Avoid the ’emperor’s new clothes’​ hallucination of startup unicorns

In a matter of weeks, WeWork, one of the world’s most highly valued private companies and an emblem of venture-backed unicorns, had become a casualty of consensual hallucination between a bombastic startup founder, and investors who seemingly shopped at the tailor who makes emperor’s new clothes.

WeWork was valued at $47bn, a staggering amount for a company that lost $1.9bn on revenues of $1.8bn last year. It’s now postponed its IPO. Softbank, the majority 29% shareholder, has a gaping hole in its $100bn Vision Fund, and departed founder Adam Neumann has left a toxic waste to clean-up behind him – but with $750m in his pockets for his efforts.

In frothy capital markets such a romantic delusion is possible, where the charisma and audacity of the founder is more alluring than spreadsheets, and venture capitalists jostle with each other to write cheques of $100m. However, for me the fundamental flaw here is that capital isn’t a strategy – which has been the WeWork and unicorn operating model.

SoftBank has been acting like it’s the 1850s Californian gold rush all over again, where the hubris of megalomaniacal founder Neumann seduced their ambition, such that they ignored the usual red flags highlighting the need for diligence in startup business models. So, here’s my summary of the WeWork story, and then my thoughts on its impact for startups in Manchester.

In 2008, Neumann was subletting part of his office space to save rent, and convinced his landlord to let him take over an empty space in one of the landlord’s nearby buildings. He divided it up into semi-communal offices, and rented them out. The original space, Green Desk, was an instant hit. The landlord wanted to expand it to his other properties, but Neumann decided to do his own thing and opened the first WeWork in 2010 in NYC. WeWork was thus born as a co-working space.

In 2017WeWork opened its 200th location in Singapore, and Neumann met Masayoshi Son, the head of SoftBank, a Japanese company reinvented as a VC. In 2016, SoftBank had launched the $100bn Vision Fund, backed by $45bn from the Saudi Arabian government. Son told Neumann he had precisely twelve minutes for a meeting, after which Son sketched out a deal to invest $4.4bn. Son told Neumann to make WeWork ten times bigger than your original plan and to recognise that being crazy is better than being smart. Neumann didn’t hold back.

Today, WeWork is the largest private occupier of office space in London, New York and Washington. In central London, it has more branches than McDonalds. It has become the biggest and fastest-moving force in what many see as the future of work and remote working. But disrupting the world of commercial property required capital, and Neumann excelled at pitching his vision, raising $12bn.

WeWork could simply be described as a leasing company, renting desks to startups and freelancers. However, the IPO filing describes it as a community company, a worldwide platform that supports growth, shared experiences and true success. This sounds like self-important deluded jargon, and therein lies the root of the problem.

Neumann declared that WeWork’s valuation and size are much more based on our energy and spirituality than on a multiple of revenue. He maintained that categorising WeWork as a property concern was too limiting. For example: WeWork Mars is in our pipeline, Neumann declared. He said he’d met with Elon Musk and offered the company’s services supporting Musk’s future Mars missions. He forgot to add that Musk wasn’t interested.

So, what are the lessons for startups in Manchester from this debacle? It is important, as there are four existing and a fifth WeWork office being built in the city.

1.     Startup valuations

Are Unicorns overvalued? In a recent survey, Yes said 91% of VCs who don’t have any Unicorns in their portfolio; and Yes said 92% of the VCs who do. The spiralling prices of tech startups have been based on unsustainable rates of assumed rocketing growth. Uber, once considered the biggest and fastest unicorn of all, lost $5.2bn in Q2. Uber’s growth has been spectacular, but there is something unreal about a company losing $40k a second.

Takeaway: We need to blend the reckless ambition of founders with the sober adult supervision of investors. Show your startup has a genuine edge and innovation, an ambitious customer scaling roadmap, but also a credible strategy to achieve cash generation – and don’t get greedy on your valuation.

2.     Attracting investors

Asked whether they make a gut decision to invest in a fledgling company rather than relying on analysis, 44% of VCs said yes. Some 9% admitted they didn’t use financial metrics to back this up.

