Dirty Term Sheets And The Coming ‘WeWorked’ Private Tech Crisis

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Written by Dana Sanchez
For the first time, a Federal Reserve policymaker has focused publicly on risks to the overall U.S. economy from the rise of flexible workspaces such as WeWork. Unicorn photo: Penny Higgins / Flickr

For the first time, a Federal Reserve policymaker has focused publicly and specifically on risks to the overall U.S. economy from the rise of flexible workspaces.

Without mentioning WeWork by name, Boston Federal Reserve Bank President Eric Rosengren said the rise in such workspaces may be a source of financial instability that could make the next U.S. recession worse by triggering a run on commercial real estate, according to a Reuters report.

WeWork’s business model is to take long-term leases on raw office locations, build out the space into cool, flexible work areas and then sublease them to smaller tenants. “Essentially their business is borrowing long to lend short with limited liquidity,” Codenameduchess wrote in a Dec. 23, 2017, Medium post. “Other firms that have engaged in similar business models include Long Term Capital Management, AIG, Bear Stearns, and Lehman Brothers. Things didn’t turn out great for them.”

In the modern tech ecosystem, the cult of unicorn worship sets a stage for those who influence perception with their participation in a funding round to potentially extract terms that uniquely benefit them. This usually comes at a cost that is paid by everyone else.

Miami-based investor Barron Channer, CEO and founder of BACH Real Estate, an affiliate of Woodwater Investments.

In January, WeWork achieved a private valuation of up to $47 billion. Now the company is considering a valuation as low as $10 billion in its initial public offering, which has been postponed until at least October. WeWork co-founder and CEO Adam Neumann stepped down this week as CEO in the face of growing investor concerns and lukewarm demand.

When WeWork released paperwork to go public in August, it tried to defend its $47 billion valuation, Recode reported. That’s a much larger valuation than it would be worth if it were considered a real estate company like its main competitor IWG. “What makes WeWork worth more, the company seems to be saying, is that it’s a tech company — meaning its innovation and flexibility make it better than a regular real estate company,” Rani Molla and Shirin Ghaffary wrote. “… that it is a tech company — and by extension deserves its high price tag.”

SoftBank Group — WeWork’s largest investor — and other shareholders turned on Israel-born Neumann, 40, over the plunge in the office-sharing startup’s estimated valuation, Haaretz reported.

During WeWorks’ efforts to woo IPO investors this month, Neumann was criticized by corporate governance experts for arrangements that were atypical. He also made the company a tenant in some of his properties, charged it rent, and secured a $500-million line of credit from banks using company stock as collateral.

Irrational valuations

Few people benefit from unicorn worship, but many pay the costs, Miami-based investor Barron Channer said in an email to Moguldom. Channer is the CEO and founder of BACH Real Estate, an affiliate of Woodwater Investments. He has nearly a decade of experience with complex real estate transactions including acquisitions, restructuring and development.

“Those that are positioned to influence market perception control the bubble-making machine,” Channer said. “In the modern tech ecosystem, the cult of unicorn worship sets a stage for those who influence perception with their participation in a funding round to potentially extract terms that uniquely benefit them. This usually comes at a cost that is paid by everyone else.”

Dirty term sheets

Bill Gurley, general partner at Silicon Valley venture capital firm Benchmark, has spoken out about sky-high valuations and the impending tech bubble. He warned about “dead unicorns” at SXSW 2015.

Listen to GHOGH with Jamarlin Martin | Episode 13: Barron Channer

Jamarlin talks to entrepreneur Barron Channer, founder of Miami -based Woodwater Investments, which focuses on real estate development and tech.

 In a 2016 essay on his website, Gurley discussed why the unicorn financing market is dangerous for everyone, not just Silicon Valley. He warned against what he calls “dirty term sheets,” when investors receive preferential treatment in exchange for funding that gives a startup a sky-high valuation.

Examples of dirty terms include guaranteed IPO returns, ratchets, PIK Dividends, series-based M&A vetoes, and superior preferences or liquidity rights. The typical Silicon Valley term sheet does not include such terms, Gurley wrote. Dirty term sheets are a massive problem because they “unpack” or “explode” at some point in the future. “You can no longer simply look at the cap table and estimate your return,” Gurley wrote.

Fine print in WeWork’s IPO paperwork shows that some investors, including SoftBank, are protected from losing money if the company lists below the price where they last valued it, according to CNBC. This provision, known as a ratchet, could give $400 million worth of additional shares to SoftBank in the event of a weak IPO performance, according to Renaissance Capital.

“Terms are the true Godzilla that should scare you to death. Taking a terms-laden deal is like starting the clock on a time bomb. Your only option is to hit the IPO window as fast as possible . . . otherwise, the terms will eat you alive.

Bill Gurley, general partner at Silicon Valley venture capital firm Benchmark

Jason Kwon and Aaron Harris discussed dirty term sheets in a Y Combinator blog. If a term sheet includes non-standard or “dirty” economic terms, examples of such terms would be:

  • Liquidation preference greater than 1x — the investor gets back more than its invested capital first.
  • Participating preferred — the investor double-dips by getting its money back plus its pro-rata portion of exit proceeds, rather than choosing between the two.
  • Cumulative dividends — the investor compounds its liquidation preference every year by X ,percent which increases the economic hurdle that has to be cleared before founders and employees see any value.
  • Warrant coverage — the investor gets extra fully diluted ownership without paying for it at the agreed-upon valuation.

Rosengren didn’t mention WeWork by name, but he did talk about the flex-space business model, commercial real estate valuations and fears of the potential for runs on commercial real estate, according to Reuters.

Office-space-sharing companies often use special purpose entities to lease space, in order to shield themselves in case of bankruptcy, Rosengren said. “The basic model provides you the opportunity to, in effect, not be required to pay your lease off. Eventually if there are enough vacancies in that building it means that banks are going to take losses.”

Willy Walker is CEO of Walker & Dunlop, a company that provides financing services to owners of commercial real estate in Bethesda, Maryland. Walker said he predicts that the demand for shared workspaces will disappear, and WeWork leases will be essentially worthless to landlords.

“WeWork has done a masterful job at signing leases at the serial LLC level, and not the parent level, so that when times get hard, they can walk (away) from their commitments,” Walker said in a Bisnow interview. “This will rock owners of office buildings who have significant square footage leased to WeWork, and will also impact lenders who are underwriting WeWork leases as long-term, guaranteed revenue, when it is not.”

Mary Ann Tighe is CEO of commercial real estate services and investment firm CBRE for the New York Tri-State Region. Tighe said she predicts that the coworking concept will survive a recession, but individual companies may not. What happens to coworking in the first downturn this industry segment will experience?

“The expectation is that there will be a sorting out among the firms, that the concept will survive the test but a number of companies will not,” Tighe said.

So how much will the overall U.S. economy pay for unicorn worship in the time of flexible workspaces like WeWork?

“That costs usually becomes obvious only after the bubble starts deflating for the company or market,” Channer told Moguldom. “The same has occurred in markets for M&A, corporate debt and most notably real estate.”