Underestimating the Impact of governmental regulations and their costs by digital companies like Uber and AirBnB

hotel images

From my old business school course in Strategy, I still follow an outline of every bullet point from my professor’s handout. Part of that strategic outline must address “regulatory” issues. In other words, in spite of the market opportunity, I must evaluate whatever regulatory barriers that exist or have the business comply within the framework.

I personally encountered such barriers during my stint in telecommunications – telecommunication carriers are obligated, as a precondition to selling international telecommunication service, to be registered with the FCC. Failure to do so represents a risk that the company will be shut down or fined by the regulator, which regulatory action represents a substantial risk to investors. It seems that Silicon Valley digital world believes that regulatory compliance rules do not apply to them. I suspect that the regulatory oversight will come back to haunt them.

In a previous blog, I describe the Internet as a portal for information. It becomes a substitute for books, newspapers, magazines, print advertising. And even the yellow pages. But it is not a complete substitute for various business models that must include all risks such as regulatory issues. A couple of digital companies with fast growth models come to mind: Uber and AirBnB.

First, let me look at the so-called disruptive technologies for those companies before discussing the regulatory issues. These companies rely on geo-positioning. But are they truly responsible for that detailed geo-positioning? Smartphones get their geo-locational data from the telecommunication companies that had to build that infrastructure by regulations imposed by the FCC. In the 1980’s, the FCC concluded that since many phone users were migrating from fixed lines to mobile ones, the regulatory body was concerned for the safety of the users when calling for emergency services. Geo-positioning had to be improved so that the emergency services could locate them wherever they were within a few meters. The FCC mandated that all wireless carriers had to implement the rigorous technical standards, so that the geo-positioning improved its accuracy within certain meters. The challenge was not the GPS satellites, but getting physical data from the radio towers themselves. It took many years and billions of dollars for the telecommunications carriers to comply with the FCC deadline.

Uber and AirBnB simply piggy backed on this expensive telecommunications network for a fraction of what it took to build that data network generating data from telecom geo-positioning engineering. All Uber and AirBnB created a mapping layer with the positioning data. Then, it also added a credit card payment layer, a fairly well established API by the time Uber and AirBnB entered into the market. So I question the level of technology embodied on those platform layers. And had the FCC not demanded the geo-locational compliance, Uber and AirBnB would not exist. Regulations facilitated their existence.

And, second, let me look at the AirBnB business model that supposedly replaces hotels and taxis. Historically, society and judicial precedence have demanded that hotels and motels operate at a higher standard of care than personal residences. Therefore, they have been regulated for hundreds of years. Recently, I read where a couple stayed at a well-known hotel where they were infected by bed bugs and initiated a legal cause of action against the hotel chain. Will they be successful? I would say yes. Hotels are required to have postings of room rates, maintain certain health code standards, fire safety equipment, etc. In the State of California, specifically, hotels/motels are required to maintain their premises free of such parasites. Meantime, the local governance charges these hotels/motels a surcharge for an average of 10% of the nightly rates in order to enforce these regulations. That revenue also finances the hiring a hotel inspector to make sure that the hotels comply with those hospitalityregulations. And, with some slight due diligence, anyone can find records for violations of those hospitality codes. So there is a minimal quality standard not found within the AirBnB environment.

Besides one’s ability to determine a history of violations for the hotels/motels, they are also rated by various publications – Travel & Leisure. And now there are websites serving the same functions.

Now let us look at AirBnB business model. Anyone can post a room for rent – with or without bathrooms, with or without kitchen access, with or without mattress covers, with or without pillows, etc. One can find out the rates and the room locations based on the geo-positioning. Former guests are requested to leave a comment on the conditions. Of course, the temporary residents are not regulators, or Travel and Leisure critics. Many guests may not be motivated to give an unbiased criticism on the space. The comments do not reflect professional experience or impartiality. I have heard of one AirBnB user who informed me that the owner would maintain the cheaper daily rates if the guest published a favorable comment on the website.

What kind of people rent out their spaces? A retired couple who rent out their extra room whose son is attending college. In order to maintain semblance for their child, they cover the bookcases and separate the child’s clothing in the closet to give room to a paying guest. Since they don’t have insurance, you have to sign a disclaimer in case of fires, accidents, etc. Another younger couple bought too large a house with guest quarters. However, they had enough money to buy the house but not enough left over to repair the broken pathways, replace electrical outlets, cover or repair the empty pool or the main gates. The rental rooms lack chairs, solid mattresses, mattress covers, or bed sheets. Another AirBnB house rents out each room with the cheapest mattresses. The owner, a real estate agent, is renting the rooms to generate the revenues to cover the mortgage until the real property jumps higher. Meanwhile, to uphold their investment, all guests are required to remove their shoes and wear sandals. If you need sheets and towels you have to pay an additional daily charge. Any parking space in front of that house has already been rented to neighbors as a way to generate additional revenue, and any renter has to park on the street while avoiding the weekly street cleaning schedule that might produce a fine. Virtually all hosts make the accommodations Spartan – without chairs – to discourage long stays in the room.

