For a company that was launched in early 2013, Zenefits has certainly crammed a lot into its short existence. Unfortunately, what transpired in that timeframe was often over-hyped and not always positive. There has been a CEO ousting, a spat with a major payroll provider and stories of employees having sex in the stairwells at work. But let’s not jump too far ahead for now.
Let’s look at the history for some perspective.
Zenefits was incubated at a startup accelerator called Y Combinator. Its initial funding was a modest $372,000. From there, the company went on to acquire additional funding at an aggressive clip.
In short order, the company’s funding increased by $1.7 million, $15 million, $66.5 million and $500 million in consecutive rounds. Likewise, valuation for the company followed an even more amazing ride with the company’s valuation peaking at $4.5 billion. That’s incredible as the company may have only had $60 million in Annual Recurring Revenue (ARR).
But the valuation has taken a hit lately. One investor, Fidelity, cut its estimate of the company’s valuation by almost half. A key question for Zenefits investors is whether the company can regain its peak valuation again.
History: trouble with regulators
Zenefits provides free HR software to small-to-medium sized businesses. It makes money from commissions/rebates it earns by upselling payroll services and health insurance to these same small businesses.
Zenefits has had issues with regulators in more than one state. One reason for this is that insurance is regulated at a state-level (not federal) in the United States. Differences between state regulations, regulatory bodies, etc. are significant.
Remember, Zenefits only came into being in 2013. Around April of that year, they supported firms in only two states. As TechCrunch reported later that year:
At the time, Zenefits only operated in two states: California, and New York. Today, they’re rolling out to all 50.
There’s one catch, though: for now, they’re only rolling out to the other 48 states for companies with 20+ employees. Come January 1st of 2014, however, they’ll be in all 50 states for all companies with at least two employees.
But, to do this, they would need to pass muster with regulators in all states. This could be a time-consuming process for a company on a high-growth trajectory. Getting things done in state government at the same speed as innovation might be tough to do.
Zenefits would likely face competitive and lobbying hurdles in some states as its business model threatens the economics and power base of established insurance providers/sellers. Tesla, another high-tech darling, has hit roadblocks from car dealers and state governments in numerous states as they want to bypass the dealership business model. Uber hasn’t exactly found their service universally loved by cab companies and some local governments either. Zenefits, like other pioneering business model disrupters, is hitting these same head winds. All this market interference might slow down their growth plans. As BuzzFeed reported:
The insurance brokerage industry is heavily regulated, and technological innovation has historically been slow to take hold. Many conventional brokers still rely on mountains of forms and spreadsheets — enhancing the appeal of Zenefits for customers who resent paperwork and value speed.
One solution to maintaining growth might have been to cut corners.
One article stated:
The company allowed unlicensed brokers to sell health insurance, according to a BuzzFeed report. BuzzFeed most-recently reported that 80 percent of the company’s deals in the state of Washington were done by unlicensed brokers.
Another story indicates that the company is being investigated by the California Department of Insurance. The heart of that matter appears to be whether employees are actually licensed and/or qualified to sell insurance in that state. In this case, Zenefits self-reported an issue it noticed with its employees’ use of a time tracking tool for pre-certification (prior to getting an insurance license).
In recent years, Zenefits has sparred with regulators in Utah. For a time, the firm was barred in Utah. The issue there was that Zenefits business model was unpopular with traditional insurance brokers. According to Fortune magazine:
Utah’s insurance department argued that Zenefits’ free software counted as a rebate. Last year, the state asked Zenefits for a settlement fine of up to $97,000 with 24 months of probation, unless it began charging money for its software.
Late last year, the Utah governor signed legislation lifting the ban. This statement in a BuzzFeed item is telling:
Many of the newly hired reps lacked any background in health insurance; several said they felt unqualified to help customers select plans for their employees. As BuzzFeed News has reported, Zenefits repeatedly failed to enforce legal requirements that anyone selling a health insurance policy have an appropriate state license, and sales reps were given software to help them cheat on the California broker licensing process. Zenefits is currently under investigation by insurance regulators in Washington state and California.
History – trouble with ADP
ADP (aka Automatic Data Processing, Inc.) is arguably one of the world’s largest processors of payroll transactions. The company offers numerous payroll solutions for small and large firms. The company also possesses broader HR software products, too.
Zenefits and ADP shared a number of customers but their relationship hit a speed bump in 2015. The dustup began in early to mid-2015 when ADP cutoff access to their RUN product data to Zenefits. What started as a technology performance or connection issue soon turned into a bunch of strong words. Eventually, a defamation charge was leveled against Zenefits.