Takeaway: Scale unit economics. A startup is a bet on a business model attaining the scale/critical mass beyond which the unit economics starts making sense. Focus on determining the economic drivers of success, not throwing out outrageous revenue projections, and build a growth story around this. WeWork failed to demonstrate any economies of scale.

3.     Growth strategy

SoftBank’s cash infusion helped WeWork cover the increasing costs of its whirlwind growth. WeWork spent heavily to fill the desks it was adding – they bought out new tenants from their existing leases, and provided a year rent free. There was thus a spiralling chasm growing between revenue and costs. WeWork’s occupancy rate went up, but the deals made it difficult to determine the natural demand and price point for its product.

Takeaway: Think of scaling as building the base of a pyramid, the foundation upon which everything else is built, and you know that it will hold. Focus on building your architecture in an intelligent way that will allow you to grow to realise your potential, without over taxing your cash or endangering your roadmap.

4.     Set and hit your (proper) metrics

WeWork has consistently been wildly off its forecasts. Their forecasted profits in their original pitch deck are: $14m (2014), $64m (2015), $237m (2016) $542m (2017), and $1bn for 2018. It hasn’t made a profit yet.

Finding normal accounting a bit boring? WeWork published a financial metric it called Community-adjusted EBITDA – a proven accountancy way of measuring a company’s performance, but Community-adjusted excluded many costs, claiming they would disappear once it reached maturity in an attempt to show it could make a profit. The Financial Times dubbed WeWork’s doctored version perhaps the most infamous financial metric of a generation.

Takeaway: The hype superseded numbers. It was accounting jujitsu at its finest. At some point, startup gestalt of overpromise and underdeliver can paint founders into a corner where they begin massaging numbers. Simply, set and hit your metrics to get trust and confidence from investors.

5.     Know the risks in your business model

WeWork isn’t a commercial property firm renting desks, it’s a Space as a Service (SAAS) firm according to Neumann; but ultimately it is a property based business model, signing long leases even though their own subleases to customers are short. The IPO prospectus disclosed $47bn in future lease obligations and forecast $3bn in revenue this year. What could go wrong?

Takeaway: In all markets, the market leader gets an unfair advantage because casual and unsophisticated customers choose the leader because it feels easier and safer. But your strategy is not to wish and dream of becoming a big fish. The strategy is to pick a small enough pond. By engaging with the smallest viable audience, you gain the reputation and trust you need to move to ever-bigger audiences.

6.     Have a vision and purpose, but don’t hallucinate

Until recently the image of an entrepreneur was of a thrifty workaholic toiling away long hours. But Neumann was more emperor than entrepreneur. In such cases, attention invariably focuses on the founders’ hubris. Their rise and fall is the stuff of barnstorming, bestseller novels. Ultimately, they fall off their pedestal because the foundations lack a sense of reality.

Takeaway: The startup world is filled with the idolatry of winners, constantly promoted on Instagram, creating a high many then chase. The ‘startup founder’ badge, the spoils, coupled with the false narrative that we live in a meritocracy, have dulled our sense of reality.

We’re kidding everyone. We’re deluding ourselves. We’ve lost sight of what’s important. We’ve lost ourselves. We’re addicted to growth at all costs. Emulate the tortoise, not the hare. I’ve always preferred opportunities where time is an ally, not an enemy.

7.     Blitzscale doesn’t work

The folly begins with a sound idea. Startups need scale to become global. The ideas spread quickly, because of network effects, and the more people use a service, the better it gets. The fastest growing firms like WeWork ‘blitzscale’, they attempt to disrupt a whole industry before anyone can stop them, raising fortunes to acquire users – at any cost.

But ultimately, unless you can finance your growth from a growing revenue stream, Blitzscaling means you need investors with very deep pockets. And you usually need more money than you thought, because you’ll need further funding to recover from the mistakes you’re likely to make along the way.

The fast-paced Blitzscaling process is marked by organisational chaos – Zuckerberg’s move fast and break things mantra at Facebook means every week is an emergency – and that’s what insiders said about WeWork. For every company like Paypal that pull off that feat of hypergrowth without knowing where the money would come from, there is a graveyard of startups that never figured it out. The risks of potentially disastrous defeat are ignored.