Meanwhile, Airbnb rakes in 10% of each dollar earned by the hosts. It provides an API that allows for credit card processing, although any company can create such a payment model within two days. It has a website where it houses the casual pictures for each room.   And accumulates the many comments that former guests authored, and reminds each former guest to make such comments on the very last occupancy day.

There are no Master-Servant legal liability for AirBnB. In the case of the actual hotel bed bug incident, no guest can sue the Master, namely, AirBnB, for health code violations. AirBnB lawyers made sure that each host is an independent contractor and therefore AirBnB should never be liable since it does not have the Master-Servant legal theory to assign liability to the Master. Since any hospitality recommendations would suggest “control” by the Master, AirBnB does not provide any recommendations to the hosts as to what each room should have, although it seems to provide a format in describing the rental space by various posted pictures of the premises.

And what about the hospitality surcharge for 10%? A noted economist authored Zero Sum Economics – where one party gains financially, another party loses economically about the same amount. It seems the AirBnB has gained financially the 10% occupancy tax, the economic costs to build safe hotel rooms while avoiding any responsibility as to the quality and safety of the temporary residences. It most likely pays to third parties less than 2% to process credit cards.

Of course, AirbNb has some costs for hosting hosts and guests, comments, and payment processing. It has to maintain the servers that house its website. These costs must be less than $0.30 per guest per month. It does add certain value to allow individuals with access to potential guests whose qualifications are vetted through Facebook page and recommendations by guests, although anyone can fabricate Facebook profiles at will.
Somehow or another the market has exaggerated valuations of companies such as Uber and even AirBnB, simply because they failed to look into regulatory matters. These risks should discount the valuations. Once taken into account, those rich EBITDAs will erode by the rising costs that an online company must account for by regulated industries: lobbyists, consultant and lawyers. How much can a company spend on those “legal” services? Citibank has posted over $2.7 billion for legal costs from compliance to litigation during the 4th Quarter 2014. And those costs exploded for an institution well experienced in handling such costs. I wonder how AirBnB ad Uber will face those regulatory challenges without employing an army of lawyers and lobbyists.

None of these comments deny that there is a market for these companies, but they cannot hold themselves out as being substitutes for regulated hotels or taxis. Unfortunately, these companies insist that they can compete head to head against the established industries. However, I suspect that is not the case.


About Juan Ramón Zarco, SVVGP 胡安•雷蒙•扎尔科

Juan Ramon Zarco, 胡安•雷蒙•扎尔科, Silicon Valley Ventures Growth Partners llp, Hygieia Healthcare Technologies Company, AllRest Technologies LLC, Crimson Growth Partners LLP, jrzarco2001@yahoo.com, is an experienced as CxO, General Counsel and Secretary to public and private companies with global operations. Established track record of producing practical, revenue-focused solutions. As Counselor and Secretary, demonstrating vision, integrity, and sound business judgment, to CxOs. Managed complex, strategic transactions, M&A, contracts support, PE Financing, IPO, SEC compliance, Corporate/HR governance, IP licensing, Budgeting, Staff, outside counsel management, International market access strategies, Domestic & foreign government relations and advocacy. Creative in designing and implementing market access strategies. Practices law beyond conventional model with low-overhead and project-based fees. Effective at managing departments, formulating marketing strategies, balancing budgets, and implementing cost-saving measures. Extensive in-house and private practice experience, advising clients on commercial, corporate, international business, and technology law and policy. http://www.docstoc.com/video/89135472/make-your-business-an-international-presence; http://www.youtube.com/watch?v=fx5gijf3yoc For Sprint, he managed iDen international development in Southeast Asia, Middle East, and Africa, and contractual issues with Verizon. In Private Equity, he worked with Pegasus in vetting international investment deals and interim President for portfolio companies, such as Data Foundation, a data storage company, handling marketing, strategy, fund raising, and accounting. Before Pegasus, Mr. Zarco, as CLO and V.P. of Corporate Development, played a principal role in the structuring, international expansions for 2 telecom companies, U.S. Cable Group and Viatel, Inc. in financing and M&A deals exceeding $200 million. Mr. Zarco earned a J.D. from NYU Law School, M.B.A. from Cornell, and B.A. from Williams College; is fluent in Spanish, Portuguese, French, and German, with working knowledge of Russian, Arabic and Japanese.
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