House of Cards
Do Fundamentals No Longer Matter in the World of Venture Capital and SPACs?
Is it possible to respect something and disagree with it at the same time? I am not an expert in the venture capital world; to the contrary there is more that I don’t understand than I do. I am fascinated with the industry, but there are elements that defy traditional logic and fundamental financial discipline that leaves me equal parts bewildered and intrigued. My goal for writing this blog is complete transparency, so I am comfortable highlighting topics that I just don’t have a clear understanding about in the hopes that I can learn something in the process. I cannot tell if I completely misunderstand the current capital environment, or if fundamentals truly do not matter anymore.
I first met Robert Reffkin from Compass in 2015. My first impression of him was that he was a very special individual. He was incredibly bright, empathetic, interested in my point of view, and he was extremely kind. While these seem like traits that all leaders should have, based on my prior experiences he was more of an outlier. As an example of the other extreme: About a year before my meeting with Robert, I interviewed with a CEO of a HealthTech firm. I will not mention the company by name, but they were crowned a Unicorn in 2015. He walked into the conference with a very intense presence and was hands down an awful person (in my opinion). The way he spoke to me, his “I cannot be bothered attitude” (even though he invited me in for an interview), the way he tried to make me feel like I was fortunate to even be in his presence, was almost comically appalling. He spent 10 minutes berating me because I couldn't explain the competitive landscape of enterprise database solutions (I was interviewing for a sales role). After the interview was over, I sent their in-house recruiting team an email from the elevator ride down removing myself from consideration for the role (I don’t think I would have gotten the offer anyway, but it still felt good to send that email). As a side note, I read a few years later that this CEO was unceremoniously ousted from his company, and while I would never relish in someone else's failures, I made an exception to this rule in this instance. This is an extreme example of poor leadership, but I included this as a juxtaposition for Robert to illustrate the quality of the person that I found him to be. Most leaders fall some place in the middle of these extremes.
Compass’s executive team is exceptionally talented. Sure, with $1.5B in funding, the case can be made that anyone could have built what they did, but I disagree. Their marketing is best-in-class, their technology is amazing (at least as far as I can tell), but most important is their culture. While some people were bound to leave the company with less than favorable things to say, the large majority of their agents are die-hard Compass supporters. This level of loyalty is unheard of in the residential brokerage industry.
So Then What is the problem?
My concern about Compass is not about the company at all. If I was an agent, I think that there is a high-probability that Compass is where I would choose to hang my license. My concern is over their valuation. It just doesn’t make sense. Compass operates on a traditional financial model, the same as companies like Coldwell Banker, Douglas Elliman, and Sotheby’s. This is not an opinion, it is a fact. Even if a company has the technology equivalent to Google, marketing at the level of Apple, and a culture like Netflix, it shouldn't make a difference to their multiple if their financial model is exactly the same as a traditional brokerage. Frankly, with the insane overhead that they have by employing such highly talented experts (they employed 200 engineers in 2019 with a goal of doubling the count within the year), I would imagine these high salaried roles would weigh heavily on the already razor thin margins that brokerages typically have. Compass has made more headlines than any other brokerage in the last 5 years, but one thing that they are not is a disrupter. Agents flow between every traditional brokerage on a daily basis, and even though they may have new systems to learn at each one, the way that they make money (and the brokerage makes money) is identical. Brokerages that I would consider a disruptor are companies like Redfin, eXp, and Radius.
How Much of a Premium are we Talking About?
The closest competitor to Compass is Realogy. Realogy’s in-house brokerage closed $184B in sales volume in 2020 compared to Compass’s $151B during the same period. As I covered in a prior article, brokerage is only one business line that Realogy offers, so even though their in-house brokerage only closed sales volume of 18% higher than Compass, their total 12 month revenue was $6.2B vs Compass’s revenue of $3.7B. So what’s the difference in valuation? At the time of me writing this, Realogy’s market cap is $1.7B while Compass’s market cap is $7.2B. Something clearly seems off here between one of these valuations, and the only way to determine which one doesn’t fit the mold is to compare them to valuations of other similar companies. Below is a list of other brokerages with “Traditional Financial models” and what their valuation was when they last had a liquidity event:
Douglas Elliman, which closed $28B is sales volume was recently valued at between $250M - $300M when their minority owner, Dottie Herman, sold her stake in the company.
Pacific Union which closed $14B in Sales Volume, Paragon Realty which closed $4.5B in Sales Volume, and Lila Delman which closed $816M in Sales Volume sold for $83M, $18.9M and $6M respectively. For anyone that wants to argue that the models for these companies are different from Compass (hence their valuation shouldn’t be comparable), I’ll give you one guess as to who acquired Pacific Union. Paragon Realty, and Lila Delman. That’s right, Compass acquired them.
You can make the case that Compass would be valued at a higher multiple than a similar company because funding rounds are typically based on projected growth, and Compass is growing at an astronomical pace. I am willing to attribute a premium to them based on their growth rate, but that does not explain the eye-popping market cap of $7.2B. Compass is no longer venture backed; they are now a publicly traded company. And that brings me to the point of my article.
While Compass may be an anomaly in the brokerage world, similar examples are popping up in the news every day. Companies are going public, oftentimes via a SPAC, with valuations that do not seem to be connected to reality. Below are just a handful of examples:
LATCH, on revenue of $18M, went public at a valuation of $1.56B. Let those numbers sink in for a minute.
Nikola went public via a SPAC with revenue of ZERO dollars. Yes, they are PRE-REVENUE, and they went public at $23B.
Opendoor, with revenue of $2.6B went public via a SPAC at a valuation of $18B. On the surface, the valuation seems more reasonable than LATCH and Nikola from a revenue standpoint. However, revenue can be very deceiving, especially when iBuyers tend to book the total revenue for the price of the home (a typical company that brokers a $1M home books revenue of about $25,000 - iBuyers book revenue on the sale of the home of $1M since the are technically purchasing and then reselling the home). Their gross profit margins are thin, and Opendoor had a NET loss of $286M. Going public at $18B seems ludicrous.
I’m not saying that any of these companies are bad. Actually, I think they all have interesting models with compelling products, and the potential to enjoy massive growth. It’s not the companies that worry me, it’s the valuation. When these companies were VC backed, the investors understood the risks. They were using their money to place bets, which is exactly how the system should work. However, most initial investors have found a way to recoup their investments (and have made handsome returns), but now that they are owned by the public, it is hard to believe that these numbers will hold. Going public provides the liquidity event that investors dream of, but at some point the party ends since the valuation is not supported by any reality. Their financials are no longer confidential, and they come with the scrutiny of quarterly public reporting. Additionally, there are no more endless infusions of fresh capital, so someone will be left holding the bag. That someone is not a sophisticated investor; they are average retail investors who are buying into the hype that they may not fully understand. These companies did a great job of building really compelling businesses, the investors didn’t do anything wrong, but it is the very system that appears to be flawed.
I started out this article by saying that there are many things that I don’t understand. Perhaps I am missing something here and the retail investors are poised for a big pay day, but my guess is that this is not going to end well. There is one silver-lining. Since so much capital is flowing into PropTech, it makes this a great time to be an entrepreneur. Really interesting models are being launched that may never have had a chance in a different economic client. This has given the industry a boost to innovate and address the challenges of an archaic industry. But once reality sets in, and these sky-high valuations start to fall in-line with the true value of where they should be trading at, I worry that capital will stop flowing and some of the great ideas of tomorrow may never see the light of day.