Hoffman and Yeh, architects of ‘Blitzscaling’ explain the conditions in which it makes sense, which includes having a sustainable competitive advantage and high gross margins, so that the business will generate positive cash flow and profits when it does get to scale. This is good advice, but it didn’t apply to the WeWork model.

Takeaway: There maybe a hard landing here. Startups with no recognisable route to profitability will find it harder to get cash, even before WeWork’s fiasco the taps were being tightened. Blitzscaling may become a dirty word. It’s a do-or-die approach. Cash-burning firms may find themselves stranded. For your startup, don’t fall for the hype.

8.     Leadership red flags

I’m stunned at how Neumann’s sheer force of personality kept the obvious questions about WeWork’s future viability at bay. The cult of personality provided for an outsized view of his own leadership capabilities, and frankly a delusional view of the firm’s role in society. Also, WeWork looked to some like an old-boys’ club, the management ranks were sprinkled with Neumann’s friends and extended-family members.

Neumann sold $750m of his shares. I understand the need for some liquidity and to diversify holdings, but three-quarters of a billion dollars? He was on the brink of becoming a decabillionaire.

Takeaway: If my daughter informed me she’s dating a premiership footballer, that would be a red flag. The vacuum of leadership and governance transparency in WeWork has undermined the often fragile startup leadership culture that investors tolerate and accept.

As a result, the balance of power may shift from founders to investors, as whilst no one wants to crush a creator’s zest, for a while at least, there could be fewer high-risk innovations funded. The key takeaway here is build your leadership team and culture as much as your brand and product.

The salutary lesson from the trauma of WeWork is that common sense has prevailed, and the free rocket fuel stoking the tech startup mania may be rationed, rewarding firms that will generate cash or profit. This will cause a shift away from the quest for growth at all costs towards more responsible stewardship of startup capital to improve runway growth.

The goal for startups should be to make their ventures sustainable, not just explosive. After years in which VCs have cast themselves as infallible Merlins, it is good to see investors shouting when an entrepreneur, for all his charisma, cannot demonstrate how they’ll zoom from unprofitability to massive profitability in a way that’s not obvious to the naked eye – the tailor making the Emperor’s new clothes has a lot to answer for.

The failure of Jamie’s Italian shows Blitzscaling isn’t a growth strategy for every startup

My Oldham born wife is one of the finest cooks I know, and at the same time, one of the most vicious critics of celebrity TV chefs. Whilst she effortlessly makes two soft centred poached eggs on toast – such seductive delights are the basis of our thirty-five year relationship – she generously peppers criticism on any TV chef who appears to pay more attention to their own ego than the flakiness or their pastry or the creaminess of their stilton and celery soup.

Whilst James Martin is in her current good (cook) books, a regular target of her wrath is Jamie Oliver. His image as a slightly mouthy, salt-of-the-earth chap was always slightly at odds to her refined Northern palate, but apart from once paying a fortune for a mediocre meal at his Jamie’s Italian outlet in Manchester, I’ve taken little notice of him.

But last week in an era of millennials eating habits graduating from cheese on toast to avocado on rye, the failure of Jamie’s Italian restaurant chain is a perfect example of how not to scale a startup venture. Susan, it seems, really does know best.

The mass-market chain was founded by Oliver and his Italian mentor, chef Gennaro Contaldo, in Oxford in 2008. The chain rapidly expanded to 43 outlets by 2016. However, appetite waned as it faced rising competition from numerous Italian-inspired rivals and the market became crowded after private equity investors piled into casual dining chains.

Consumers became nervous amid the uncertainty of Brexit, while the rise of takeaway apps and delivery services such as Deliveroo and JustEat and high street food takeaway emporiums, and the emergence of home-eating kits such as Gusto and Hello Fresh, encouraged the Netflix generation to stay at home on the sofa.

Jamie’s Italian struggled for relevance as people changed their eating habits. It first showed signs of trouble in 2017 when it closed six outlets as its relatively expensive prices and unexciting menus failed to stand out from the crowd. The chain made a £30m loss that year and the chef pumped £13m of his own money to keep it afloat. January 2018 saw the closure of a further twelve outlets, and Oliver injected another £4m. Customers would buy his books and watch his shows, but choose to eat out in a rival restaurant.

