WeWork cofounder Adam Neumann’s peccadillos are covered extensively in an award-winning book and an ... [+]
Andreessen Horowitz’s record investment in Adam Neumann’s bold new real estate venture prompted harsh criticism and more than a few doubts about the wisdom of Marc Andreessen’s whopping $350 million seed-round bet on Neumann, the disgraced co-founder of WeWork. While there are legitimate questions about such a risky deal between these two principals, it’s not so unusual in the context of recent venture capital trends.
Neumann’s numerous peccadillos have been covered extensively in an award-winning book and a dramatic series on Apple TV+ that presented a caricature of bizarre CEO behavior and portrayed Neumann as the architect of a bacchanalian culture and leader of a catastrophically failed IPO.
Andreesen’s critics lined up on Twitter to call out his seeming hypocrisy on affordable housing issues as he proudly celebrated his investment in Neumann’s housing project. Belying Andreesen’s frequent calls for public policies to deal with “Crazily skyrocketing prices in places like San Francisco,” the billionaire tech investor strenuously resisted such initiatives in his own backyard.
The Andreesesens filed their “IMMENSE objection to the creation of multifamily overlay zones,” using all caps in a letter to the Atherton, California, town council, adding: “They will MASSIVELY decrease our home values, the quality of life of ourselves and our neighbors and IMMENSELY increase the noise pollution and traffic.” Andreessen’s NIMBY-ism triggered hypocrisy-shaming on Twitter.
While it is understandable to question why a deeply flawed founder like Neumann would receive such a large investment in a risky new venture, research has shown that serial entrepreneurs — even those with failed prior ventures –generally secure more VC funding in less time, with higher valuations and better deal terms than first-time entrepreneurs.
Neumann may have secured such a sizable seed- round investment in Flow, a pre-revenue deal for which details remain sketchy, not despite, but because of his tumultuous tenure at WeWork. It also helped that Neumann tapped his own personal wealth (he reportedly walked away from WeWork with a $2.1 billion payday) to acquire majority stakes in over 4,000 apartments valued at more than $1 billion that will jump start Flow’s business.
Andreessen’s bet on Flow is more than 40X larger than the top decile of U.S. seed rounds this year, and more than triple the top decile of late stage
Flow vs. Top Decile VC Investments By Round
Flow vs. Top Decile VC Investments By Round
We’re Living In A Blitzscaling World Now
VCs have been making “blitzscaling” investments of this magnitude on almost a daily basis over the past two years.
The term “blitzscaling” was popularized in a book by Reid Hoffman, a senior partner at Greylock Partners. Hoffman described blitzscaling as “what you do when you need to grow really, really quickly. It’s the science and art of rapidly building out a company to serve a large and usually global market, with the goal of becoming the first mover at scale.”
For VCs, blitzscaling seeks to exploit capital as a weapon, enabling anointed ventures to prioritize speed over efficiency in the face of uncertainty, to outrace competition to global domination.
While Hoffman may have coined the term, SoftBank’s CEO Masayoshi Son provided the rocket fuel for blitzscaling to take off. After SoftBank launched its record-breaking $100 billion Vision Fund in 2017, venture capitalists embraced blitzscaling with a vengeance. Over the ensuing two years, VCs closed two to three “hypergiant” funding rounds — in excess of $250 million – per week, mostly in unprofitable ventures with unproven business models. Following a brief slowdown during the 2020 pandemic, hypergiant funding rounds roared back in 2021 — more than one deal per day or about 60X the rate just seven years earlier. So while Andreessen’s investment in Neumann’s new venture is large, it is consistent with the growing VC preference for bigger, bolder bets.
VCs have always played a long-shot game, where the rewards for backing a few breakout winners outweigh the losses associated with the large majority of duds. Over two-thirds of funded startups typically turn out to be complete busts, while only 0.5% hit the jackpot, monetizing exits in excess of $1 billion, driving 10X or higher returns on investment within a decade of initial funding. Hoffman’s own early entrepreneurial successes — he was a founding board member of Paypal and co-founder of LinkedIn – certainly fall in this category.
To manage risk, VCs have historically tended to co-fund startups through a series of stage-gated investments, where the size and focus of each round reflect a venture’s evolving development needs. Early funding rounds of $5 million to $20 million were typically used to validate product market fit and revenue potential, while later stages stepped up funding to $25 million to $50 million to scale ventures.
