Exponential Growth for HR Software Company Proves Costly
Nasir Pasha & Matt Staub

Exponential Growth For HR Software Company Proves Costly [e255]

The guys break down the rapid growth of HR Software company Zenefits and why it is now facing an investigation from the California Department of Insurance. (Photo: Tom Tingle/The Arizona Republic)

Transcript:

NASIR: Welcome to our podcast where we cover business in the news and add our legal twist.
My name is Nasir Pasha.
MATT: I’m Matt Staub.
NASIR: This week, we are covering – what did I call it? Rapid-rise startups or rapid-growth startups? And the problems that they face with that.
MATT: Yeah. Well, the one today is I guess they both technically fall into that category but I think the one today is a much greater version of that. Wednesday’s episode, I don’t think it was over that long of a period and I don’t know how much growth they’ve had in terms of financial…
NASIR: Yeah, that’s true.
MATT: Today, we’re talking about Zenefits which had some pretty substantial growth.
NASIR: Yeah, three-year-old company, I think last year – 2015 – they had a $4 billion – with a B as in “boy” – valuation.
MATT: Yeah, reached $1 million at the end of 2013. They have a subscription-based software with health insurance but $1 million by the end of 2013 – not bad in year one. This is revenue. $20 million late 2015 and then $100 million projected late 2015. Like you said, $4 billion valuation based on half a billion dollars they raised somewhat recently. That’s pretty rapid growth, I’d say, for many sort of characterization.
NASIR: Yeah, I would say so.
MATT: The way I see it is basically they’re health insurance brokers that basically help out companies and I think they started off fairly small and then, at some point, in terms of the companies they were assisting, they started ramping up to these bigger companies. Obviously, bigger companies, more employees, more opportunity so you can charge more because it was subscription-based. But, more or less, they kind of broker or intermediary in helping these companies figure out the convoluted and complex issue of health benefits for their employees.
NASIR: Yeah, pretty much. They’re basically insurance brokers and I think that’s the best way to characterize them but the novelty of what they do is they provide a software that helps small businesses manage these kind of benefits and so-called Zenefits. It is difficult for small businesses to kind of wrap it around and they make it easy, especially with the paper work and things like that – everything from onboarding an employee to terminating them and how that works. Even most, frankly, employment attorneys don’t necessarily know that stuff because it’s a lot of logistical issues and forms and filings and things like that and so they make it easy for you. But the catch is the software is free and so, of course, how they make their money is through the actual brokering of the insurance policies.
MATT: Yeah, and I shouldn’t have said specifically health insurance. That’s kind of what got them into trouble. It’s more of a greater HR – they call themselves an HR platform – payroll benefits, time-keeping, other compliance issues, things like that. They are much more than just basically a broker for insurance but that’s really what got them into trouble. Let’s see. When did this happen? Their CEO just stepped down.
NASIR: It was like February 8 so about ten days ago or so, yeah – around that time.
MATT: Once you look in a little bit deeper into this, you can see some other issues. But, I think, kind of the big thing here – at least the thing that really drove him to stepping away as CEO – is there was an investigation. Where are they based out of?
NASIR: I wanted to say Seattle – no, California-based.
MATT: I was going to say Seattle, too. Then, I remembered that was the other company we’re talking about. Well, they operate in California and Washington State. But, basically, there was an inquiry or an investigation in California.
NASIR: San Francisco.
MATT: That they’d created macros that allowed the employees of Zenefits to essentially bypass the online broker license course. I guess it had some way where it kept them logged in. it’s a 52-hour course – correct? Or 52 hours total. Basically, the CEO said, “Well, that’s too long for someone to have to learn this.” And so, he created this… I don’t know what they created but it was something to kind of cheat the system.
NASIR: Some kind of internal software, right?
MATT: Yeah. I mean, they are a software company.
NASIR: Just to describe what this is, what I think it is basically, in California especially, in order to actually sit for the exam – just to clarify, this wasn’t cheating on the actual exam itself – in order to sit for the exam, you needed to have certain courses and there’s plenty of third parties that provide these courses which you can do online or at home or what-have-you and it seems like that actual course, to get that certification was somehow circumvented.
MATT: Yeah, and that’s the craziest thing. You know, he’s paying a handful of people to take the exam for the hundreds of employees. I mean, this is just essentially the training to get to sit down and take the exam so these people still had to pass the exam portion of it which, to me, it’s definitely not as bad as cheating on the actual exam and 52 hours total is not that long. I mean, what is that? Five and a half days?
NASIR: Yeah, that’s right.
