Uber, IPOs, moats, and valuations

Unlocking Potential is a newsletter by me, Francisco H. de Mello, founder of Qulture.Rocks (YC W18)

Howdie :)

I’ve just finished Super Pumped: The Battle for Uber. It’s crazy how the book seems to be so related to many other things that are either happening in the world or in my head.

First, there’s the WeWork soap opera unfolding right before our eyes. Their IPO was put on hold after public market investors refused to take the company’s asked valuation, right around the levels of their latest Softbank-fueled private valuation of $ 47 billion, not to mention the governance stuff, like the sale of the We trademark (watch this interview with Adam Neumann and Ashton Kutcher as they repeat four times in a row that We is a tech company).

Newspapers report that they’ve considered going public at a $ 15 billion valuation, which is a gigantic haircut from the latest round [1]. WeWork drama seems relevant to my Uber reflections because there are striking similarities (or coincidences): a) there’s a pointed discussion about private x public market valuations (as you can see below, the stock has lost quite a bit of value since the IPO); b) there’s the ousting a founder thing, especially since investors are in WeWork are also Softbank and Benchmark; c) there’s the “capital as a differentiator” strategy, which seems to be highly correlated with Softbank getting involved (and Benchmark getting cold feet). Anyway, you get the picture.

Second, I’ve been reading a lot about competitive strategy, moats, and all that stuff this year. I’ve reread Michael Porter’s Competitive Strategy and Competitive Advantage masterpieces, and also recently found a gem in the form of Hal Varian’s [2] Information Rules. Looking at Uber through these lenses is quite interesting since they are the natural embodiment of a network effects business, but also because it’s a money-losing company that spends a ton of money to keep its leadership position because of these alleged network effects and their winner-takes-all consequences.

Uber as a public company

As you can see from the graph below, Uber lost a lot of value since its IPO earlier this year.

Super Pumped narrates the whole process of how Travis Kalanick was ousted as CEO. First, investors and employees proposed a leave-of-absence, since Kalanick had just lost his mother in a boat accident. Then investors took a turn and outright demanded Kalanick’s resignation a few days later, which happened via a letter delivered by two Benchmark partners in Chicago). The book also covers what the search for a new CEO looked like, and how Dara Khosrowshahi was chosen (I still can’t come close to pronouncing his name). 

The book also tells how Dara had a massive compensation package of $ 120 million that was mostly predicated on achieving a $ 120 billion valuation on a much-expected IPO. 

That valuation just didn’t happen. 

Uber got about half of that number, which was right around their latest private valuation. 

Anyway, a bunch of high-profile IPOs this year (Lyft and Slack are two other examples) spurred interesting debates around three main themes:

  • Private x public equity investors valuations and perceptions

  • The merits of IPOs x direct listings, and

  • Whether companies should go public earlier on in their lives

Private x public market valuations

First, there was a lot of back-and-forth about whether private equity investors (strictly speaking both early-stage and late-stage venture capital are forms of private equity, as opposed to public equity, which is investing in publicly traded stocks) or their public equities counterparts do a better job at valuing companies. 

In general, I feel venture capitalists, especially the inexperienced bunch that is flourishing in the past few years, think public market investors are short-term-thinking fools who can’t envision the future. I think they are, in general, a bit too skeptical and short-term oriented. But the fact of the matter is that private equity investments are not fully realized until either stock gets bought outright, in case of an M&A, or becomes more or less liquid through an IPO. Therefore, public markets and their players are still very relevant and the fact that they are not buying everything that’s served to them is worth noting. They are where the buck stops. (By the way, I think the world’s best investors are pretty rational, as you can see from this amazing interview with Patrick Dorsey, who runs a public equities fund.)

Fred Wilson discusses why he thinks public market valuations tend to be more rational in a recent post (brackets are mine):

“The public markets are a lot different than the private markets.

