com crash in 2000 erased an astonishing $70 billion of his paper fortune, Son rebooted by investing in Alibaba and Yahoo, providing the foundation of his current fortune. Son’s involvement with Alibaba is indicative of his freewheeling investment mindset. Son met Alibaba founder Jack Ma shortly after Ma had received seed funding from Goldman Sachs, and wasn’t in the market for additional capital. Six minutes into their meeting, Son offered Ma an investment of $40 million for 49 percent Alibaba’s shares. The two young executives ultimately agreed on a $20 million investment, which today is valued at over $100 billion.

Son’s story has the familiar ring of other tech luminaries—Gates, Zuckerberg, Musk, Bezos—made all the more remarkable by his humble upbringing. It’s understandable that the intelligence and resilience that allowed Son to earn, lose, and retain a vast fortune could instill a sense of personal infallibility. In Masa’s world, instinct and snap business judgment seem to reign supreme, which lies at the heart of an investment philosophy that fundamentally rejects venture capital investing norms.

VCs have always played a long-shot game, where the rewards from backing a few breakout winners outweigh the losses associated with the vast majority of duds. To manage risk, VCs typically cofund startups through a series of stage-gated investments, where the size and focus of each round reflects a venture’s evolving development needs. Over two-thirds of funded startups turn out to be complete busts, returning nothing to VCs. Only half of one percent monetize an exit of at least $1 billion within a decade of initial funding.

Masa launched Vision Fund to transform the rules of the game. Rather than joining shared VC funding rounds, SoftBank often decides unilaterally whether a venture is worthy of a massive cash infusion–often several times greater than the venture’s ask–at a significantly stepped up valuation. For example, the median size of late-stage VC investments worldwide in 2018 was $35 million. SoftBank led or sole-sourced 18 late-stage funding rounds of $350 million or more.

From a venture’s standpoint, such unprecedented largesse reflects both an opportunity and a threat. Those that accept SoftBank’s offer can tear up their old business plan and shift focus entirely to ramping up organic growth and acquisition. It’s hard to refuse, particularly knowing that SoftBank is prepared to make the same offer to a venture’s fiercest rival instead. As Uber’s CEO Dara Khosrowshahi remarked after accepting SoftBank’s $10 billion investment in 2017, “Rather than having their capital cannon facing me, I’d rather have their capital cannon behind me.”

Son seems to believe that the Vision Fund’s massive capital investments can be used as a weapon to convey sustainable competitive advantage, global domination, and superior returns for his chosen winners. But this thinking is profoundly flawed for three reasons.

1. The notion that one VC can exploit money to achieve sustainable competitive advantage is ludicrous on its face. In virtually every category in which SoftBank is heavily invested—real estate, ridesharing, meal delivery, freight brokerage, hotels, construction—SoftBank is facing well-capitalized and resilient competition. In a world awash in capital, none of SoftBank’s funded ventures has achieved anything close to monopoly pricing power. This marketplace reality has contributed to chronic and escalating losses across Son’s portfolio.

Bewilderingly, SoftBank itself occasionally backs direct competitors within the same business category such as Doordash and Uber Eats in the US and Didi Chuxing and Uber in Latin America. Not surprisingly, in these cases, SoftBank’s competing ventures have suffered deep losses.

2. SoftBank’s philosophy ignores the value of low-cost learning from stage-gated investing, and instead exposed blitzscaled ventures to massive risk and wasted resources. Capital constraints aren’t an inconvenient nuisance for early stage ventures. Rather, fiscal discipline encourages experimentation to optimize business performance in terms of product/market fit, technology reliability, supply chain efficiency, business process stability, and business model viability.

By often investing too much, too soon in unproven ventures, sometimes with minimal due diligence, SoftBank compels its portfolio companies to rapidly scale businesses that still have unproven or deeply flawed business models (e.g. WeWork and Uber), inadequate core business processes (e.g. Brandless, Wag) or weak defenses against competitive threats (Slack). Prematurely picking winners with massive bets heightens the risk that a company’s race for global domination winds up becoming a race to oblivion.

3. Even if weaponizing capital could promote winner-take-all outcomes, SoftBank has been investing in the wrong types of businesses to achieve its goal of profitable market dominance. Ventures in the best position to benefit from explosive global growth exhibit a specific (and rare) set of business model characteristics: a massive addressable market; compelling consumer value proposition; strong network effects and scale economies; inherently high contribution and operating margins; extremely high customer loyalty; which collectively yield a growing competitive advantage and profitable market dominance.

Companies like Alibaba, Facebook, and Google that have exhibited such characteristics didn’t need massive cash infusions to fuel rapid expansion. Their business models generated much of the requisite growth capital from operating cash flow. Alibaba raised only $50 million of VC capital before becoming cash-flow positive in its third year of operation. In 2014, the company’s $6.6 billion in operating cash flow helped Alibaba float the largest IPO in US history. Google raised only $64 million, and was highly profitable prior to going public. Facebook raised $2.3 billion in venture capital and was generating over $1.5 billion in operating cash flow before going public.

Why then do SoftBank’s portfolio companies need so much growth capital, yet remain unprofitable for so long? Because SoftBank has focused its investments on capital intensive, low-margin, mature businesses wrapped in a patina of technology that, for all the hype, don’t fundamentally improve weak operating economics. Add to that SoftBank’s relentless cheerleading for growth-at-all costs, the siren song of unlimited follow-on capital at artificially inflated valuations, and breathtakingly inadequate board oversight, and you have the prescription for disaster.

Take WeWork. The temporary office space market has traditionally been modestly profitable, slow-growing, and subject to business-cycle risk. Thanks to SoftBank’s nearly $11 billion injection, WeWork embarked on a frenetic worldwide expansion spree, attracting customers with a compelling but profit-killing value proposition: deeply discounted short-term leases, pricey design touches, and unlimited free kombucha and craft beer. Like Uber, despite predictably ballooning losses in its core business, WeWork also invested heavily in new ventures with scant evidence that its technology or operating model could ever deliver sustainable profitability.

SoftBank’s flawed investment strategy extends to other companies in its Vision Fund portfolio, from food delivery (DoorDash) to construction (Katerra) to dog-walking (Wag). Each requires immense capital for expansion, in low-margin businesses, with little demonstrated technology potential to improve operating economics. While these ventures may still carry artificially elevated valuations from prior SoftBank-led hypergiant funding rounds, Wall Street’s diminishing appetite for profitless growth is taking a heavy toll on returns.

By rewriting the VC rules, Son has led Vision Fund to tank, and his plans for an even bigger Vision Fund 2 are in serious jeopardy. Entrepreneurs and investors would be wise to learn from Son’s mistakes and get back to the following sound venture management principles. A short list of what Son has unwittingly reminded us.

• Due diligence matters. Business instincts are great, but they don’t replace the need for sound due diligence.
• Business models matter. Pouring money into unproven ventures doesn’t overcome broken business models; it often accelerates profitless growth.
• Risk management matters. Stage-gated investments with relevant performance metrics and milestones promote fiscal responsibility, low-cost learning, and effective venture management.
• Business focus matters. Businesses built on a shaky foundation should not be diversifying into multiple new businesses to prop up topline growth, while losses mount. Fix the core before extending the core.
• Governance matters. Giving messianic founder/CEO’s unfettered control over strategy and spending, followed by post-IPO majority voting control makes a mockery of effective governance.
• Transparency matters. Companies with the worst bottom-line performance are always the most creative in conjuring up non-GAAP financial reporting, like “earnings before all the bad stuff.” Wall Street has sent a strong signal that investors now expect legitimate and relevant accounting for financial and operating performance.