- Jonathan Price concludes a three-part series examining how to value a flexible workspace company.
- Here, Price considers how coworking businesses are valued in the context of a merger or acquisition.
- He also looks at how WeWork was able to persuade supposedly rational bankers that it was worth $96 billion.
In parts 1 and 2 of this article we looked at the four main ways of valuing businesses, Comparable Companies, Precedent Transactions, Discounted Cash Flow and Asset Based Valuations, and we started to consider how these techniques can be used to value a coworking business, whilst avoiding the ‘having your cake and eating it’ valuation mistake.
- Read Part 1 – looking at company valuation in general, including two methods of valuing companies: comparable companies and precedent transactions.
- Read Part 2 – introducing two more methods of valuation: discounted cash flow and asset-based valuation.
In this part we go on to consider a little more deeply how coworking businesses are valued in the context of a merger or acquisition, and we look at how WeWork was able to persuade supposedly rational bankers that it was worth $96 billion.
“Profit is a matter of opinion”
Before the Covid pandemic struck, most of the acquisition activity in the coworking sphere was related to expansion of the larger brands in the sector, such as those belonging to IWG plc.
The directors of the Business Centre Association (BCA), the former name of the Flexible Space Association, a trade association for the sector, used to complain how difficult it was to grow the membership, because, as quickly as they recruited new members to the association, Regus would buy them up.
Most of those deals were done based wholly or partly using the comparable companies valuation method, which is not a surprise because that is the most common method of valuing mature businesses in many areas of activity. As you will remember, that method involves comparing companies using various ratios, so that you value the target company using an extrapolation from another similar company or group of companies.
The method allows you to compare companies using many different ratios, but fundamentally the valuation itself will be done using one or two ratios expressed as multiples.
The two most common are a multiple of EBITDA and a multiple of Revenues/Turnover, using those two terms as meaning the same. The EBITDA multiple is the most common valuation tool in mergers and acquisitions generally, though it has a weakness in that the calculation of EBITDA is subject to some manipulation. As a City friend of mine is fond of remarking, “Profit is a matter of opinion.”
The multiple of turnover or gross revenues is less subject to manipulation, as Sales is generally speaking a ‘hard’ number in the accounts. A multiple of sales is also useful where the company is loss-making and so the EBITDA may be negative.
Whichever multiplicand is used, the key question will be as to the appropriate multiplier, and this can vary over time and is affected by changes in market conditions.
For small businesses the multiplier will be a low number, generally in low single digits, which brings me to a very important point. The single most important factor in the value of a coworking business is scale. That doesn’t mean to say that a big business will always be valuable – when HQ collapsed, it was the second largest operator – but assuming that the business is reasonably well run, the bigger it is, the better. Size counts in two dimensions as well, the size of the available space in each location, as well as the number of locations.
Size and Economies of Scale
There are a number of reasons why size is important. This business has important economies of scale in both operations and marketing, which can boost the operating profits, and integrating different operations after acquisition can be challenging, as HQ found out, so it is important for a buyer to amortise the costs over a large asset.
Apart from financial considerations such as these, size has an important effect from a strategic point of view and it is important in considering valuation to distinguish between a strategic buyer or investor on one hand, and one driven purely by financial motives on the other.
A single coworking centre will rarely, if ever, have any strategic value, but a network of centres may well do so.
How much value depends on the needs of the buyer. For example, a regional cluster of centres may well be attractive to an operator wishing to expand into that region, whereas a target with a national network of centres may be less attractive. A different buyer, seeking to create or boost a national coverage, might prefer a national network. Because beauty is in the eye of the beholder, a buyer who sees a strategic advantage in a target may well be prepared to pay more than a purely financial buyer.
Regarding the size of the individual centres, the bigger the better rule also applies. That isn’t to say that small centres cannot be profitable, it is just more difficult to achieve consistent profitability.
Perceptive readers may see similarities in this analysis with the hotel industry.
Turning now to discounted cash flow, that method is mainly used to double check valuations derived from other methods, or where the target is immature or very large. The method is sensitive to the choice of discount rate and to assumptions made about future business, particularly the terminal value (your estimate of what the business might be worth as a lump sum in five years’ time).
Because the calculation involves a large number of assumptions, some or all of which will be wrong, it can produce some surprising valuations.
How Did WeWork Gain Such High Valuations?
In the case of WeWork, there are two numbers to keep in mind, $47 bn, as the valuation at the time of the last investment by Softbank before the derailment of the IPO, and $96 bn as the valuation by Goldman Sachs during the IPO mandate bidding process. When thinking about those two numbers also keep in mind the real market cap of IWG plc, WeWork’s main competitor of around $5bn-$6bn.
How could Softbank and Goldman’s have arrived at such high numbers?
In Softbank’s case it’s important to remember that the fund was only investing a relatively small amount of cash and so having those shares issued at a very high price made little impact in dollar terms. In fact, Softbank benefited from having such a high valuation because it allowed the fund to revalue upwards the rest of its much larger existing holding of shares.
Goldman’s case is more troubling, even allowing for the fact that when bidding for such a prominent mandate, investment banks will tend to offer the possibility of a very high valuation.
What could have been the justification? The answer is to be found in the very high rate of growth achieved by WeWork and the theory that when global coverage had been achieved and the rate of growth had slowed down, a vast wave of profits would be available from the huge network of centres. This theory was behind the novel way of measuring profit – Community Adjusted EBITDA, that WeWork’s advisers came up with.
To counter the obvious objection that IWG had never seen such a wave of profits from its much larger network of centres, WeWork claimed that it was a technology company and that it had found new drivers of profitability from its community, much in the same way that Amazon has derived huge profits from Amazon Web Servers.
Unfortunately there was no evidence that such drivers really existed at WeWork and the company was in reality just a retailer of space and associated services, as critics had maintained all along.
Emperor Neumann was not wearing any new clothes after all.