Financial transactions in the private markets [i.e., funding rounds] are controlled by the issuers, happen when the issuers want them to happen, and are generally auctions, particularly in the late stage markets.

Public market investors can buy and sell stocks every day based on what is attractive to them and what is not. If they feel like they missed out on something, they can get into it immediately.

For this reason, valuations in the private markets, particularly the late-stage [sic] private markets, can sometimes be irrational. Public market valuations, certainly after a stock has traded for a material amount of time and lockups have come off, are much more rational.”

Fred Wilson’s AVC

IPOs and direct listings

Another interesting discussion revolves around the merits of IPOs x direct listings. Bill Gurley, of Benchmark fame, argues that investment bankers do very little during these processes and charge too much for the little they do, which is scheduling meetings with investors and running an Excel spreadsheet to figure out allocations. 

(In listening to people discuss the merits of IPOs, I heard a very interesting argument as to why private investors prefer companies to remain private, or at least until they invest. In an IPO, a huge allocation is 5%, maybe 10% of the offering. In a late-stage round, a lead can get 30% of an offering, maybe more on later stages. Therefore, private transactions allow investors to put more money to work.)

Anyway, Gurley rightly points to the fact that investment banks don’t actually underwrite anything, as the name implies wrongly: the term came from when banks would buy the shares themselves (or at least commit to buying them, effectively guaranteeing liquidity, i.e., the success of the offering for the company) and sell them to investors, whereas nowadays banks risk zero capital in the process. Gurley also argues that banks underprice most offerings, effectively directing money away from pre-IPO investors towards IPO investors, which can be “proven” by the fact that many IPOs pop a lot on the first day of trading and on subsequent months (e.g., just look at the Zoom stock).

When to go public

Finally, Gurley also argues that companies should go public earlier on, which counters the trend that has gained momentum in the past few years of companies taking longer to IPO. One argument is that late-stage rounds can have tricky terms, that are detrimental to earlier investors (things like preferred returns). Another is that going public represents “going to the next level” for companies and their founders, who have to act up, and accordingly, to the stricter governance practices needed to be a public company, especially in the USA. But also because it drives more discipline.

Anyway, Uber deferred going public as much as it could. It raised many private rounds with pockets such as Softbank (who else) and an Arab sovereign wealth fund, as well as from David Bonderman, from TPG. Eventually, it went to the market and is suffering as investors remain skeptical about its prospects.

Uber’s competitive position

Despite these discussions about IPOs and whatever, I do think public market investors are right in giving Uber stock a hard time.

To me, the biggest reason I’m bearish Uber is its competitive positioning. I do think there are significant barriers to entry in the ridesharing space. It takes a lot of cash to build a network like Uber’s, both to make the brand known to riders and to attract enough drivers so that riders have a good experience. So even though capital needs are a weak(ish) moat per se, I think it’s not negligible. The problem with Uber is the intensity of its rivalry with Lyft. Both companies at least think this is a winner-takes-all space (I disagree – more on that below), and therefore spend huge amounts of cash to gain market share. 

A winner-takes-all market is one in which network effects (or, according to Hal Varian, demand-side economies of scale) are reasonably linear so that the product with more of it keeps getting better until it kills everything else. The positive feedback is big enough so that the gap just keeps on getting wider. According to Hal Varian,

“The technology starting with an initial lead, perhaps 60 percent of the market, grows to near 100 percent, while the technology starting with 40 percent of the market declines to 10 percent. These dynamics are driven by the strong desire of users to select the technology that ultimately will prevail – that is, to choose the network that has (or will have) the most users. As a result, the strong get stronger and the weak get weaker; both effects represent the positive feedback so common in markets for information…”

From Information Rules, by Hal Varian

I’d argue that’s not the case with ridesharing.

