Last week, the HR/HCM technology industry experienced a full-fledged unicorn sighting in the form of Zenefits announcing a $500 million round led by Fidelity and Fort Worth-based TPG Capital at a whopping $4.5 billion valuation.
I’ll just come out and say it — I think this is an absurd valuation based more on the dreams of investors than business reality. It’s a bad bet based on a misunderstanding of the market opportunity, the complexity of the benefits industry, and a shift in investor attitudes about the traditional SaaS growth model. It’s also everything wrong with Silicon Valley’s slavish pursuit of unicorns that claim disruption where little new exists.
Zenefits focuses on SMBs and offers a free HCM tech platform with payroll, benefits, HRIS, and time and attendance. It drives revenue from commissions on benefits coverage. In a little over two years in business, Zenefits grew from $1 million in annual recurring revenue (ARR) in 2013 to $20 million in 2014 and says it’s on track for $100 million this year. This explosive growth has earned the company the title of “fastest-growing SaaS enterprise company ever” — faster than Salesforce or Workday.
No less an authority than Lars Dalgaard, a general partner at lead Zenefits investor Andreessen Horowitz and founder of SuccessFactors, said: “In my experience, the momentum that Zenefits has achieved in two years is unprecedented.” That’s an impressive statement from a man who ran the fast-growth playbook in HR technology better than anyone.
There’s a reason for the excitement around HCM technology for small businesses. Research from TSCIU and HR Executive® magazine shows that 59 percent of firms with fewer than 1,000 employees (and 60 percent of firms with fewer than 100 employees) plan to invest in human resources technology this year. Combine this fact with the following data from Raymond James that shows HR outsourcing services companies (payroll, benefits, etc.) outperforming not only the rest of the HR technology industry but also the S&P 500.
Also, some of the fundamentals of the SMB buyers make this segment of the market prime for fast growth. As we discussed in our HCM brandscape report, successful vendors in the SMB market don’t experience the same infrastructure issues that extend time to revenue and cost of sales. Sales cycles can be under 30 days, and the sale can be as close to frictionless as possible. The market is also huge. According to the latest U.S. Census data, there are 42 times more firms with 100 to 4,999 employees than with 5,000 or more employees.
So what’s the problem? I think there’s plenty to concern Zenefits investors and customers and a lot of opportunity for Zenefits competitors. This move is a bluff on an epic scale — a “game over” round meant to intimidate competitors such as Maxwell Health and Namely. All in all, creating a sense of inevitability is a smart business move if Zenefits can deliver. But I don’t think it can. Things have changed in HR technology for the following reasons.
No. 1: Fast growth isn’t an advantage if you can’t scale.
Winning a category in enterprise technology requires fast growth and gaining the most market share in the shortest period of time. During its fast-growth phase almost a decade ago, Lars proved this at SuccessFactors. In 2006, Taleo and Kenexa both had 3x more revenue than SuccessFactors. By 2012, SuccessFactors was the category leader with more revenue than its two rivals, which led to its acquisition by SAP at an 11.5x multiple.
Sure, SuccessFactors grew fast. But it also scaled to an end-to-end talent management platform and built the sales, marketing, and product infrastructure that enabled it to become a $300-plus million company. Rapid, successful growth takes leadership at the top and at all levels, which Zenefits has not always displayed. Consider these two moves by Zenefits CEO Parker Conrad:
- “A lot of scaling up a company is not very sexy or strategic,” Conrad told the San Francisco Chronicle last year. “I’m not sure that I would say that I know how to scale a business that quickly.” As a customer, that’s not the kind of confidence that would inspire me to turn over my company’s payroll and all my employees’ social security numbers for benefits.
- Just last week, Conrad very publicly flamed a job candidate on Quora and rescinded a job offer. Whether or not the candidate made a dumb move, I sort of feel like the CEO should have better things to do.
In HR technology, the jump from $20 million to $100 million is one of the hardest to make. It’s hard enough to do it in two or three years. Can Zenefits do it in one? Maybe it can by throwing money at the problem. But I’ll bet it ends up creating a lot of process and infrastructure problems that don’t surface for another year or two when they are bigger, more expensive, and far more painful to fix.
No. 2: Customer success is no longer optional in SaaS or HR tech.
One dynamic that has changed significantly since Lars ran his fast-growth playbook at SuccessFactors is expectations around customer support. During its fastest-growth years from 2006 to 2010, SuccessFactors wasn’t exactly known for its happy customers. Of course, it wasn’t exactly unique. Everybody did it that way. However, HR buyers put up with shit then that they won’t now. And in the world of payroll and benefits, the stakes are a lot higher than in talent management. Unlike with performance reviews, end up with a service outage or enough mistakes in benefits, and you have an insurrection on your hands.
