Zenefits — Like Starting Over
Howard Yeh is a co-founder of Healthcare.com with two decades of experience building companies in healthcare, insurance, and digital distribution. More about Howard →
There was startling news from Zenefits last week (February 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 came only 2 months after 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, onboarding and payroll processing. For companies without dedicated HR, Zenefits can be a tremendous time-saver and a central place to manage information.
The numbers speak for themselves. They launched their product, 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 — generating revenue by becoming the health insurance broker of record if the business decides to enroll in health insurance through Zenefits.
From Zenefits' website:
We get paid by benefits providers — for example, your health insurance carrier — if you choose to manage your benefits through Zenefits. 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.
Zenefits employs a clever Trojan Horse strategy built on an upsell: the sale of group health insurance. Their core platform achieves high take-up because they're providing software automation for free for essential business operations. That user base becomes an ingrained, almost-perfect source of leads for their brokerage business.
The business model is brilliant. Business clients don't pay commissions directly — those are paid by the insurance companies. So instead of using a local insurance broker, there are no switching costs to choosing Zenefits. In fact, there are even benefits to having everything in one place.
Mo Money Mo Problems
In May 2015, Zenefits was a high-flying startup. Earlier that year, TechCrunch had heralded them as "one of the fastest-growing SaaS businesses ever" when annual recurring revenue hit $20M. The company was projecting $100M in ARR by end of 2016.
On this traction, Zenefits completed a Series C raising $500 million, valuing the company at $4 billion. That high valuation was predicated on hyper-growth — which meant the cycle had to continue:
- To get a high valuation → demonstrate high growth
- To sustain growth → invest in sales
- To invest in sales → raise capital
- To raise capital with minimal dilution → maintain high valuation
- Repeat
The Cracks Start Showing
In November, BuzzFeed reported serious lapses regarding the licensing requirements for Zenefits' salespeople. After the news of Conrad's departure, it emerged that Zenefits' software developers had built a program called the "Macro" to help salespeople mimic completing the required 52 hours of online coursework in California — without actually completing it.
The problems began much earlier, and were deep inside how the organization did things.
The pressure to grow at all costs following May 2015 must have been enormous. 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+.
In hyper-growth mode, Zenefits couldn't be slowed down by:
- Great salespeople sitting on the sidelines while getting licensed
- Great salespeople who couldn't pass the licensing exams
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 was growing by taking away commission streams that used to go to traditional health insurance brokers — people who have spent their entire careers in the space and understand its regulations. Any misstep was going to be an opportunity for brokers to heighten interest with regulators.
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
While the news of Conrad's departure is anything but a positive, the move does give the company a chance to reset. With new leadership, new CEO David Sacks can go back to their board with a downward-revised set of projections. The valuation is coming down — Fidelity, an investor in the last round, had already marked down their investment by 48%.
But since there's no driving force for a sale of the company, and assuming that the $500M raised will last a while, there isn't an explicit cause for alarm. What matters in the long run is that Zenefits grows the business and eventually grows into its valuation.
I'm reminded of the treasury auction scandal at Salomon Brothers in the 1990s that caused Warren Buffett to step in as CEO. Buffett insisted that every employee report to him on any illegal behavior short of a parking ticket. Significant organizational changes were made. The company needed the cultural reset — and it was critical that this was conveyed both internally and externally to regulators. They survived.
New leadership is a start. Zenefits is no longer the precocious, rule-breaking teenager. It had some growing up to do. Now is its chance.