Zenefits Scandal Highlights Perils of Hypergrowth at Start-Ups

Zenefits Scandal Highlights Perils of Hypergrowth at Start-UpsIf you've never heard of the human-resources start-up Zenefits, get ready to never forget it.

Source: Source: NY Times - Farhad Manjoo | Published on February 18, 2016

The company announced last week an escalating series of errors and investigations that will most likely go down as a defining scandal of the latest tech boom.

The situation looks bad, and is likely to get worse. It's bad in ways specific to this start-up, but also in larger ways - ways that highlight how last year's enormous funding rounds and their attendant overinflated expectations may wreak havoc on Silicon Valley for years to come.

In particular, Zenefits may be among the first of several cautionary tales to highlight a sobering lesson: For a start-up, growing too quickly can produce just as spectacular a failure as growing too slowly.

First, the back story: Zenefits is a three-year-old company that makes software for small businesses. In its short life span, it has been called both the most unsexy company in tech, and one of the most promising.

Its investors have argued that Zenefits, which makes money by acting as a health-insurance brokerage firm for its customers, has the potential to cut the red tape that small businesses have to battle to provide benefits for their employees.

These grand promises were bolstered by Zenefits' early growth. Its annual recurring revenue - an accounting measure preferred by subscription-based software companies - reached $1 million by the end of 2013, the year Zenefits was founded. Recurring revenue hit $20 million by late 2014, and was projected to reach $100 million by late 2015.

The exponential growth was catnip to investors. The start-up raised $500 million last year at a $4 billion valuation, one of the largest financing rounds in a year of mega-fundings. At one point, Andreessen Horowitz, Silicon Valley's pre-eminent venture firm, had invested more in Zenefits than in any other company. In total, Zenefits has raised about $581 million.

Then, last week, poof. Zenefits announced that Parker Conrad, its co-founder and chief executive, had resigned. In emails to employees, David O. Sacks, the former chief operating officer and new chief executive, explained that Mr. Conrad had overseen a company that had become derelict in its culture and ethics.

Insurance regulators in California and Washington State have been investigating the company. According to people with knowledge of the investigation, at the root of the California inquiry is software that Mr. Conrad created to let Zenefits' employees cheat on the state's online broker license course. It was the discovery of this software that led to Mr. Conrad's departure. The news of the investigation was first reported by BuzzFeed - also an Andreessen investment - which has been examining Zenefits' rise.

Zenefits has sought to paint the executive changes as a new beginning. One person close to the company said when Mr. Sacks briefed employees on Mr. Conrad's exit last week, there were celebrations and tears of relief at the San Francisco headquarters of Zenefits.

Yet the story is more complicated than the single instance of a founder's misdeeds. Zenefits' recklessness seems to have been merely the worst symptom of a larger sickness that infected the company, according to investors, former employees and others who worked with the management team (and who all requested anonymity because no one in Silicon Valley wants to be seen as kicking a start-up when it's down).

That sickness: Zenefits was a company consumed by impossible expectations. In return for fund-raising at a stratospheric value, Mr. Conrad promised the moon to investors.

Then, to reach the moon, he began to transform a tiny start-up into a mighty rocket ship - only to watch it careen out of control as it stretched to accomplish the impossible. Though many noticed trouble, neither Mr. Conrad, nor the board of directors, nor anyone else in management could afford to stop, take a breath and fix the problems. Growth was the only imperative.

Many investors and former employees blame Mr. Conrad, who had pushed for the huge fund-raising, and whom they described as demanding, undisciplined and either uninterested in or incapable of building a sustainable company.

Mr. Conrad did not respond to requests for comment, but some who were privy to his thinking said he should not shoulder all the blame for Zenefits' flagging fortunes.

These people pointed to the dynamic on Zenefits' board, which consisted of three company executives - Mr. Conrad, Mr. Sacks and Laks Srini, a co-founder and chief technologist - and Lars Dalgaard, the Andreessen partner who led the firm's investment in the start-up.

Some investors said Mr. Dalgaard was as instrumental as Mr. Conrad in pushing for steep revenue targets, and that both men's ambition pointed in the same direction - toward hypergrowth.

