Sucking All the Oxygen Out of the Room

Watching the total and utter meltdown of We Work is interesting to me.  Why?  It’s not because I have some sort of macabre fascination with seeing titans knocked off their pedestals.  It’s because I invested twice in the co-work vertical.  I have an investment in Deskpass.  They are doing well.  I had an investment in Nextspace.  Nextspace was started right around the time We Work was started. We Work was an NYC based company with a very NYC vibe.  Nextspace was a California based company with a Cali vibe.

There were other differences too.

So, why would someone invest in co-working?  It’s a great question.  Seems like an easy enough business.  Rent desks in a big office.  But, it’s actually a really hard business to operate.  I watched Sam and Pat run The Coop in Chicago.  They were able to create a really good vibe there with real network effects in the space.  They built the original version of Deskpass because of their experience with The Coop.  Two successful startups initially set up their operations there, Uber and Airbnb.  So, I was interested.

A side story that is not germane to this post is that one potential investor in Sam and Pat bounced a check for $350,000.  I helped them get out of that problem which is one reason I made an investment but the other was I was truly interested in it.

I have seen places like Novel Co-Working turn a profit on their business.  I don’t think We Work ever turned a profit and I know for a fact Nextspace never did.  One thing about real estate; you ought to turn a profit on rent.  That should have been the first clue this wasn’t going to work well.  However, Nextspace had one co-work space that was a niche. It was called Nextkids and it was based in SF.  It seemed to be successful.  I was betting that Nextkids could really be interesting since the millennial generation was starting to have children but still wanted to work.  Many women become independent contractors post babies, and co-working seemed like a good way for them to operate.

Nextkids eventually failed for a variety of reasons.  Some of it was rent, but a lot of it was because the culture didn’t match the way it needed to.

The other thing that I was betting on was that Nextspace would be able to create a network across spaces the same way Sam and Pat did inside their space at The Coop.  In We Work’s sales deck, they talk about that.  However, neither Nextspace or We Work has been able to pull that off.  There isn’t any network effect from being inside a We Work except when you travel you can still use We Work.  Big whup I can do that at Regus.  But like I said, Nextspace couldn’t pull it off either so it’s a lot easier to put in a slide deck and sell to potential investors than it is to execute.

We always talked about a “LinkedIN type network effect across spaces” to the Nextspace management team.  Great idea, but probably too pie in the sky to execute on a broad basis when it comes to co-working.  You’d need to write some customized searchable software.  This is difficult.  The human brain sometimes does this better.  Plus, how do you establish a trust network inside a new startup co-work space?  If you think about a trading floor, the clearinghouse stood behind everyone and that allowed a trusted network to be created.  What’s the clearinghouse in co-working?  There is no financial skin in the game except paying rent and no direct interaction between disparate companies so no network effects.

The other thing that killed Nextspace was rising rents.  In their spaces, rents when through the roof turning marginal losses or profits into big losses.  Nextspace was really smart about where they located.   They picked areas that were hip and up and coming.  By the time they were hot, Nextspace couldn’t cover rent because that cheap rent for a seedier area all of a sudden was full price for a hot area.  The Logan Square, Pilsen and Humboldt Park area of Chicago is seeing that today. At the same time, the employees were all getting way too much salary.  Nextspace was a B Corporation which is why B Corporations leave such a poor taste in my mouth.  There was a lot of virtue signaling among management and not enough attention was paid to bottom-line business.  Frankly, I think the whole B Corporation thing is just a vanity metric and means nothing when it comes to running a business.

Then came We Work.  Adam Neumann is getting a lot of flak now, but he was and still is a great salesperson.  Initially, We Work had an ideologically committed investor who funded a lot of the initial growth.  We Work raised a lot of capital and when they raised from the likes of Softbank, all the oxygen left the room.  Nextspace couldn’t even get a meeting with a higher level investor.

That’s what I see happening again and again in startups.  One company seems to grab an early lead and gets the right people to invest.  Other VCs that aren’t in the round look at the competitive landscape and don’t see a huge moat so they avoid the sector entirely.  Some VCs look at the sector a bit differently and might make an investment despite a dominant competitor but lose in the end when all the funding oxygen is taken away.  Think about investments in competitors to Uber and Lyft and see how many look-alikes are gone.

I think part of the VC reticence is that the valuations of the companies at later stages are sky-high.  Hence, there is higher risk and they don’t see how they can get the reward with an already dominant competitor.  Another aspect of it is many of these companies don’t have super high competitive moats.  Is it that tough to start a competitor to We Work?  Can one exist regionally and dominate?  I never understood why hotels didn’t get into this space.  It would seem they could take a part of a lower-tier floor and turn it into co-working.  We know their business centers really suck.  Or, is their contribution margins from other kinds of offerings superior to co-working?  That would be a tell that you shouldn’t invest in co-working or at least think a lot harder about it.

Investing in startups that are successful come down to the old brass tacks of business.  What’s the competitive moat?  What’s the differentiator?  What’s the profit margin?  All the flowery stuff goes out the window.   It makes good cocktail discussion but it doesn’t pay the bills.

Startups that succeed have a great business model on Day 1.  They also have founders that can get them to the next level.  But, as I posted the other day, Professor Steve Kaplan’s research shows that very few of those founders are the leaders that take the startup to IPO.   Also, the big winners really can scale.  It’s either across verticals, in a new vertical that didn’t exist, or crushing the existing competition in an existing vertical.  They make money doing it.

I lost 100% of my investment in Nextspace.  I am not bitter.  I have taken worse losses.  I made some mistakes in my analysis.  I learned a lot.