Did California just crush the “gig economy?” It’s a real possibility, and you should stay away from Uber (NYSE: UBER) and Lyft (Nasdaq: LYFT).

It was already an easy call to avoid UBER and LYFT. Both names had an initial public offering (IPO) earlier this year. As of this writing, they are down about 30% and 25% respectively. If California’s new law sets a precedent, though, there could be far more downside ahead.

To give a brief bit of history, the gig economy didn’t exist before 2009. It is based on a combination of smartphone technology, GPS tracking, and mobile payment technology layered on top of the “app economy” — the explosion of smartphone apps available for iPhone and Android phones.

The combination of technologies available post-2009, the year Uber was born and mobile commerce really started to take off, lets consumers pay for goods or services via super-convenient apps on their phone. It also lets Silicon Valley companies, which run the apps, hire contract workers to deliver the goods and services. Along with drivers for Uber and Lyft, for example, there are delivery workers for companies like Instacart and DoorDash. There is even an app called Wag! for finding someone to walk your dog.

These app-based services power what has been dubbed the “gig economy” because, in a very real sense, the human workers who fulfill the services do not have a job. They have contractor-type “gigs,” working flexible hours and sometimes logging just a few hours a week. Many gig economy workers work for multiple apps simultaneously, with no job security to speak of.

The trouble is that all the gig economy companies lose money, and some of them burn it by the truckload (Uber lost $5.2 billion in the second quarter, which is astonishing for a 10-year-old company).

Part of the trouble is that gig economy companies aren’t purely digital. Companies like Facebook and Google and Microsoft have models wholly based on bits and bytes; there isn’t any physical “stuff.” For app-based models serving millions of customers in the physical world, however, the “physical world” part turns out to be wildly expensive.

Because there is no precedent, and because the capital burn rates are so high, some investors think today’s gig economy companies may never turn profitable, at any point ever.

For instance, Hubert Horan, a transportation analyst with decades of experience, has written up an extensive critique of Uber, the mother of all gig economy companies. Horan points out that Uber took in more than $20 billion worth of venture capital over a nine-year period — a truly staggering sum — and yet it still burns billions today and may never earn that capital back at all.

And the problem is not just Uber. When Lyft went public, it revealed the same horrible cash-burning economics on a smaller scale. Ride-sharing competitors in Asia, like Didi and Ola and Grab, have the same profile, and so do grocery and food delivery companies like Instacart and DoorDash.

Investors who are bullish on these gig economy companies argue that, one day, they will stop spending oceans of money on market share acquisition and competitive subsidy pricing. Skeptics like Horan think that day will never come.

A scary thing for these companies is how little the “gig economy” workers actually earn. Drivers for Uber and Lyft, for example, are estimated to make between $9 and $16 per hour after factoring in vehicle, gas, and insurance costs. That earnings range is mostly below minimum wage, and on top of that, drivers are expected to take on significant financial risk in handling their own vehicles and insurance.

This is quietly alarming because, if the gig economy companies can’t make the economics work now, with contractors getting paid little and shouldering much of the burden, how will the economics work if worker costs start to rise?

A rise in worker costs is exactly what is happening in California with “Assembly Bill 5,” or AB5 for short. AB5 had been making its way through the California legislature for most of the year and was signed into law this month by California Gov. Gavin Newsom.

California’s new bill uses a strict three-part test to determine whether gig economy workers are true independent contractors. If those workers don’t meet the three criteria outlined, they must be given the benefits of employees under California state law, which means things like sick leave, health care, overtime pay, workers’ comp, rest breaks, and more.

If companies like Uber, Lyft, and DoorDash have to start treating their contractors like employees — which is exactly what California wants — their losses could get much worse, which in turn could push back their “turning profitable” date by years, or possibly tip it to “never.”

Morgan Stanley estimates that, if California’s AB5 goes into effect as it stands, in-state costs for Uber and Lyft could rise 35%. Barclays, meanwhile, thinks Uber could lose $500 million a year, and Lyft $290 million, because of AB5.

And that doesn’t take into account a spread into other states. The goal of California’s legislation is to set a precedent for “gig economy” workers everywhere, across the United States and the world. New York has gone in this direction, too, requiring a minimum wage of $17.22 after expenses.

The key players are fighting back hard against California’s AB5, which goes into effect in January 2020. Uber, Lyft, and DoorDash have said that, if the rules are not loosened, they will spend $30 million each ($90 million jointly) supporting a ballot countermeasure to amend AB5.

Uber and Lyft are also making outlandish arguments to say their contractors are exempt from AB5. Uber, for example, has argued it simply provides a “technology marketplace,” bringing drivers and riders together, and that drivers are another form of customer and not essential to Uber’s business.

The argument is silly but convincing people by word of mouth is not the point. The purpose of such arguments is to buy time via tying things up in the courts, where even the silliest assertion can be defended by lawyers. Uber’s hope is that, if it can push back compliance via stonewalling, it can move closer to profitability or figure out a plan B before the new wave of losses hits.

The hundreds of thousands of rideshare drivers in California — Lyft claims 325K drivers in the state and Uber claims 200K, with many of those overlapping — are split on whether or not they want employee status. Some think it is a great idea and that it’s only fair. Others fear they will lose their part-time flexibility advantage or get less work overall.

Either way, California’s AB5 legislation will soon take effect. It is a huge long-term risk to the profitability economics of gig economy companies, which were already losing money hand over fist. And AB5 also points in the direction of a broader trend. In the U.S., the millennial generation is larger than the boomer generation, and they are far more inclined toward workers’ rights.

So, what will ultimately happen to these gig economy companies — not just Uber and Lyft, but DoorDash, Instacart, and others — if their worker costs rise sharply?

One possibility is that the cost of app services in general will rise, in the manner that rideshare costs are higher in New York due to the $17.22 minimum wage. It may be that the low cost of delivery and rideshare services that customers have enjoyed over the past few years is a mirage, paid for by billions of dollars of venture capital money vaporized in the name of scale. A resort toward more realistic economics could mean a rise in the cost of app services, which would reduce the scale and footprint of these businesses as a smaller percentage of consumers use them.

If this happens, the countless billions that VCs and investors poured into these companies to massive scale would simply go up in smoke, never to return. It might be that the entire “gig economy” expanded to a large multiple of its rational size by way of Silicon Valley losing its head, and that the forces of reality and gravity will cause it to brutally contract.

This, again, makes gig economy companies like UBER and LYFT an easy call to stay away from — or even to buy puts on after extended multi-week rallies.

Richard Smith
Richard Smith, Ph.D.
CEO & Founder, TradeSmith