A judge did not find enough evidence to support that charge and the parties fairly quickly and peaceably settled later that year. Diginomica’s Phil Wainewright, Den Howlett and I conducted a number of interviews with executives from both sides while this matter was playing out — you can read our assessments here. You can also see the Wall Street Journal’s take, too.
History – sales
The only way one can support a valuation like Zenefits’ $4.5 billion number is to grow massively. Investors anoint this kind of valuation on a firm that will quickly grab huge market share, hang on to it and then reap oversize profits. That’s a tall order.
Zenefits would have to do a pile of deals to get any kind of big revenue numbers since its solution is designed for smaller firms (i.e., firms that will likely only generate a modest commission/rebate per customer). To get more revenue/customer, Zenefits would need to move upmarket to larger customers or broaden its solution set.
But capturing ever larger amounts of customers and customer revenue can be expensive. In Zenefits case, they would need more sales people to canvas potentially greater numbers of sales prospects. Expanding their sales force means more hiring costs, more training costs, more licensing costs, more commissions/bonuses, etc. There is a real cost to acquiring new business and in the SaaS world it can be pricey (in the short term).
While it was frequently touted as one of Silicon Valley’s faster/fastest growing firms, the monthly recurring revenue numbers may not have lived up to expectations.
According to the Wall Street Journal:
Human-resources startup Zenefits Inc. is falling short of its aggressive revenue targets and has started to curb expenses, making it the latest highly valued venture-backed company struggling to meet investor expectations.
Since late summer, Zenefits has frozen hiring in certain departments as sales teams have repeatedly missed targets, according to people familiar with the matter. It has cut the pay of some employees and dozens of people, including at least eight executives, have left or been fired, the people said.
Zenefits has said it aims to reach $100 million in expected annual revenue, based on its number of users, by January. A customer milestone hit in August suggested the figure had reached about $45 million by that point, according to people familiar with the matter, who say it will be difficult for the company to reach its target.
So how much revenue was Zenefits actually bringing in? A recent Fortune magazine piece quoted new CEO David Sacks as saying:
This is why Zenefits more than tripled its Annually Recurring Revenue (ARR) last year, growing from $20 million to over $60 million.
Readers should note that ARR is not the same as GAAP revenue. SaaS companies frequently describe their sales success with non-GAAP metrics like bookings, MRR (monthly recurring revenue), Average Contract Value, etc. These terms all describe something different and are not comparable.
Private firms rarely provide full financials or audited financial results to non-investors. From what we’ve seen in the press, press releases and other sources, Zenefits had approximately $1 million in ARR in 2013, $20 million in ARR in 2014 and $60 million in ARR for 2015. Apparently, the board was expecting $100 million in ARR for 2015 and the fact Zenefits is falling short of these expectations may have contributed to the recent leadership changes and staff cutbacks.
Why is this important? If the company isn’t growing at a meteoric rate, then it doesn’t warrant an oversized valuation. Investors want to see that original valuation back to the $4.5 billion mark.
For an epic read about how dysfunctional the Zenefits sales practices/environment was, readers should check out William Alden’s Buzzfeed piece.
History – turmoil in executive and worker ranks
Aggressive but undelivered growth, controversy and drama are having an effect on the Zenefits workforce. A quick perusal of Glassdoor comments re: Zenefits gives a clue to the long hours and challenging atmosphere there.
Let’s recap some of the recent personnel related matters:
- Founder/CEO Parker Conrad ousted in early 2016
- Former COO David Sacks assumes CEO role
- Sacks bans alcohol on the job
- Sacks prohibits employees from having sex in the stairwells at work
- Sacks does a reduction in force and lets 17% of its workforce (mostly larger enterprise sales people) go
Even non-technology publications took notice. Vanity Fair noted in this story titled A Multi-Billion-Dollar Start-Up Is Forced to Ban Sex in Stairwells that:
Earlier this month, the company’s CEO, Parker Conrad, publicly resigned amid concerns over the company’s regulatory compliance and its frat-like culture.
The frat reference did seem appropriate. Now the cleanup must begin and it will fall to many of the surviving Zenefits employees to:
- re-create sales momentum
- get costs in order
- raise morale, and,
- introduce a more professional workplace environment.
After that gets done, then the company can focus on the external market’s impressions of the firm.
Can Zenefits become a phoenix?
Time will tell if Zenefits has already peaked.
Few tech companies get second chances. They peak and then they fade away. Sure, they can try to re-invent themselves but the original magic or spark is often gone.
