The Fundamental Flaws of Softbank’s New Rules of Venture Investing

“Sherman takes a machete to standard thinking in strategy, offering up a common sense but deeply insightful—and sometimes surprising—recipe for what it takes to win in business.”

~Sydney Finkelstein, professor, Dartmouth College and author of, Superbosses: How Exceptional Leaders Master the Flow of Talent

The week’s featured book is If You’re in a Dogfight, Become a Cat!: Strategies for Long-Term Growth, by Leonard Sherman. In this work, Sherman takes the reader on a provocative journey through the building blocks of business strategy by challenging conventional wisdom on a number of questions that redefine management best practices. In the post below, Sherman discusses the flaws in SoftBank’s approach to venture investing.

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My book, If You’re in a Dogfight, Become a Cat, addresses how companies can achieve the Holy Grail of business: long-term profitable growth. The key to enduring success is continuous innovation, not for its own sake but in order to deliver meaningful product differentiation, supported by sound business models and an entrepreneurial, customer-centric corporate culture. It’s easier said than done, and only 15 percent of large companies manage to outperform the market from one decade to the next.

Recently, we’ve witnessed a significant shift in how new ventures, flush with unprecedented levels of venture capital, are racing for market domination across a range of industries, from transportation to real estate to enterprise software. But in their haste to short-circuit the development of robust management processes, sound business models, and defensible bases of competitive advantage, many of these companies are finding their race for global dominance is turning into a race toward oblivion.

“…many of these companies are finding their race for global dominance is turning into a race toward oblivion.”

No venture better epitomizes this problem than the collapse of WeWork’s IPO in November. WeWork’s once high-flying CEO, Adam Neumann, lost his job, his corporate jet, billions of dollars of net worth, and voting control over the company he founded a decade ago.

It would be easy to write off this humbling experience as the inevitable result of Neumann’s singularly avaricious, impulsive, and sometimes just plain weird behavior. But that misses the broader point that WeWork reflects only the most recent and extreme example of irrational exuberance and fantastical thinking that has transformed private equity markets in recent years, spearheaded by SoftBank’s $100 billion Vision Fund.

Since Vision Fund’s launch in May 2017, venture capitalists have engaged in a race to the top, raising and spending unprecedented amounts of capital. Over the past two years, VCs have closed two to three “hypergiant” funding rounds—more than $250 million—every week, mostly in unprofitable ventures with unproven business models. In contrast, VCs closed only seven hypergiant rounds in all of 2014. What accounts for this nearly twenty-five-fold increase in pursuit of “blitzscaled” growth?

Masayoshi Son, the charismatic and self-proclaimed visionary CEO of the Japanese holding company SoftBank and its Vision Fund VC arm, is blitzscaling’s enabler in chief. His investment entities led or participated in nearly 11 percent of the total global value of VC investments in 2019. Most notably, over the past two years, Son has poured over $16 billion into WeWork, which went from being the highest valued U.S. private company to a distressed asset in just six weeks, and about $10 billion into Uber, which has lost more money faster than any start-up in history and also has shed over 35 percent of its market value since its IPO in May 2019. Wall Street’s wake-up call has put SoftBank’s investments in Uber and WeWork underwater.

“To understand the method behind this seeming madness, one needs to know more about Masa Son’s background and investment philosophy.”

To understand the method behind this seeming madness, one needs to know more about Masa Son’s background and investment philosophy. Son made a fortune by investing in scores of start-ups at the dawn of the internet, often with little or no due diligence. In one of the best investments of all time, Masa committed $20 million to Alibaba within ten minutes of meeting its founder, Jack Ma. Son’s investment is now valued at over $140 billion.

Given this sudden good fortune, in Masa’s world, instinct and snap business judgment reign supreme, underscoring an investment philosophy that fundamentally rejects the investing norms of venture capital.

