I met with someone yesterday who has an office at WeWork and was pleased to see the relaxed atmosphere, posters advertising Meditation Hour, and beer on tap. (It was morning so I couldn’t have any beer.) That visit reminded me that I wanted to look at their prospectus and check out issues relating to their valuation as it had been under attack recently. Lo and behold, yesterday happened to be the day that WeWork delayed their IPO. After looking at their prospectus, I understand why.

In total, the company has raised $5.6 billion of equity and has revenue last year of $1.8 billion. That’s a ratio of 3.1 times which isn’t far above the ratio of 2.3 times for software industry IPOs over the last six years. (Check out our recent report on IPOs for data.) The problem is that WeWork isn’t a software company but it looks like they tried to value themselves like one.

The average software company going public has a gross margin (Gross Profit/Revenue) of 65% whereas WeWork has one of 16%. (Bear with me here, I’m about to get even more boring.) That means the Capital to Gross Margin ratio is 18.7 times, way more that that of the software industry’s recent IPO ratio of 2.59 times. 

WeWork has a great growth rate, 105% in the last year which puts them well above software industry IPOs of 55% over the last six years. They were initially looking for a valuation of about $47 billion and this would imply a revenue multiple of about 26 times. Even this would be high compared with Shopify’s which was worth a revenue multiple of 20 times for an equivalent growth rate. 

The problem is that you can’t use a revenue multiple similar to software companies when the gross margin is so low. WeWork is a high cost operation so a better way to look at it would be to look at a Gross Margin Multiple. Software industry IPOs over the last six years averaged revenue multiples of 8 times. This would be equivalent to a Gross Margin Multiple of 12.3 times. WeWork was looking for a Gross Margin Multiple of 157 times. 

Even if you factor in their high growth rate, they might have deserved a gross margin multiple of 30 times. This would have valued the company at under $10 billion. They had already reduced expectations to a valuation of $20 billion. The problem was that with a valuation of below $10 billion, it was less than half their valuation at the beginning of the year. Someone was about to get a haircut.

Overall, I think they are in a great market with a very needed product that users love. There may be a problem though with unit economics. The average software company is losing 60% of revenue or 100% or so of gross margin. WeWork is losing 89% of revenue which is not out of line. What is out of line is losing 536% of gross margin. Overall, something has got to change in their business model as these numbers do not point to a company that can ever make money and whose valuation was justifiably questioned.

Three years ago, I started doing research at the Impact Centre at the University of Toronto to discover the root causes of Canada’s challenges in creating a world-leading innovation economy. I thought it would be useful at this juncture to summarize our findings. This report highlights some of the issues we have identified. This blog also announces the move of our content to this new site and the launch of what we are calling the Narwhal Project, an exploration through research of what it takes to scale a tech company. I promise to blog more frequently again but meanwhile, you can check out a summary of our findings in our latest report.

For fifty years, the federal and provincial governments have been spending billions to improve our innovation economy, but without performance improvements. The usual discussion is centered on Canadian businesses and their lacklustre performance on research and development (R&D) and intellectual property (IP) protection. In addition, our productivity has lagged relative to the US because of insufficient investments into productivity-enhancing technologies, along with the lack of available capital and talented people to grow technology firms. 

But we believe that a critical challenge is our inability to scale companies to a world-class size. Larger companies boast several advantages. They have greater revenue per employee, pay better salaries, undertake more R&D, and take out more patents.

We lack large companies, particularly in the technology sector. We have only one Unicorn (with perhaps another one qualifying but not listed as such at the date of this publication) compared with over 150 in the US. Few tech companies in Canada grow large enough to go public. This means less R&D, fewer patents, and, ultimately, lower income per capita and productivity. 

Perhaps the solution to our innovation challenge is not more R&D and more patents, but rather scaling and building of companies. But why are we challenged do this in the tech field? What we have found is that:

• Few Canadian companies are founded in large consumer markets capable of generating the desired scale.
• We invest less per company relative to the US.
• Canadian firms spend less on marketing and sales (M&S), activities that are critical to building the customer base.
• We have fewer qualified people in marketing functions.

The underinvestment and underspending result in lower growth rates for Canadian tech firms compared to their US counterparts. Fundamentally then, Canadian firms do not look as attractive as potential investments due to slower growth. Because of this, they do not attract large amounts of late-stage capital and are often sold before they can scale to world-class size.

All of these factors converge to create serious barriers to growth of Canadian companies, thus necessitating smarter and more strategic thinking about how we will overcome these challenges.

You can get a full copy of the report here.

Over the last four years, there have been substantial changes in initial public offerings (IPOs) in the software world. Firms tend to wait longer to go public, while raising larger late-stage private rounds and eventually experiencing high public market valuations. We wanted to take a closer look at this trend with the objective to gain some insights into current practices. To that end, we looked at the results of 58 software companies that have gone public in the US since 2013.

The data suggests that the average gestation period for firms pursuing an IPO has increased from just over eight years to about 12 years, resulting in a 50% increase in the time firms stay private before going public. The average revenue of the firms at the time of the IPO has increased from under $100 million to over $300 million. As a result of this change, there has been a dramatic increase in the capitalization of these firms, both before and after going public.

For firms that have taken venture capital money and who hope to go public, there are a number of lessons and current practices that can be learned from the set of software firms analyzed in our study:

1. Firms should consider raising money as early as possible (even in their first or second year of existence) and should also get in the habit of fundraising more frequently (every 18 months).
2. Although the amount raised can start below $10 million, companies should strive to quickly increase that amount, even to the rate where a firm has a financial velocity of above 20. (An example of this would be a firm that raises a minimum of $100 million over the first five years of its existence.)
3. Firms should not be discouraged by losses and should even expect to lose considerable amounts of money in order to drive growth. As the data shows here, firms with $10-$50 million of revenue suffered average losses of 69% of revenue, but this rate declined to 26% when firms grew to above $250 million in revenue.
4. Businesses should consider spending more on M&S. Among the firms studied here, the biggest expense line was for M&S which took 64% or revenue for firms with $10-$50 million of revenue, but declined to 38% when firms reached $250 million in revenue.