We think about all of the old ERP and financial software vendors we have dealt with over the years. Firms like McCormack & Dodge, Walker Interactive, SSA, Baan, Management Science America, etc. They had great days, to be sure, but the market has moved on and many of their founders moved on. The founders are often the key as they are the entrepreneurs and visionaries with the passion that drives the business. Without them, the momentum within the tech firm often goes missing. Apple is an exception to this and serves a great example of how a tech company can re-invent itself and regain market relevance. Apple even threw out its founder (Jobs) and later brought him back to create some breathtaking products (e.g., iPod, iPad, iPhone). But it took a $150 million injection of cash by Microsoft at a point when Apple was on the brink of collapse to catalyze the company into a turn in direction.
New Zenefits CEO Sacks recently opined in a company email:
During my years in Silicon Valley, I’ve seen a number of attempted tech turn-arounds. Frankly, they don’t have a very good track record. But that’s because those companies had become obsolete technologies; they had lost their product-market fit. That is not Zenefits. Zenefits has made mistakes but it never lost its product-market fit.
Sacks may be right on that measure but the Zenefits brand has been hurt. It has a PR problem and stories continue to emerge about the toxic culture at the company.
How Zenefits should proceed - our counsel
Since Den, Phil and Brian have each been close to this firm/evolving story, we thought it appropriate for each to offer thoughts as to what Zenefits must do.
Sacks definitely has his work cut out for him. I can appreciate all of his recent communications to employees and the changes he’s making to the culture. In an internal memo that Fortune quoted, Sacks wrote:
I believe that the measures we are taking—self-reporting our issues to regulators, fully cooperating with their investigation, instituting new controls that bring us into compliance, naming a new exec team and Board, introducing new company values—put us on the path to fixing these problems.
Sacks also understands that company grew too fast – its growth outstripped its controls.
Sacks should read the LinkedIn piece by Caroline Fairchild. She interviewed a large number of current and former Zenefits employees. It’s a stark and disturbing piece that points to a number of issues Sacks will have to address.
But I believe the bigger, future story will be what happens to the company in the macro sense and not all of the myriad micro things Sacks will need to accomplish. If you look at Zenefits from an investor perspective, then you might think:
- We may never see the promised $4.5 billion valuation and certainly not in the aggressive timeline we wanted for a liquidity event. If we can’t get that valuation, how do we get a second-best liquidity event to come through for us?
- We should look for a strategic merger partner for Zenefits. Do we smash them together with a small business accounting solution like Xero? Can we interest someone like Sage in Zenefits as they have a lot of SMB accounting solutions? Could someone mend fences with ADP and see if they’ll take this off our hands? Could Paylocity or Paychex get interested in this?
I suspect that Sacks will need a real COO to clean up things and get the internal machinery right and tight in short order. While that new COO is taking care of those matters, Sacks will likely need to work magic on something big and strategic to satisfy the needs and wants of the company investors.
That new COO will also be challenged to run Zenefits 2.0 as a more fiscally moderate firm. It’s doubtful they’ll see any new capital investment until (and if) they get close to a mezzanine or IPO financing event. That means they’ll need to grow a lot with whatever capital they have or can generate through new sales. That’s always tough in the SaaS world and it will be tough for Zenefits, too.
Fairchild's discovery that:
“Nobody had any clue what the hell was going on,” said a former HR and benefits coordinator who left the company in 2014. “There were managers, who had never really managed, overseeing teams of 100-plus people. Favoritism was absolutely rampant. But mostly, nobody had a clue.”
How do investors get hoodwinked unless they're either asleep at the wheel or sucking up the kool-aid with scant attention to any detail? I can tell you how, again from personal experience. People simply lie until the lies become too great of a burden and the ugly truth spills out.
The former CEO will take a big part of the blame for this but I also say the lead investors should be examining their own behavior. I'm not alone. The SF Chronicle comes to much the same conclusion, noting that Lars Dalgaard, former CEO of SuccessFactors and now general partner with lead investor Andreessen Horowitz was one of only three board members. The other two were the co-founders, including the now disgraced former CEO. While it is said that Dalgaard insisted on a hiring freeze last summer, that was limited to operational staff who often had to clear up after sales.
No-one in their right mind drops $500 million on any company without substantial due diligence. But if all investors were doing was looking at projected ARR and star struck by the 1>20>100 numbers then is it any wonder things went wrong?
This was a topic I recently discussed with someone who was at SaaStr. They loved the event but I came away disturbed. I was shocked at the lack of obvious support for people wanting to run a disruptive business and grow wildly but with almost no clue about the most basic of business management requirements. The only talk was that of sales and funding rounds. I get that but as I said on a call earlier in the week, any business can show the kinds of growth that Zenefits has. You simply overload the business with sales people with scant regard to cost.
