Zenefits — Like Starting Over

There was startling news from Zenefits last week (2/9/2016) that Parker Conrad, its co-founder and CEO, had resigned both as CEO and as a board director, and would be replaced by David Sacks. (Note: David Sacks founded Yammer, is part of the PayPal Mafia of highly successful entrepreneurs from PayPal’s early days, and produced the satirical film “Thank You for Smoking” in 2005.)

This is only 2 months since Zenefits was named the top-ranked unicorn of 2015 by Inc. Magazine in December. What happened? Answer: A lot.

Zenefits — The Unicorn

It helps to provide a backgrounder on the company. Zenefits is a provider of cloud-based HR and benefits software to small business. 401k administration, employee time-tracking, employee onboarding and payroll processing. For companies without dedicated HR, Zenefits can be a tremendous time-saver, and place to centralize information. We’re not a user at my company HealthCare.com, so I don’t have first-hand experience on the software itself. However, the numbers speak for themselves. They launched their product offering, launched their business, and grew. Fast. The rapid growth of the SMB user base suggests that they achieved product/market fit early.

A Twist on the Freemium Pricing

Zenefits’ revenue model introduces a twist to the freemium model. They provide the core Zenefits software to small businesses for free. It generates revenue by becoming the health insurance broker of record if the business decides to enroll in health insurance through Zenefits.

From Zenefit’s website:

We get paid by benefits providers — for example, your health insurance carrier — if you choose to manage your benefits through Zenefits. Managing your benefits through Zenefits is free (though you still have to pay the providers for your underlying benefits).

Because we can operate profitably on the revenue paid to us by the benefits providers on our system, we can offer you our service for free — a service PEOs, HR Outsourcers, and other HR software typically charge for.

No hidden fees, contracts, or surprises.

Zenefits employs a clever Trojan Horse strategy that’s built on an upsell, which is the sale of group health insurance. Zenefits’ core platform gives a high take-up rate because they are providing software automation for free for essential operations of a business clients. That user base ends up becoming an ingrained, almost-perfect source of leads for their brokerage business.

The business model is brilliant. It works because their business clients don’t pay commissions directly. Instead, those commissions are paid by the insurance companies. Thus, the business is indifferent from whom they buy their health insurance. Instead of local insurance brokers, there are no switching costs to choosing Zenefits as your health insurance broker. In fact, there are even benefits to doing so to have all of your information in one place. So far so good.

Mo Money Mo Problems

In May 2015, Zenefits was a high-flying start-up. A few months earlier, it was heralded as “one of the fastest-growing SaaS Businesses Ever” by TechCrunch, as Zenefits announced that annual recurring revenue had reached $20M. More impressively, the company was projecting $100M in annual recurring revenue by the end of 2016. (To be fair, it’s not a traditional SaaS business with users directly paying. But nonetheless, it’s extremely impressive.)

On this traction, Zenefits completed a Series C funding, which raised $500 million, and valuing Zenefits at a $4 billion. No doubt that the high valuation was predicated on hyper-growth.

But it’s a bit of a circular premise. To get a high valuation, you need to demonstrate a high rate of growth (which Zenefits already had, but had to continue). To get to high growth (and assuming you already have product/market fit), you need to invest in sales. To invest in sales, you need to invest capital, which needs to be raised from the outside. To raise equity capital, you need to stomach some level of equity dilution. To minimize the amount of equity dilution, you need a high valuation. And then the cycle starts again. (When I wrote this paragraph, I tried to type as fast as I could and take as few breaths as possible.) Note that Zenefits was already fast-growing, but the amount of capital raised and the high-valuation upped the ante.

The Cracks start Showing

In November, Buzzfeed reported that there were serious lapses regarding the licensing requirements for Zenefits’ salespeople. After the news of Conrad’s departure, there was even news that Zenefits’ software developers built a program called the “Macro” to help salespeople mimic taking the required 52-hours of online coursework in California, without actually taking it.

The problems began much earlier, and were deep inside of how the organization did things.

The pressure to grow at all costs following May ’15 must have been enormous. Maybe even preceding the Series C. But no doubt things escalated after the funding. The New York Times reported that there were some days where Zenefits brought in 100 new employees, on the way to a headcount of 1,500+.

This isn’t excusing the actions and decisions of the company. I’m just trying to rationalize (for myself, more than anyone) how and why this happened. (Although on the same The New York Times article referenced above, it might not have been exogenous pressure pushing the grow at all costs mentality. It might have been internally-driven based on previous interviews with the founder.)

As stated earlier, Zenefits had to invest in sales. They needed people who knew how to generate and cultivate small business leads. They had to be adept at selling software. They had to be able to close and meet numbers. But on top of that, they needed salespeople to be licensed as insurance brokers. Good people are hard to find, especially when it’s all at once.

In hyper-growth mode, Zenefits couldn’t be slowed down by:

• Great salespeople sitting on the sidelines while they were getting licensed
• Great salespeople who couldn’t pass the licensing

Every startup should be finding shortcuts. But when it comes to a regulated business, the confines are clearer. There needed to be supervision on what the boundaries were, and that needed to come from the top.

Target on Their Backs

In hindsight, Zenefits would have been well-served to recognize that the companies they were displacing weren’t going to sit quietly while their lunches were being eaten. Zenefits is growing (still growing, by the way) by taking away commission streams that used to go to traditional health insurance brokers. Since the sale of insurance is their primary business, the traditional brokers understand and respect the regulations. They are people who have spent their entire careers in this space, and not a rambunctious Silicon Valley startup that didn’t exist 2 years ago. Any misstep was going to be an opportunity for brokers to heighten interest to regulators. (Zenefits had already faced regulatory pressures in Utah for an issue unrelated to broker licensing.) Indeed, if everyone else has to play by the rules, so should the new kid on the block. In fact, especially the new kid on the block.

Chance for a Reset

All of this preceded the news from last week.

While the news of Mr. Conrad’s departure is anything but a positive, the move does give the company chance to reset. With new leadership, I imagine that new CEO David Sacks can go back to their board with a downward revised set of projections. This is going to be a hit for the investors, and for employees with option grants, because the valuation of the company is going to come down. (Note: It’s not just theoretical because Fidelity was an investor in the last round and they’ve already marked down their investment by 48%. I wonder how many people thought Fidelity’s valuation was going to be public news when they took money from Fidelity.)

But since there’s no driving force for a sale of the company, and assuming that the $500M raised will last a while, then there isn’t an explicit cause for alarm. Yes, the secondary market for shares would dry up, and there will be fewer paper millionaires. But in the long-run, what matters is that Zenefits grows the business and eventually (maybe over years) grows into its valuation.

The business can continue to grow (assuming there aren’t any company-killing penalties imposed on the company). A number of salespeople will have to be re-credentialed by the appropriate insurance regulators. A number of the sales leaders aren’t going to stick around. Those changes will have to happen.

I’m reminded of the treasury auction scandal at Salomon Brothers in the 1990’s that caused Warren Buffett to step in as CEO. Buffett — one of the most respected businessmen — explained his role in his biography, in particular his insistence that every employee report to him on any illegal behavior short of a parking ticket. Significant changes in the organization were made. Salomon company needed the cultural reset, and it was critical that this was conveyed both internally and externally to the regulators. They survived.

New leadership is a start. Read this blog post from David Sacks announcing the change.

Zenefits is no longer the precocious, rule-breaking teenager. It had some growing up to do. Now is it’s chance.

photo credit: 167725033GH00172_TechCrunch via photopin (license)