Since WeWork’s S-1 was filed, the company has come under a fairly significant amount of scrutiny by potential investors. It appears as though there are very few people left in the group that would consider themselves bullish on the stock and the pending IPO. One of the most glaring items in the S-1, that was not entirely new information, was the extent of the transactions taking place between WeWork and its founder, Adam Neumann. How will the valuation of WeWork be impacted?
Included in the S-1 were disclosures on these related party transactions. It is the case that there is some real estate that is owned by Adam Neumann personally, that WeWork then leases from him, and then in turn sub-leases to other tenants. This obviously raises speculation around conflicts of interest for the company and its founder. Is WeWork operating to pad the pockets of its founder through these lease payments to Mr. Neumann for real estate he owns individually? Why is the real estate owned by him personally and not the company? What is clear is that these related party transactions need to be closely examined by any potential investors.
Transactions that take place between a company and its owners is fairly commonplace in small, privately held businesses.
Oftentimes, a company may lease office space from an entity that has related or the same ownership. In valuing privately held companies, this related party arrangement must be identified and has the potential to result in an adjustment to the financial statements for valuation purposes.
Let’s suppose WeDon’tWork, Inc. is a company that operates in the technology space and rents an office from WDW, LLC. Both WeDon’tWork, Inc, and WDW, LLC have the same three owners. WeDon’tWork, Inc. pays rent to WDW, LLC for use of the office space on a monthly basis. In performing a valuation of WeDon’tWork, Inc., the valuator would need to examine the lease agreement between the two entities to determine if the monthly lease payments are at market value.
A potential for adjustment to the company’s net cash flow arises if the lease terms are not at market rates. If, for example, WeDon’tWork, Inc. was leasing space at $15,000 per month, however, market rates would dictate a lease for similar office space at $10,000 per month, the company’s net income would be understated by an amount equal to the difference in market rent and actual rent paid. So, it is possible for a potential acquirer of WeDon’tWork, Inc. to value the company based on the net cash flows the business generates after paying market rate rent on its office space. The acquirer can make the case that more cash flow would be available to pay out as a dividend if the company was not overpaying rent to the related party.
There are some other factors to consider as well, such as, if the potential acquirer is purchasing a controlling interest in the business. If the purchaser was only buying a small percentage, he or she may be unable to change the monthly lease terms to something that more resembles market value. The same may be true in the case of WeWork. Once shares hit the public markets, are individual investors going to be able to influence the magnitude of lease payments that are made from the company to its founder that owns the real estate individually?
Whether a company is large or small, public or private, related party transactions must be considered in virtually all valuation analyses.