I think Uber and Lyft have surpassed a critical level of network effects, at least in most dense regions, and that there’s little to gain from adding a marginal driver/rider to the network. I’d argue network effects follow kind of an S-shaped curve in ridesharing, and we’re way past peak inclination. Intuitively, it doesn’t really matter if it takes 5 minutes or 4.5 minutes for my ride to arrive. I’d argue Uber and Lyft could coexist without a dominant player really emerging because of demand-side economies of scale. [3] As Pat Dorsey puts it:

“Network effects can be very valuable, but if you think about, let’s take Uber and Lyft for example, both have strong network effects. As a consumer, I want the service that has the most cars, that are likely to be near me at any point in time so that I don’t have to wait very long. But they both are essentially commodities because they provide the same service. They take me and get me to a place. And so in the US, when some of the news about Uber’s unpleasant internal culture and Travis Kalanick came out in early 2017, Uber lost almost 15 to 20% market share very quickly, because there is no switching cost. As a consumer, if I don’t like Uber, I go use Lyft.”

From Pat Dorsey

Also, I think by assuming theirs is a winner-take-all market, Uber and Lyft are destroying each other, competing too fiercely when they could operate in a much gentler fashion, by giving away fewer incentives to both riders and drivers.

You could argue, on the other hand, that cutting incentives across the board (i.e., both Lyft and Uber cutting back on them) would cause overall market growth to stale. I’d argue that’s an even deeper problem because it would prove the problem is not with how stupidly Lyft and Uber compete with each other, but rather with how weak ridesharing’s bargaining power with consumers is – fewer incentives would mean people reverting to other modes of transportation.

WeWork and supply-side economies of scale

Even though WeWork argues it benefits from demand-side economies of scale (the thesis is that they are building a mega community of entrepreneurs and creative professionals beyond physical spaces), the fact is it most probably only benefits from supply-side economies of scale. 

Their whole business is buying – or renting – real estate in bulk and selling – or renting – it retail to small businesses. Or, as a real estate developer friend told me, “buying meters and selling centimeters.” 

Anyway, if your business is dealing in office space, you will probably derive advantages from being a huge player in that market (not to mention getting better prices on renovations, etc.), which will be hard to replicate.

Conclusion

I know I’ve been all over the place, but I’ll end this post with a suggestion and a prediction. The suggestion is that you read/listen to everything I’ve linked to in this post. It will be a great lesson in business management. 

The prediction is that I think Travis Kalanick will be back at Uber at some point in the future. I think Uber’s share price will continue to suffer (even if it gets a years-long tailwind if a merger with Lyft happens) because the sort of game-changing path that the company could have with its founder in command just won’t happen under Dara’s more risk-averse leadership. He’s a manager, not a builder, and Uber’s valuation still prices in a lot of building work. 

By the way, I couldn’t refrain from comparing Kalanick’s ouster with Steve Jobs’ ouster from Apple in the 80s, and my prediction with his comeback (the NeXT acquisition) – bear in mind that Kalanick has been running his new company, Cloud Kitchens, in an adjacent space, supplying kitchens to online-only “restaurants” that operate on Uber Eats, Doordash, Postmates, and other delivery apps.


Suggested readings

This is the best interview I’ve read in quite a long time by Pat Dorsey, founder of Dorsey Asset Management.

Bob Iger just released his sort of autobiography, Ride of a Lifetime, which is a very interesting inside peek at one of the world’s most successful capital allocators (I’m a huge Disney Parks fan!!)

I’ve already linked to Super Pumped and Information Rules within the text.


Notes

[1] It’s unclear to me how much of a proper round it was, as opposed to small marginal stock purchases by Softbank (I’ve read something about warrants somewhere).

[2] Hal Varian has been a Chief Economist at Google (maybe now Alphabet) for a long time, and it’s quite curious that Google had and has a Chief Economist in its ranks 

[3] Or, by the way, the ROI of shaving those thirty seconds is probably negative, since the marginal investment must be gigantic by now, and requires so much capital in absolute terms that none of the companies will be able to get it.