MATT: And you could even kind of blow through that in one week if you wanted to and pay them overtime but I guess it depends on how many people. I don’t know if you saw a number on how many people this applied to but I imagine it was probably quite a few if they’re dealing with all these big companies, especially looking at how they handled some of their other business practices that we’ll talk about later on here.
NASIR: That brings up the issue, right? I mean, he resigns which, I mean, a CEO after three years, I assume he started with the company and resigns. That’s a pretty big deal but, at the same time, it’s not crazy because, frankly, what person is qualified to raise a startup from the ground up and, in over three years, become a $4 billion-dollar-company. Most people aren’t qualified to be a CEO of that company, let alone go through those growing pains. And so, what people are kind of talking about now is the culture of non-compliance and this is not from a legal attorney perspective, when we’re representing clients or even seeing other companies, if you see one thing that is not compliant, the question that we always ask is, “What do we not know?” We found out about this non-compliance issue because it was brought to our attention or there was an investigation. But the scary part is what do we not know and what kind of protocols do we have to discover these kind of things and that’s always the scary part from a legal perspective.
MATT: Yeah, and this guy we’re talking about, he’s the CEO, one of three board members but it sounds like at least two – or I guess one of the other ones, if not both of the other ones – all had a knowledge of what was going on. I mean, clearly, the CEO and one board member I believe they detailed that a second one might have had a pretty good idea of what was going on, too. It’s one thing to toe the line on compliance but it’s another to blatantly disregard it or find a way to cheat the system all together. I just saw this number here – 83 percent of their insurance deals in Washington State through August 2015 were done by employees without necessary state licenses. That’s probably an issue.
NASIR: Yeah. I mean, this has something to do with why the California insurance commissioner is basically expected to announce that they’re looking into the investigation of the business practices of Zenefits. Obviously, we have the pleasure of knowing what’s going on afterwards but, I’m telling you, the sign of the CEO dropping two weeks ago and then, because of compliance reasons, as an attorney for them, you have to know that there’s other legal issues going on. Sometimes, even if they have counsel, they may not be aware of it and so the question is, I mean, I’ve experienced this many times personally with our clients. Okay, you have an issue that someone in the business has implemented a procedure that’s broken the law. What do you do now? The most important thing that everyone has to start thinking about is how to avoid jail because some of the things that might not be in compliance may actually give rise to criminal liability and making sure that you investigate internally, take corrective action, these are the kinds of things that third-party regulators or government regulators look to in order to determine whether they’re going to prosecute you or not. And so, this CEO resignation may have been due in order to prevent those kinds of escalating investigations.
MATT: Yeah, at least it removes the bad seed or the bad influence.
NASIR: Bad apple?
MATT: Bad apple, that’s it – close, seed. The bad apple from this company and, in this case, obviously, it’s a pretty high-up important person as well. I guess that’s a good way to start things. They technically didn’t terminate him, I guess. I think they probably just had a conversation with their attorneys and said, “It’s probably best if you just walk away and we’ll figure this out.”
NASIR: Look at this quote from Dave Jones of the California Insurance Commissioner and keep in mind that this announcement of the insurance commissioner came after the resignation. Whether the Zenefits already knew that they were under investigation – most likely they did, maybe through some audit correspondence from them but Dave Jones says, “The recent resignation of Zenefits CEO Parker Conrad is an important development but it does not resolve our ongoing investigation of Zenefits’ business practices and their compliance with California law and regulations.” At the least here, it’s indication that the resignation impacted the California Insurance Commissioner’s evaluation of the company.
MATT: You think they should be worried about this coming off as whether it even be in just his capacity as an officer and director the company but it comes off as an admission of guilt?
NASIR: That’s a great question because clients are always concerned about that and it kind of depends upon the circumstances – under what stage of the investigation it is, what exactly is the legal defect.
Here, the problem with compliance and kind of going through these reviews and internal audits is that, once the mistake is done, you can’t fix it. Some things are not fixable. For example, all these policies that were sold by agents that weren’t licensed, those are done. And so, now, the question is Zenefits needs to continue doing business going forward. And so, what does it need to do to minimize the impact of future business? Sometimes, that means cutting the fat and fixing the problems within and really taking a hard look at processes and implementing them and documenting them and so forth. That may entail a resignation of the CEO. On one hand, yeah, it could be looked at as an admission of guilt but, at the same time, what’s worse? Would you rather continue as is with the same person implementing these policies, leaving it as is and then finding out later that you did it wrong and then causing more problems later?