That's easy when you've snagged what looks like a bottomless pot of money in a funding round. Then-CEO Conrad Parker admitted as much. Any idiot could follow that path. There's absolutely no magic there at all. Is that sustainable? No. Sacks seems to be responding, ridding the company of what turned out to be the toxic enterprise sales teams to focus on SMB sales. That's all well and good but it will require an operating model reset with different growth assumptions.
I regret I didn't keep comprehensive notes at the time I discovered that many of Zenefits named insurance sales managers neither had a background in leadership nor insurance sales. I wish I had named names. I know, again from personal experience, that it is impossible to confidently do those kinds of sale without experience and/or without an appreciation of the impact legislation has on closing those deals and maintaining the trust of customers. My guess is that Sacks, who is known as a tough operator, will have to get rid of entire layers of management, replacing them with people of quality. But who would want to work in such a damaged firm? What comp plan could you put in place that both allows for the establishment of a professional organization while looking for high growth in these difficult circumstances? Dalgaard, ever the optimist, says of Sacks and Zenefits:
"...the best CEO in Silicon Valley” and the new board of directors, which now includes Peter Thiel, “the best tech board I’ve ever seen.”
That's a nonsensical answer. It takes a lot more than a strong board to execute what will be a messy turnaround. If the investors are prepared to take the hit, then Zenefits will have to invest massively in the right people, well before it can confidently go back into market in any meaningful manner. I don't think it helps when high profile Silicon Valley alums like Dave McClure are quoted as saying that some of the problems are exaggerated but without stating what he is seeing. Therein lies the path of fools. The good news is that Sacks is very strong on getting people to focus on the right things. Whether that is enough will only become evident over time.
One thing that has not been touched upon in this story and that's Zenefits code quality. We already know about the allegations of rogue code impacting ADP. We also know that the operational systems could not keep up with sales. What is less well known is that last year, Zenefits delivered code to customers that showed data from more than one customer to other customers, sources recently told me. If Sacks is not already undertaking a code audit then that should be high on his agenda. Along with finding a competent CTO who understand enterprise scale.
I first started noticing Zenefits in the fall of 2014, when a series of interviews started appearing in the media in which CEO Parker Conrad spoke of his sheer terror at the company's breakneck growth. Here's what Conrad told the New York Times in September of that year:
We’re obviously growing very quickly, but I can tell you that that is just as scary as the other way around. It doesn’t feel like we’re successful. It feels like we’re bouncing from one terrifying near-catastrophe to the next.
In retrospect, this looks like a case of a CEO deliberately hiding his incompetence in plain sight. But Conrad was merely fulfilling his mandate as CEO, to grow Zenefits at breakneck speed in order to justify increasingly insane valuations. All the CEOs of so-called unicorns — venture-funded businesses valued at $1 billion or more — are under similar pressures. Some survive, others crumble.
Although it's received less publicity than Zenefits' fall from grace, an even greater calamity has befallen London-based fintech unicorn Powa Technologies, which last year was valued at close to $3 billion. Powa entered bankruptcy proceedings last month and has been broken up and sold. A year ago, CEO Dan Wagner was fulfilling his mandate by boasting to the Financial Times and other financial media that he was building "the biggest tech company in living memory." It now turns out that the company was still essentially pre-revenue and that most of its claimed 1,200 clients hadn't actually signed financially binding contracts, only letters of intent.
Most startups are a gamble — an entrepreneur making a bet that they will find success with some new idea or business strategy. Most CEOs are risk-takers. When the stakes reach unicorn proportions, the CEO has to front huge risks in order to deliver the expected returns.
It seems that Conrad was gambling on two things happening, neither of which happened fast enough before his bluff was called. Firstly, I suspect he imagined that the state regulations around insurance brokerage were so outdated and disrespected that they would crumble before Zenefits was forced to comply with them. Secondly, he believed that if Zenefits grew fast enough then it would reach a point where it could fund whatever training would then be necessary to comply with whatever regulation was left standing.
Mix that in with the usual dusting of Silicon Valley bluster and self-belief and you have the recipe for Zenefits' collapse. Like many SaaS ventures, it has discovered that the overhead of training up and maintaining its sales team is higher than it first calculated, and that its product is not as effortlessly appealing to a volume market as it originally imagined. The question now is not whether it will ever justify the lofty peaks of its valuation (it won't — or if it ever does, it'll be long after the original investment has been written off), but whether it can survive at all.