When a Unicorn Stumbles…

Sometimes when I walk by my kids’ room and they are watching a scary movie, I just can’t seem to look away. I stand looking back over my shoulder waiting for a commercial break, sometimes grimacing. That’s what it has been like for me as I watched the Zenefits saga play out, and with the stabilizing influence of the new CEO David Sacks, it now finally appears that there is a break in the action.

In general, there are two paths for innovation: one is the creation of a new industry and the other is to reinvent an old industry – it appears that Zenefits told the first story line when in reality it was more the latter. Potential upside for the former path is arguably much greater. Under the extraordinary expectation and self-induced fanfare of having raised $580 million, most recently at a valuation of $4.5 billion early in 2015 – only to see in September 2015 one of its largest investors (Fidelity) mark down the company’s valuation to $2.3 billion – the senior team set ambitious growth expectations and drove the company unsustainably hard. And while the growth was indeed impressive for the less than three-year-old company, at those valuations there is no safety net for a unicorn that stumbles. In January 2016, the company announced that annual recurring revenue for the year would “only” be $60 million which was meaningfully below the $100 million initially forecasted. After a series of embarrassing disclosures (“please no sex in the stairwells”), the CEO was fired. This past September, 17% of the staff was laid off – mostly in insurance sales.

The proposition of Zenefits is quite clever, but not a new industry. Many would simply refer to it as a tech-enabled business service. Customers were provided “free” technology packages to automate payroll and benefits administration, and in exchange, Zenefits would receive commissions for all insurance products sold on the platform. The company competed against old-line insurance brokerages by giving away software, and in so doing was remarkably disparaging of them. By the end of last year, Zenefits claimed to have over 10,000 accounts (which, by the way, implies that the average account was well less than $100k in annual revenue to Zenefits which makes the economics somewhat problematic; analysts estimated commissions to be around $450 per covered life).

The level of fear in the traditional benefits brokerage community was rising over the last few years. Position papers were drafted by large agencies on how best to sell against Zenefits. In May 2015, Benefits Selling magazine published a survey entitled “The Sky Hasn’t Fallen Just Yet” (true story) which highlighted the level of brokerage anxiety, particularly within small agencies, over the impact of technology. Nearly all brokerages of less than 25 employees felt commission revenues would decline between 25-50% by 2016; only 33% of those firms thought they would exist in five years. More than 50% of brokerages in excess of 1,000 employees were developing proprietary online tools; 88% felt that offering technologies to customers was a business necessity. Over 85% of all respondents indicated that they would be forced to offer ancillary products such as life, dental, vision and disability just to be viable. Brokers talked about becoming “solutions providers” – in large part as a response to Zenefits’ presence in the market.

While the full impact of the ACA on the health insurance brokerage industry is still playing out, there were a handful of market developments that contributed to the (partial) commoditization of that industry. Community rated plans, where the cost of the products for groups of less than 50 employees are based on demographic data by geography meant to preclude discriminatory pricing practices, made products more uniform, competing largely on price. Brokers pushed certain employers to increasingly look to partially self-insured plans as alternatives to traditional fully insured community rated plans. As state regulators encouraged greater plan flexibility, they also increased dramatically the reporting and compliance burdens on small employers, who now required even more from their brokers. So with less attractive core insurance product margins, increasing costs and complexity to provide adequate customer service, and an overarching trend to outsource non-core activities by customers, the pressure on brokers became intense.

So against this backdrop, along comes Zenefits. The seduction of high software gross margins is real – VC’s love SaaS business models – but when a company gives away the software (resulting in negative gross margin), attention has to turn to other revenue streams like insurance commissions. How ironic for what was heralded as a “SaaS” company. Under extreme growth pressures, corners appear to have been cut. A series of states have launched investigations into fundamental business practices. The Massachusetts Division of Insurance is looking into whether employees were properly trained and licensed to even sell group insurance products. According to BuzzFeed, 80% of all sales in Washington were by unlicensed brokers. And in California, it is now evident that brokers lied about how extensive their training was, which makes it even more understandable why so many insurance sales staff were let go last fall. Ironically, the company which provides benefit administration tools allegedly failed to properly pay overtime to employees in California. More evidence of the product’s immaturity.

And while some in the brokerage community believe all of this will continue to unravel – if Zenefits loses its various insurance licenses around the country, carriers are likely to terminate their relationships “for cause” – the new CEO appears to have brought “law and order” back to the company. According to Glassdoor, while the company is rated only 2.9 out of 5 stars from employees, and only 47% would “recommend to a friend,” David receives an extraordinary 86% CEO approval rating. Ironically, many employees commented that the company’s benefits package was “mediocre at best.” And when the question about employee morale was put out on Quora, the most recent answer simply stated “it’s gone.”

Like many other explosive growth companies, after lofty expectations are not met, those companies often retrench to survive. It is not unusual to see a prolonged period of slow steady growth emerge when proper controls are put in place. There are undoubtedly a host of other insights, maybe lessons learned, about how much capital to raise and at what valuations. For a company that was just over two years old with only around 1,500 employees, it is not clear why there was the need to raise over half a billion dollars. But it was quite evident that the prior CEO, who was very focused on optimizing valuation, failed to understand that Fidelity as a mutual fund company would post the valuation of its position.

It is quite likely that Zenefits will recover and probably prosper. Ironically, Fidelity, which was so visibly associated with the last (very) high priced equity round, is also rumored to be launching private exchanges in all 50 states to sell insurance products (they already provide extensive record keeping, billing and wide range of administrative services). Other large companies – ADP comes to mind, which loudly disputed Zenefits’ claims last year about cutting off integration due to the risk of exposing sensitive employee data – are developing compelling platforms for employers to manage employee related matters. And so while maybe little in the near term has changed for brokers because of the ACA, the future will force continued consolidation and the requirement to reinvent their core offerings.

And I am really glad my office has no stairwells…