Over the last five years, many VCs have shifted from disciplined stage-gated investments in search of home run exits, to far bigger and often exclusive blitzscale rounds in search of grand slams capable of generating ROIs of 100X or more. Three forces have driven this trend.
1. Favorable macroeconomic conditions
The combination of low interest rates, the lack of attractive alternatives in other asset classes, and a $5 trillion spike in U.S. government stimulus greatly boosted liquidity for VC fundraising and investing.
2. Enormous growth in tech stock valuations
The four highest valued U.S. companies, with market caps in excess of $1 trillion, were all originally tech startups. The siren song of finding the next Apple, Microsoft , Google, or Amazon leads many VCs to seek outsized returns by stepping up their bets.
3. Widespread belief that blitzscaling can sustain competitive advantage
When blitzscaling works – think TikTok, Roblox, Google – companies can achieve explosive growth. But Hoffman cautioned that blitzscaling is not suitable for all ventures, but only businesses with powerful network effects to rapidly build demand, scalable business architectures to facilitate rapid growth, and sizable scale economies to generate high operating margins.
In practice however, very few highly funded ventures meet these requirements. When they don’t, ventures may be able to stimulate topline growth for a while by subsidizing prices below cost, but absent strong business fundamentals, they will eventually burn through their cash reserves. Look no further than the portfolios of the two biggest venture investors: SoftBank and Tiger Global.
No VC in the past five years has written as many hypergiant investment checks with as little due diligence as SoftBank. The results have proven “embarrassing,” as SoftBank’s CEO, recently acknowledged. The chart below shows the deep losses from SoftBank’s four biggest VC bets, from the date of its last investment to current public market valuations. Across its entire Vision Fund portfolio, SoftBank recorded a $33.4 billion loss in the first half of 2022, prompting Son to openly question his company’s blitzscaling investment strategy.
Returns On Softbank’s Biggest Investments
Returns On SoftBank’s Biggest VC Investments
Following in SoftBank’s footsteps, Tiger Global Management crossed over from its private equity roots to become the biggest venture capital investor in 2021. Tiger Global prides itself on the speed of its investment decisions – a key tenet of the blitzscaling mantra — outhustling more conservative VCs and paying higher prices, despite little due diligence and forgoing board seats at high growth potential start-ups. Last year, Tiger Global’s 30 investment professionals closed over 360 funding rounds from $2.3 million to $1.8 billion, with more than 30 deals over $250 million.
The rationale for such frenetic investment presumed that high-growth tech ventures represented a particularly attractive opportunity to deliver the biggest payoffs to the boldest investor, or that Tiger Global’s willingness to place bigger, quicker bets would convey competitive advantages to its portfolio companies — or both. While it is still too early to validate either of these assumptions for Tiger Global’s VC portfolio companies, the hit Tiger has taken on its public market tech holdings suggest that a reckoning is coming.
After losing billions of dollars in this year's technology meltdown, Tiger Global slashed or exited most of its tech stock holdings in Q2 2022, including online used-car seller Carvana (-85% stock price decline YTD), cryptocurrency exchange Coinbase (-73% YTD), food delivery app DoorDash (-58% YTD), online brokerage Robinhood (-46% YTD), and enterprise software company Snowflake (-40% YTD). Moreover Tiger Global has signaled its intention to decelerate its VC investments in startups for at least the next two quarters.
The premise that massive capital investments can be widely used to sustain competitive advantage, achieve global domination and earn superior returns is proving to be flawed for three reasons.
1. The notion that VCs can exploit the most commoditized resource in the world – money – to achieve sustainable competitive advantage is ludicrous on its face.
In virtually every category in which SoftBank heavily invested – real estate operations, ridesharing, restaurant delivery, freight brokerage, hotels, construction, and even dog-walking services – it has faced well-capitalized and resilient competition. None of SoftBank’s funded ventures achieved anything close to monopoly pricing power, leading to chronic and escalating losses across its portfolio.
2. The blind pursuit of growth-at-all-costs ignores the value of low-cost learning from stage-gated investing, wasting resources and exposing blitzscaled ventures to strategic risk.