At The Starr Conspiracy, we have years of market research that shows that HR buyers increasingly expect a higher level of support than they are getting. In other industries, great customer service is table stakes; in HR technology, it’s a differentiator. It’s little wonder that customer satisfaction with HR technology is cable-company low, with an average NPS around minus-35 percent. It’s also little wonder that stories about Zenefits customer churn are widespread, not just stories from competitors (which you expect) but also from consultants and practitioners.
With SaaS technologies, the barrier to switch is low. In the world of benefits, buyers will quickly make a switch if their needs aren’t being met. In payroll and benefits, experience matters. This isn’t stuff you can screw up. Benefits and payroll are high compliance-risk areas. To reference Ray Wang’s hierarchy of business needs, regulatory compliance and operation efficiency are basics.
No. 3: Investors are losing faith in the traditional SaaS growth model.
The growth model has been the same since 2000:
- Step 1: Secure private funding. Overspend on sales and marketing.
- Step 2: Go public. Expand market share and platform capability with multiple acquisitions. Overspend on sales and marketing.
- Step 3: Get acquired. Shift to a profit strategy. Pull back on sales and marketing.
This is one that Salesforce pioneered (and appears to be running the final step now) and the one that made Dalgaard a lot of money at SuccessFactors. It’s also the one that Zenefits is running to the tune of $100 million in the red. It’s also one that appears to be losing favor with stockholders as companies such as Workday, Cornerstone OnDemand, and Benefitfocus have faced difficulties for not showing enough progress for moving out of the red and into the black fast enough.
Investors are losing patience with companies that lose money quarter after quarter and year after year. It’s possible to build a solid, profitable company that posts ho-hum (in comparison to Zenefits) 20 to 30 percent year-over-year growth — Ultimate Software is one. It’s especially possible in a category such as benefits technology, where it’s possible to generate revenue from multiple channels — which can include software subscriptions, brokers, and carriers — and grow profitably year over year — Businessolver is an example.
Is the traditional SaaS growth model dead? Not entirely. But any company following this model needs to show a faster path to profitability, not just leave profitability for the company that acquires them to figure out.
No. 4: Zenefits isn’t really that disruptive.
It’s easy to point to Zenefits as the Uber of benefits because it’s ostensibly disrupting a traditional business model with a new way of doing business. Except as one benefits-industry watcher asked me the other day, “Isn’t Zenefits just a dressed-up PEO by another name?” Well, more or less … yeah. Of course, PEOs aren’t really that disruptive. But you can build a multibillion-dollar business on them, as TriNet has. And if you’re going to bet on a “disruptive” company that is actually only iterating on an established business model, I’d bet on another Bay Area startup called Zuman, which is founded by the TriNet founders (and just landed a much smaller financing round this week). As I mentioned above, experience matters.
No. 5: Zenefits is flat-out overvalued.
When is too much money a bad thing? For most of us, never. But, as loyal viewers of HBO’s Silicon Valley know, it can be sometimes for tech companies. For Zenefits, a half-billion-dollar round could set the bar unreachably high at a $4.5 billion valuation. Of course, SuccessFactors got $3.5 billion — almost twice what Taleo did. So, it’s possible, right? If the company can scale in a far more regulated market. If it can retain customers. If it can show a path to profitability. And if Zenefits can overcome some troubling market fundamentals that VentureBeat pointed out when it cited a blog post from Redpoint VC Tomasz Tunguz:
“[The] ratio of enterprise valuation to current year revenue for SaaS companies has increased exponentially from 3x to 5x pre-2011 to 12x to 20x today while the underlying cost structure and revenue structure of these companies doesn’t appear to have changed. If that seems like a big jump, let’s look at Zenefits one more time. Although it may be an outlier among SaaS companies in terms of its earning potential, assuming Zenefits hit its target of $100 million ARR by the end of 2015, its recent valuation will still be between 45x and 50x its revenues. Regardless of the deferred earnings inherent in the SaaS business model, this looks to me like significant over-valuation of a two-year-old company that has proved its ability to acquire customers but has not yet had the chance to prove its ability to retain those customers and to drive the lifetime value to achieve profitability in the medium term.”
In conclusion: So what?
I’m not generally a believer in bubble talk when it comes to enterprise software and specifically HR technology. I believe that the solutions being developed in this category — Zenefits included — are solving real business problems created by structural shifts in the U.S. economy such as the Affordable Care Act and in the global economy by the rise of contingent labor, among other factors.
However, $4.5 billion is a valuation that I believe is unrealistic and unreachable for Zenefits. By 2017, the North American market for benefits administration will be $16.4 billion according to Nelson Hall. And worldwide, IDC says the entire HCM market will be $15.4 billion. Is Zenefits good enough to claim 25 percent of market share in these categories – more than SAP, Oracle, or Workday in HCM or ADP and Aon Hewitt in benefits? That’s the bet investors have made – that Zenefits will build the dominant company in a very competitive industry in which they have little experience. I don’t see that happening. Let’s just hope the inevitable bubble bursting is just the expectations of a few investors and not our entire market.