Susan always said the end was nigh when he added chorizo to paella. But of course he’s not alone, other chains, such as Carluccio’s, Prezzo, Byron Burger and Gourmet Burger Kitchen, have closed many outlets.

The boom which increased the number of chain restaurants by a quarter since 2014 has come to an end. The latest sector analysis from Alix Partners, reports the number of restaurants in Britain fell by 2.8% in the year to March 2019, with 768 net closures over 12 months – that’s 15 per week – with five successive quarters of decline. Compare this to the heady days of 2013-18, when the restaurant sector expanded by 15%.

In the midst of the barrage of negativity, it’s easy to forget the positives – his 20 years in broadcasting, selling 40 million cookbooks that cajoled reluctant cooks to give it a go, campaigning on issues such as school dinners and energy drinks, and his charitable venture Fifteen Cookery schools, which helped the poor and underprivileged to become chefs.

But that was not enough to persuade diners to pay £4.50 for a garlic flatbread or £15.30 for a prawn linguine at Jamie’s Italian – the ingredients needed to make a celebrity chef aren’t those for a businessman. The restaurant business margins are notoriously slim and those who do well do so by either constantly evolving – anticipating rather than following trends – or delivering classic experiences with superb service and outstanding food.

Oliver did neither of these, his hubristic approach led to Jamie’s Italian expanding at a ferocious pace.. This for me shows why the populist Blitzscaling growth strategy for startups is fundamentally flawed.

Blitzscaling is an accelerated growth path, prioritising speed over efficiency to move a company from startup to scaleup at a furious pace to capture the market. Its advocates are Reid Hoffman, founder of LinkedIn and Chris Yeh.

Dropbox cofounder Drew Houston described the feeling produced by this kind of growth when he said, It’s like harpooning a whale. The good news is you’ve harpooned a whale. And the bad news is, you’ve harpooned a whale!

While blitzscaling may seem plausible, it is fraught with challenges and is just about as counterintuitive as it comes. The classic approach to growth strategy involves taking risks when you make decisions, but conventional wisdom says take calculated ones that you can both measure and afford. Implicitly, this technique prioritises efficiency over speed.

However, when you blitzscale, you deliberately make decisions and commit to them even though you’re very uncertain about the outcome. You accept the risk of making the wrong decision and willingly pay the cost of significant operating inefficiencies in exchange for the ability to move faster.

Historically, stories of breakneck growth involved either tech businesses, which offers nearly unlimited scalability in terms of distribution – for example Amazon – or software-enabled hardware, such as the Fitbit fitness tracker or Tesla electric car, whose software component allows the company to innovate on software timescales (days or weeks) rather than hardware timescales (years). Moreover, the speed and flexibility of software development allow companies to iterate and recover from the inevitable missteps of haste.

So, the failure of Jamie’s Italian looks to be a good example of why Blitzscaling doesn’t work. Here’s why I think this, against my own ten-step startup scaling growth plan.

1. Scale the personalised customer experience Every company needs to connect to customers as individuals, with highly personalised experiences. That’s why it is vial to make the most out of every customer interaction by transforming single moments into personalised customer journeys.

Oliver’s growth plan was classic blitzscaling, driving rapid expansion in pursuit of bums-on-seats to the detriment of the dining experience. Behind every social post is a customer.  They ignored the feedback from TripAdvisor local ratings, which always showed a poor dining experience.

2. Scale simplicity Oliver said he relies heavily on others to help with the day-to-day running of his businesses. Don’t forget that my day job’s making content for television and books. I can’t do everything.

The rapid growth in branches meant they were effectively franchises, and run very differently to the TV chef’s early restaurants. Blitzscaling means you quickly dilute the culture and personality of your startup venture.

3. Scale through validated learning How many moving parts in your startup do you need to scaleup? Maintain a learning mindset, be the best at getting better, recognise growth is never done. Maths and metrics don’t lie but they don’t tell us everything.

The expansion of the chain was intended to provide economies of scale and market share, but in fact market share fell. It’s one thing having a strategy, but when it’s obviously not working you ought to change it.