Capital constraints aren’t always an inconvenient nuisance for early stage ventures. Rather, fiscal discipline can encourage experimentation to optimize performance in terms of product/market fit, technology reliability, supply chain efficiency, process stability and business model viability.
By investing too much, too soon in unproven ventures, often with minimal due diligence, VCs compel their portfolio companies to rapidly scale businesses that still have unproven or deeply flawed business models, inadequate core business processes or weak defenses against competition. We saw this in the 2000 internet bubble, when overinvestment in nascent ventures like Webvan and Pets.com led to IPO-to-bankruptcy failures in as little as nine months.
3. Even if capital could promote winner-take-all (or most) outcomes, many VCs have been investing in the wrong types of businesses.
Ventures in the best position to benefit from explosive global growth exhibit specific (and rare) characteristics.
- A massive addressable market
- Compelling customer value propositions (B2C or B2B
- Strong network effects and scale economies
- High contribution and operating margins, fueled by scalable fixed assets, low marginal costs, and minimal distribution and customer acquisition costs
- Extremely high customer loyalty and recurring revenue streams
These characteristics collectively yield competitive advantages and improved financial performance over time.
Companies like Alibaba, Salesforce, and Google that exhibited such characteristics didn’t need massive cash infusions to fuel rapid expansion, as their business models generated much of the requisite growth capital from operating cash flow. Alibaba raised a total of $50 million in venture 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 U.S. history. Google raised $64 million from VC and was highly profitable before going public. Salesforce raised $65 million and was also highly profitable before going public.
WeWork however is an epic example of a capital intensive, low margin company wrapped in a patina of technology that, for all the hype, didn’t fundamentally improve weak operating economics. Add to that SoftBank’s relentless cheerleading for growth at all costs and inadequate board oversight, and you have the prescription for disaster.
The temporary office space market has traditionally been a modestly profitable, relatively slow-growing sector, subject to considerable business cycle risk. Thanks to SoftBank’s multi-billion dollar largesse, WeWork embarked on a worldwide expansion spree, attracting customers with a compelling but profit-killing value proposition: deeply discounted short-term leases, pricey design touches, overstaffed, high-touch services and unlimited free kombucha and craft beer. WeWork, like Uber, another SoftBank company, also spent heavily on diversifying into new ventures with no evidence that its core technology or operating model could ever deliver sustainable profitability.
SoftBank’s flawed investment strategy also extends to other companies in its Vision Fund portfolio, including food delivery (DoorDash), hotels (Oyo), construction (Katerra), and real estate brokerage (Compass). Each of these ventures required immense capital for market expansion in low margin businesses, with little demonstrated technology potential to improve operational and financial performance. Wall Street’s recent loss of appetite for profitless growth has taken a heavy toll on all of these companies’ valuations.
Implications for Andreessen’s Blitzscale Investment in Neumann’s Flow Venture
It is simply too early to tell whether Flow will achieve its ambition to profitably disrupt large swaths of the U.S. housing market. After all, very little is known about Flow’s business plan or the terms of its seed investment (e.g. equity vs. debt structures, liquidation preferences, governance/voting rights).
Supporters can rightfully claim innovative housing solutions can tap a massive addressable market with significant opportunities to reduce process inefficiencies and improve customer experiences. But Neumann appears to be following a familiar — and flawed — blitzscale playbook.
Andreessen professes to love seeing repeat founders build on past ventures by growing from lessons learned. In that spirit, it would be prudent for VCs to also learn from past experience and get back to sound investment management principles.
Due diligence matters
Business instincts are great, but they don’t replace the need for solid due diligence.
Business models matter
Pouring tons of money into unproven ventures with flawed business models isn’t a viable solution; it only accelerates profitless growth. Ventures whose business models truly justify explosive, winner-take-all growth probably don’t need massive VC investment.
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 diversify into new businesses to prop up topline growth, while core business losses mount. The priority should be fixing the core before extending the core
Governance matters
Giving messianic founder/CEO’s unfettered control over strategy and spending, along with super-voting shares, disables effective governance.
Transparency matters
Companies with the worst bottom-line performance tend to be the most creative in conjuring up non-standard financial reporting, like “earnings before all the bad stuff.” Wall Street has recently sent a strong signal that investors now expect legitimate and relevant accounting for financial and operating performance.
Time will tell whether Flow turns out to be an inspirational comeback story or a sad rerun.