Another person familiar with the board disputed this, saying Mr. Dalgaard, who formerly ran the cloud software company SuccessFactors, was among those asking Mr. Conrad to restrain Zenefits' growth plans and fix the culture. A representative for Andreessen Horowitz declined to comment.

In either case, it's clear the board was unable to effect much change, until recently. Mr. Conrad resisted attempts to expand the board, according to one person familiar with the matter. It was only last week, upon Mr. Conrad's exit, that Zenefits added three additional directors to its board.

The unyielding pressure to grow sapped Zenefits. The company opened two satellite offices in Arizona and went on a hiring spree.

Zenefits began hiring people who had little experience with software sales in a highly regulated industry. There were some days in which 100 people joined; overall head count grew to a reported 1,600 late last year from 15 at the end of 2013 .

Growth broke stuff. To increase revenue, the company moved beyond small businesses to customers with hundreds of employees - and the software struggled to keep up. Instead of pausing to fix bugs, Zenefits simply hired more employees to fill in where the software failed, including repurposing product managers for manual data entry.

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Employee morale sank. Regulatory compliance suffered (in addition to the cheating software); Zenefits had a process for making sure that only licensed brokers spoke to clients about their benefits, but young and inexperienced managers did little to enforce it.

There was a laxity about rules and decorum. Zenefits offered beer kegs in its offices, and in the Scottsdale, Ariz., office, people freely imbibed during the workday. According to one staff member, managers had to remind employees to turn their Zenefits T-shirts inside-out before partying at local bars, so their rowdiness didn't reflect badly on the company.

Despite the hordes of new workers, many felt like there was too much to do. Pay was a problem. People were given low salaries with the promise of increases when funding came through, but Zenefits didn't make good on those promises when it raised new investments.

For all its straining, Zenefits began to fall short of revenue goals. One insider said that by late 2015, recurring revenue was around $70 million, not the $100 million the company had projected. In any other company a nearly fourfold increase in sales would have prompted celebrations, but it wasn't enough for some investors who'd been promised the world. Last fall, Fidelity Investments, the mutual fund company that had invested in Zenefits in May, marked down its stake in the company by half.

Mr. Conrad and the board were undaunted. They recently projected Zenefits would hit $150 million in recurring revenue by the end of 2016, and that it would keep doubling sales annually for years to come.

Yet internal disagreements grew. Late last year, Mr. Dalgaard pushed Mr. Conrad to freeze hiring, according to one person familiar with the company. Mr. Conrad disagreed.

The two men also differed over whether to address employee morale by re-pricing stock options to the new lower valuation, according to people familiar with the matter. Mr. Conrad favored the move, but Mr. Dalgaard believed it would train employees to expect a re-pricing any time the company's fortunes changed.

Now Zenefits appears to be on a path in which growth is no longer the only goal.

In a statement, the company said, "Zenefits now is focused on developing business practices that will ensure compliance with all regulatory requirements, and making certain that Zenefits operates with integrity as its No. 1 value." And in an email to employees last week, Mr. Sacks wrote, "I'm glad that Zenefits is one of the fastest-growing business software companies, but that's not our mission. It alone doesn't fill my life with any meaning, and I doubt it does yours."

From what I can tell, growing as fast as possible did fill Mr. Conrad's life with meaning. Two years ago, for an article in which I marveled at Zenefits' business prospects, I interviewed Mr. Conrad about why he was bent on expanding Zenefits so quickly.

In a conversation that at times resembled a therapy session, he explained that he felt his life was marked by a succession of failures. He had been forced to take a leave of absence from Harvard because he'd neglected his classes while working at The Crimson, the daily newspaper, where he was managing editor. He had been asked to leave his first company, SigFig, after falling out with his co-founder.

"All these things have made me absolutely petrified of failure," Mr. Conrad said. In Zenefits, he'd found a chance at redemption - and the faster it grew, the faster he'd find it. "Slowing down doesn't feel like something I want to do," he told me.

At the time, I heard this as nothing more than run-of-the-mill entrepreneurial ambition. Looking back, it was obviously something darker: a warning sign.