4. Scale the right mindset When your startup enters the scaleup stage, ensure you’re not just thinking about the numbers, you need to have the right mindset for your current phase of development, and ensure the people you’re working with are on the same page too.

Scaleups are especially vulnerable to mindset mistake when things are working well. Rather than developing their customer base organically, Jamie’s Italian tried tie-ins with voucher schemes, such as Groupon, which attracted fickle bargain hunters, and didn’t inspire loyalty or regular customers. The blitzscaling mindset is ‘growth’, not ‘experience’

5. Scale unit economics You need to reach a point where unit economics start making sense. A startup is a bet on a business model attaining the scale/critical mass beyond which the unit economics starts making sense.

Again the focus on blitzscaling isn’t efficiencies but simple raw growth. Reports about Jamie’s Italian raised questions about the location of new venues and the suitability of those he appointed to run and the way the business was run, hurting Oliver’s reputation in the process.

Blitzscaling means you lose sight of your purpose, your ‘why?’, and when the numbers don’t add up, you’ve no other options.

6. Scale transaction frequency The purpose of scaling is to build a sustainable, repeatable business model where customer attraction, acquisition, retention and traction build the revenue model, and brand builds transaction volume and value.

Research showed tourists and those who happened to be passing by became the key clientele, with very few people coming in because of excitement of being at a Jamie’s Italian. Again the focus was on growing numbers, not learning about customer habits. Blitzscaling doesn’t focus on the right growth metrics.

7. Scale thoughtfully Scaling means ensuring everything moves together. There is no shortcut leading a startup restaurant from one customer location to 50+, each function must mature, staying in line with equal attention to detail and support.

By avoiding the trap of ‘one-size fits all’, and smaller thinking, growth is considered and intelligent. For Jamie’s Italian, the feedback is glaring, as one critic review stated: firstly, the restaurants are far too big; due to pared-down staffing numbers, on busy evenings staff are waiting on as many as eleven tables at once, while managers and chefs also felt overburdened.

8. Scale things that don’t scale The early days are the perfect opportunity to do things that don’t scale, for example cultivating special, one-off menus. Keep doing this as you scale for as long as you can. Startups become Scaleups because founders make them take off.

Again Blitzscaling ignores the finesse, personalisation and remove the opportunity for localisation. Jamie’s Italian was just a faceless, soulless franchise vehicle that had no connection to Jamie’s personal passion, vision and focus on food. It was a business model.

9. Subtract as you add Scaling is all about more – adding employees, customers and processes. Often, this masks what you are losing and what you should lose. Scaling is actually a problem of less, there are lots of things that used to work that don’t work anymore, so you have to get rid of them.

You have to be aware of necessary subtractions even as you keep your eyes fixed on additions. The Blitzscaling model is ‘wash, rinse, repeat’, it may work for a global software application, but not in a competitive local market where experience is a key aspect of the customer purchase.

10. Scale Out. Think of scaling out as building the base of a pyramid, the foundation upon which everything else is built, and you know that it will hold. Most startups focus on building their architecture in an intelligent way that will allow you to grow to realise your potential, without over taxing your team or endangering your roadmap.

For me, this is the fatal flaw in Blitzscaling. It’s a bet. Blitzscaling combines the gut-wrenching uncertainty of startup growth with the potential for a much bigger, more consequential failure. It’s a do-or-die approach. A mass market roll out without a solid foundation gives you nothing to fall back on when the growth stalls.

The failure of Jamie’s Italian also shows the flaw in the financial model of Blitzscaling: unless you can finance your growth from an exponentially growing revenue stream, Blitzscaling means you’ll need investors with deep pockets, and you usually need more money than you thought, because you’ll need further funding to recover from the many mistakes you’re likely to make along the way.

At the beginning, there was so much promise. Oliver was the fresh-faced, down-to-earth culinary whizz with his charming, stripped-back style and no-nonsense approach. Then, just like me when I refuse to choose between cheesecake and chocolate mouse, his eyes became bigger than his belly.

His ambition and ego absorbed the Blitzscaling hype, and the metaphorical soufflé went flaccid. I bet he felt like I did recently when I burned the home made sausages, and Susan’s retort was simple: the whole plate looks like it should go straight into the bin and then the dishwasher.