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Zillow was outsmarted by the market

No one has played a more important financial role with Zillow than venture capitalist Jay Hoag, who serves on the company’s board of directors.

Many moons ago, he served on one of my boards and was the lead funder at HomeGain, which I sold in 2005.

Before that exit, Jay once asked, What if we used our new funding, then $40 million, to buy houses? He was half-serious. At that point, the company was trying to figure out the best business model.

That was right before the massive run-up in home prices in the early part of the 2000s. Fully leveraged, the payday would have been mighty in the early years and a disaster in 2010 to 2012.

Jay also founded and helped Netflix founder Reed Hastings figure out his online DVD business, lending his intellectual firepower to the shift to video streaming. This put Netflix on the course of changing television and moviemaking and creating billions of dollars in value for investors, including Hoag’s TCV venture fund.

Soon after HomeGain was sold, Jay funded Zillow.

The hardest part of any start-up is figuring out a business model. But if you are lucky enough to solve the perennial start-up riddle and enjoy ample funding, you are off to the races.

By 2012 or so Zillow was set up for success. It figured out a very scalable and successful business model, selling leads to real estate agents. Its revenue jumped and it began to shrink the burn rate and cut losses.

But as the company matured, it became weary of working with agents. It tweaked its business model to a success fee (online referral cut) and saw a looming limit to its digital marketing strategy, capped by how much agents would ever spend on internet ads.

It also feared becoming a tired incumbent, as iBuyers like Opendoor and Offerpad entered the digital real estate scene. Then, funding came its way because of institutional investors’ appetite for buying single-family homes. Zillow CEO Rich Barton feared being left behind and jumped into the iBuying business. A big chunk of his management team left the company, and he reinvented Zillow. Bold and risky for any business.

The rest is history. Yesterday, Zillow announced it was shutting down the program and is scrambling to unload $7 billion of overvalued real estate. The company’s stock got hammered.

Smart real estate investors know too well the danger of buying homes at frothy times in the housing market.

Access to too much capital often blurs good real estate investor judgment. Over-leveraged investors can easily lose everything.

Tech entrepreneurs can come to believe that they are invincible. Barton was a wonder kid from his early days at Microsoft. Everything he touched turned to gold. Humble but charismatic, he seemed to have no limits.

What’s next for Zillow? Its core business isn’t going anywhere. Agents love leads and they’re flush with cash from a strong housing market, so expect that opportunity to grow.

Also, Zillow is investing in all parts of the digital transaction, like ShowingTime, and will begin to focus on further monetizing opportunities like that.

In the end, this may be as much about a new competitor, Andy Florance’s CoStar, as anything else.

When Realogy got hammered by the 2010 housing meltdown and was distracted and plagued by debt that it took from private equity company Apollo, Zillow stepped into the digital void and made hay with both consumers and Realogy agents. Realogy struggled with a crashing market cap, as low as $600 million, as Zillow’s market cap jumped to more than $30 billion.

At Connect last week, Florance made clear which company he was gunning for, even though he used a fake name to trash Zillow.

This is a mighty war and Barton cannot afford to be distracted by a risky proposition like iBuying when Any Florance is gunning for him.

By Brad Inman

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