MATT: Yeah. I think in this case, they thought it was pretty clear cut they did something wrong. I don’t know if you saw the email that the new CEO sent out to all the employees but basically it’s saying, “We self-reported this issue. We’re in full cooperation with the California Department of Insurance.”
NASIR: Interesting.
MATT: Explains what they did. There was this macro issue – well, they call it an issue. It leaves the door open.
NASIR: “Issue.”
MATT: Yeah. “We’ve terminated leaders who created and encouraged use of the macro. We’ve disabled the use of it. We’re developing a remediation retraining program.” Probably the right way to go about this. I don’t think they’re going to be able to hide and try to get by this.
NASIR: Yeah, but it’s interesting. The things you named is exactly what a company needs to do.
You know, there’s certain things that there might be an advantage of self-reporting but there was some things that, okay, maybe you did something wrong, maybe someone in the company did something wrong, but you don’t have any obligation to report it. Obviously, you need to talk to your attorney whether that’s the case. But let’s assume it’s one of those cases where you don’t need to self-report or there’s no advantage to self-reporting. And so, all you have to do now as a company is to document it, review it internally with management and say, okay, for example, let’s assume this isn’t a self-reporting issue like we said, we had a claim that was sold by someone that didn’t have a license and you bring this up to the CEO, the officers, and your compliance officer or your attorneys, “Okay, this is what happened. This is what caused this to happen. Let’s write it down. This happened on such and such date. Going forward, we need to implement this policy to make sure that this doesn’t happen again.” That’s your safety ticket. That’s what’s going to protect you from criminal misconduct versus a cover-up or intentional misconduct that could really put you in jail. This happens, by the way, surprisingly all the time. We don’t necessarily see it with big companies but, every once in a while, of course, there’s high-profile cases but this is also very common in healthcare with Medicare fraud and things like that that really just could have been avoided by just from a compliance perspective or being kind of due diligent in being aware of these issues and how to deal with them.
MATT: Yeah, exactly. Obviously, this issue we talked about with the macros is going to be in an investigation in California but it seems like that was kind of the other huge problem. You know, they got this investment, they have these revenue goals. They were either falling short of them or thought they were going to fall short of these other long-term goals. They really just wanted to make a push at whatever-we-can-do mentality to achieve these goals. I think that’s really what ultimately led to the downfall because that probably caused them to install this macro and have this save time, blah blah blah. I mean, this company grew so fast. This is faster than any company can even imagine – even if they had their best-case scenario.
NASIR: This kind of scares me if I were a client of Zenefits because, if I was a client or customer of Zenefits, here I’m putting the responsibility in a software that they developed to handle really sensitive regulatory issues that are highly regulated and here they are not complying internally with their own stuff. It kind of makes me question, you know, it’s a trust issue, right? I mean, it makes you kind of question, “Is this a company that I really want to trust my payroll and accounting?” or whatever else they do – the internal processes for HR with benefits.
MATT: Yeah, that’s a good point. But, obviously, that’s not something that a lot of these companies considered. They went from smaller companies to bigger ones. Do we know what companies they were working with?
NASIR: They started out with a bunch of tech companies when they first started out. In fact, a big portion of their clients happen to be in California. But, now, they’ve ballooned to pretty much serving all types of small businesses. I think they have some larger businesses, too, if I recall. But I think the majority of their businesses are small or medium-sized.
MATT: I’m looking at an article now. This was done in September 2014. December 2013, they had fifteen employees. Less than a year later, in September 2014, they had 220.
NASIR: Geez.
MATT: That’s pretty extreme growth.
NASIR: Well, at least they have a software program to handle that kind of HR needs.
MATT: Exactly.
NASIR: Well, I think we covered Zenefits, the company to have rapid growth and have growing pains.
MATT: This week is rapid-growth companies. This obviously falls under that. The other one is a little bit different but kind of the same but still pretty different.
NASIR: You’ll see.
MATT: You’ll see when we do the episode. It’ll make more sense.
NASIR: Yeah, and you’ll judge for yourself.
MATT: Yeah.
NASIR: Anyway, thanks for joining us.
MATT: Yeah, keep it sound and keep it smart!

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