[By Dileep Rao]

As I noted in my last blog, there is a difference between the business models of WeWork, Uber, and Lyft. The business models of Uber and Lyft are based on revolutionary innovations where the existing giant competitors would have trouble imitating the new business model without negatively impacting their existing business model. Amazon.com was also based on a revolutionary innovation, the Internet, and that’s why Amazon.com was able to beat Borders and Barnes & Noble.

WeWork, on the other hand, is an evolutionary innovation to rent existing space to entrepreneurs and others on flexible and short-term arrangements. There is nothing revolutionary about this – the existing giants can easily imitate, improve, and destroy the new incubator model.

And that is exactly what’s happening to WeWork right now. As I noted previously, landlords are developing incubators in their space and destroying any advantage WeWork may have had. So while Uber and Lyft can build a whole new transportation industry based on the gig concept, the WeWork business model is just a part of the existing real estate industry.

However there is a common problem that results in unicorn over-valuation – ratchets.

Put very simply, ratchets are a mechanism that allow entrepreneurs to raise venture capital at a higher valuation than is ‘reasonable,’ and allows venture capitalists to adjust some of the ‘excess’ valuation if the valuation does not keep going upwards. Son has some protection with ratchets as do most VCs when they invest in ventures.

Here’s an example:

· Venture is ‘really’ worth $10 million (pre-money) but the entrepreneurs want to raise the next round of $2 million at a valuation of $20 million because they are naturally optimistic and think the venture will grow at a higher rate and to a much higher level than the VCs think

· VCs invest the $2 million at a pre-money valuation of $20 million and get 10% of the venture.

· But the VCs usually have a clause (the ratchet) that allows the VCs to get additional shares if future valuations fall (or sometimes if growth does not meet expectations).

Ratchets have a benefit for both the entrepreneurs and the VCs.

The benefits for the entrepreneurs include:

· A high valuation that allows them to keep more of the venture if they can perform

· Increased credibility for future investors and potential customers

· The potential of reaching unicorn status at a rapid pace

· The ability to attract desired employees, where the employees may be willing to work for lower cash salaries and higher stock options

· Positive coverage in the press that helps raise more money at attractive valuations.

The benefits for the VCs include:

· Ability to claim high portfolio valuation, without having to wait for exits

· Ability to use these higher valuations to raise the next VC fund

· More publicity in the press and TV shows about their expertise in finding, evaluating, financing, and nurturing great deals, which helps them become more attractive to the best ventures seeking VC

· Ability to adjust the valuation if they have to exercise the ratchet and protect the VC if the venture stumbles.

In theory no one loses so long as the venture eventually reaches the level of performance or credibility or perception where some deep-pocketed corporation buys the venture at a huge price, or where the venture goes public at a high valuation.

There is a simple solution for Son – invest more money in WeWork at a ridiculously low valuation along with the other VCs who are already in WeWork, and dilute Adam Neumann. This has been done before and there is no reason why Son cannot do it – and as an experienced operator, he can run the business much better than Neumann has. So as the song goes, ‘don’t cry for me, Argentina.’

~source