VCs have always played a longshot game, where the rewards from backing a few breakout winners outweigh the losses associated with the vast majority of duds. To manage risk, VCs typically fund start-ups through a series of investment stages, where the size and focus of each round reflects a venture’s evolving development needs. Over two-thirds of funded startups turn out to be complete busts, returning nothing to VCs. Only half of one percent monetize an exit of at least $1 billion within a decade of initial funding.

Masa launched Vision Fund to transform the rules of the game. Rather than joining shared VC funding rounds, SoftBank often decides unilaterally whether a venture is worthy of a massive cash infusion—often several times greater than the venture’s ask—at a significantly stepped-up valuation. For example, the median size of late-stage VC investments worldwide in 2018 was $35 million. SoftBank led or sole-sourced eighteen late-stage funding rounds of $350 million or more.

“Masa launched Vision Fund to transform the rules of the game.”

From a venture’s standpoint, such unprecedented largesse is both an opportunity and a threat. Those that accept SoftBank’s offer can tear up their old business plan and shift focus entirely to ramping up organic growth and acquisition. It’s hard to refuse, particularly knowing that SoftBank is prepared to make the same offer to a venture’s fiercest rival instead. As Uber’s CEO, Dara Khosrowshahi, remarked after accepting SoftBank’s $10 billion investment in 2017, “Rather than having their capital cannon facing me, I’d rather have their capital cannon behind me.”

Son seems to believe that the Vision Fund’s massive capital investments can be used as a weapon to convey sustainable competitive advantage, global domination, and superior returns for his chosen winners. But this thinking is profoundly flawed.

Why then do SoftBank’s portfolio companies need so much growth capital yet remain unprofitable for so long? Because SoftBank has focused its investments on capital-intensive, low-margin, mature businesses wrapped in a patina of technology that, for all the hype, does not fundamentally improve weak operating economics. Add to that SoftBank’s relentless cheerleading for growth at all costs and breathtakingly inadequate board oversight, and you have the prescription for disaster.

Take WeWork. The temporary office space market has traditionally been modestly profitable, slow-growing, and subject to business-cycle risk. Thanks to SoftBank’s $16 billion injection, WeWork embarked on a frenetic worldwide expansion, attracting customers with a compelling but profit-killing value proposition: deeply discounted short-term leases, pricey design touches, and unlimited free kombucha and craft beer. Like Uber, despite predictably ballooning losses in its core business, WeWork also invested heavily in new ventures with scant evidence that its technology or operating model could ever deliver sustainable profitability.

Rewriting the VC rules has led to several impairments in Softbank’s Vision Fund, and Son’s plans for an even bigger Vision Fund 2 are in serious jeopardy. Entrepreneurs and investors would be wise to learn from Son’s mistakes and get back to the following sound venture-management principles. A short list of principles that Son has unwittingly reminded us of:

• Due diligence matters. Business instincts are great, but they don’t replace the need for sound due diligence.
• Business models matter. Pouring money into unproven ventures doesn’t overcome broken business models; it often accelerates profitless growth.
• Risk management matters. Stage-gated investments with relevant performance metrics and milestones promote fiscal responsibility, low-cost learning, and effective venture management.
• Business focus matters. Businesses built on shaky foundations should not be diversifying into multiple new businesses to prop up top-line growth while losses mount. Fix the core before extending the core.
• Governance matters. Giving messianic founder-CEOs unfettered control over strategy and spending and then allowing them majority voting control after the IPO makes a mockery of effective governance.
• Transparency matters. Companies with the worst bottom-line performance are always the most creative in conjuring up non-GAAP financial reporting, like “earnings before all the bad stuff.” Wall Street has sent a strong signal that investors now expect legitimate and relevant accounting for financial and operating performance.

Son made a fortune by betting big on a few hunches at the dawn of the internet. Counting on lightning to strike twice by following the same playbook in the current business environment is proving to be a fool’s errand.

If you enjoyed this post, enter our drawing for a chance to win a copy of If You’re in a Dogfight, Become a Cat! And remember to check back throughout the month for more free book drawing guest blog posts from Columbia Business School Publishing authors.