Amid the many stories of business turmoil this spring has produced, the legal drama surrounding WeWork and its lead investor, SoftBank Group, stands out for its roots not in disease and social distancing, but old-fashioned bad decision-making.
In early April, WeWork announced it had filed a lawsuit against SoftBank for backing out of a tender offer to purchase about $3 billion of WeWork stock, an offer made as part of a bailout package from SoftBank after WeWork’s planned initial public offering fell through last fall. About a month later, WeWork cofounder and former CEO Adam Neumann, who could have sold up to nearly $1 billion of stock as part of the tender offer, filed his own suit against SoftBank.
To the uninitiated, the saga of WeWork’s journey toward an IPO—which was abandoned after a precipitous decline in the company’s valuation, from $47 billion to $8 billion—must have raised a number of questions. Is it typical for failed founders to demand nearly a billion dollars for their efforts, as Neumann has done, no matter how badly things turn out? Is an entrepreneur’s compensation package directly and positively proportional to the amount of money he loses for investors? Are startup funds so abundant, borrowing costs so low, and big risks so encouraged that giant paydays are the rule even for losing CEOs?
The answers to all of the above are the same: generally, no. Most failed CEOs walk away with little or nothing. Some get a modest payout, but all lose their jobs, and most give up control over the companies they founded. It is, of course, not unusual to see companies at massive scale, and funded by massive investments, fail to turn a profit, but that’s no reason to pay out a handsome reward to unsuccessful founders. The implosion of WeWork is substantially more troubling than a simple failure of revenues to exceed expenses. The massive scale of the valuation write-down WeWork suffered is usually cause for a swift departure without a cushioned landing for the founder.
So what enabled Neumann to walk away expecting to be so very well compensated?
The answer comes down to Masayoshi Son, chairman and CEO of SoftBank. Son’s experience with WeWork contains lessons, both positive and negative, that other investors can and should internalize to avoid finding themselves dealing with similar disasters (even if few of them have the resources to create a catastrophe on the scale of WeWork).
Lesson 1: Failure is the most likely outcome
Son’s fundamental error was that he behaved as though WeWork couldn’t fail. This idea is reflected in the deal he negotiated with Neumann, who was allowed to retain vast amounts of power over his startup. This power included special voting rights that enabled him to remain in control no matter how poorly the business was run. Breaking this contract would require either a messy, yearslong lawsuit or a quickly negotiated settlement that acknowledged Neumann’s advantageous position in spite of his poor performance. Conceding this power suggests a conviction that WeWork was as sure a thing as anyone had ever seen.
But that is hardly what 40 years of VC investing have taught us.
WeWork appeared to have sailed right into the ultimate disaster of creating a very large business that did not make money while making it very hard to remove the founder/CEO.
What are the basic odds of success and failure in venture-funded deals, a metric Princeton’s Daniel Kahneman, a decision scientist, would call the “base rate”? Most analyses indicate that about one in 10 VC deals becomes a very successful business—successful enough to make up for the 90 percent of deals that don’t pan out. The rate of those successes varies by the year of the fund, the type of business, the size of the investment, and the public market’s appetite for IPOs at the time the company is ready to leave private ownership. One analysis, by the Corporate Finance Institute, puts the aggregate odds of a funded company succeeding at 8 percent.
Lesson 2: Negotiate for disaster preparedness
The vast majority of VC deals propose provisions to ensure control of the company can be retrieved from founder/CEOs should key milestones be missed. The drafting of these agreements is something of an art form, as they are shaped by the many ways companies can appear to be doing well yet actually be failing under the surface.
The simplest provisions revolve around making profit, under generally accepted accounting principles, a robust marker of success. An investor may also be satisfied with a cash-flow measure such as earnings before interest and taxes (EBIT). In a medical-technology company, the milestones may revolve around successful clinical trials or approvals from regulatory agencies, as both will presage profits and cash flow yet be highly predictive of success. In other cases, milestones can be constructed regarding products shipped, size of customer base, website visits, or other measures that investors believe represent real progress.
In the case of WeWork, one obvious set of milestones would have been the profitable renting of certain buildings. Subsequent milestones might have targeted cities such as San Francisco and New York for fully profitable operations, followed by select cities outside the United States. Each of these milestones would have paved a “path of profitability.”
Yet WeWork was presented with a mandate to scale quickly, even well before profitability had been achieved in individual markets. While at first glance this may seem foolish, the idea behind this approach is that the business has no special claim on its revenue model—no patents or other barriers to competitors’ entry—so the way to win is to gobble up market share and effectively lock out competitors.
There are probably multiple reasons why Son made a public apology over his disastrous investment in WeWork. I imagine he is in fact very sorry this deal ever happened.
This can be a controversial move because in many cases, locking out other players is risky, expensive, and often ineffective. In the case of WeWork, which faced large established competitors, it would seem tough to push those competitors out of the market. Further, this orientation toward boosting market share complicated what should have been a key goal for investors in their contract negotiations with Neumann: forcing WeWork’s leadership to prove the viability of the business idea prior to going through a rapid scale-up. WeWork appeared to have sailed right into the ultimate disaster of creating a very large business that did not make money while making it very hard to remove the founder/CEO.
The lead investor is in charge of drafting appropriate change-of-control terms. It’s possible Masayoshi Son failed to do so because he felt quite certain of the future success of WeWork. But it’s also possible he was concerned that Neumann would find funding from another source and SoftBank would miss out on a deal with big potential. Fear of competing investors can lead to tough decisions for venture capitalists. That’s why it’s paramount for investors to remember Lesson 1 above when their pulse starts to race: the landscape is littered with failures, many of which once looked like sure things.
Lesson 3: Own up to a bad deal
SoftBank’s Son did do one thing right in his handling of WeWork: he apologized for it. That’s quite unusual, given most venture capitalists understand the long odds of success on any given deal. Failure, as we’ve established, is just a part of the job. But Son acknowledged on a conference call that he was “looking back with true regret about the mistaken investment moves that [he had] made,” perhaps honoring a long-standing Japanese business tradition that directs those who make big mistakes to display public contrition.
Contrast that with Silicon Valley venture capitalist Tim Draper, who has made many successful investments in companies such as Coinbase, Skype, Tesla, and Twitter, and who went on national TV to defend his investment in the now-failed blood-testing company Theranos. In a televised interview, he claimed that the Wall Street Journal articles reporting highly unusual activities inside the startup were the result of a “personal vendetta” and expressed his full belief that Elizabeth Holmes, founder of Theranos, was going to “change the world of medicine” if she could be left alone to finish her work.
There are probably multiple reasons why Son made a public apology over his disastrous investment in WeWork. I imagine he is in fact very sorry this deal ever happened. Further, I believe he feels badly for the publicity he has received while losing so many billions for investors.
But Son’s apology may also be an essential step toward avoiding similar mistakes in the future. Research by my Chicago Booth colleague Ayelet Fishbach and Booth postdoctoral scholar Lauren Eskreis-Winkler suggests that people tend not to learn from failure, likely because their egos get in the way. If we are to learn from our mistakes we must first acknowledge that they are mistakes and recognize our role in committing them.
Of course, it is left to his future investors to decide if Son has learned his lesson. Regardless, his handling of WeWork, and his apology for it, should remain in the minds of others navigating the long odds of venture investment.