Zenefits Loses Over Half of Its Value
fortune.com
fortune.com
What the former CEO did amounted to a form of fraud on the investors. They thought they were investing in a company they thought was worth x but whose real value was less than half the value of x. The company had actual or constructive knowledge of the facts underlying the fraud, to wit, that there was in place an automated program that facilitated and attempted to cover over blatant regulatory violations. This was a material fact known to the then CEO and the company, legally speaking, is charged with his knowledge. Therefore, it constructively knew the truth as well and failed to disclose it to investors when they invested in the prior round (Series C). Since this was highly material to their investment, the sale of securities to such investors without such disclosure amounted to securities fraud.
Now, when something like this has happened, people can sometimes let it slide but the impact here was huge and the investors have easily lost at least half the value of their investment.
So what does new management do? With the historic problem cleaned up, it reprices the shares in the previous round to set the valuation at the level it should have been (or least much closer to it) had all facts been known and disclosed to investors. This is speaking hypothetically, of course, because investors of this type do not invest in a company that is committing serious legal wrongs and they would not have actually invested here had they known all the facts at the time of their original investment. But, given that the damage had already been done, the proposal made to investors gives them the chance after-the-fact to affirm their investment, release their legal claims, and take the hypothetical value that presumably would have more accurately reflected the real value of the company at the time of their investment had all facts been known and disclosed to them.
Is this a perfect solution? No, of course it cannot be. This is a real mess and the wrongs committed were serious. But it gives investors a path through repricing to get more than double the shares they had bought at the prior pricing. The trade-off: they must release all legal claims against the company.
Now the carve-outs: if any given investor sees this as an imperfect solution, they can always just say no and file suit against all parties, including the company; and, even for investors who take the deal, there is no absolving of the former CEO in that the release of claims does not extend to him - hence, they reserve all rights to sue him if they like.
On top of all this, employees are given RSUs that help minimize the effect of the dilution that is built into this for the benefit of investors. Again, not perfect but another indicator that this has been carefully thought out. If the company revives and its stock value goes up, the employees will essentially be paid bonuses via the RSUs to help make up the difference.
This is actually a pretty elegant attempt to salvage what must have been seen by many as a situation beyond repair, first (and formally), by setting up a mechanism to prevent the company from being swamped by lawsuits and, second (and much more importantly) by taking a good faith (and, for the company, painful) step in order to save its relations with its key investors.
People should not flippantly dismiss this action just because it is unusual. It may wind up being right or it may wind up being wrong but it clearly is a carefully thought-out attempt to deal with an exceedingly difficult set of circumstances in a creative and constructive way. If it does work, it will be because the investors perceive the business model of the company as fundamentally sound in spite of the earlier illegality and corner-cutting. It is their opportunity to register a vote of confidence for new management to give it another try, this time with an honest respect for the relevant regulatory environment even as the company attempts to disrupt its target market.
Whether it works or not, only time will tell.
Could the former founder make an argument the valuation and structure was artificial. It sounds like they basically diluted him to oblivion by ramping up RSUs and doing a down round. That would open them up to litigation as well.
Perhaps the end result is- Conrad doesn't want to get sued - and so they are gambling that he won't sue himself. That works as long as everyone is on board or they get a release from Conrad (in turn he'd want one as well).
Yup.
You mean insightful. An inciteful comment is something I'd never expect grellas to write!
That said, there are some assumptions in here that we need to remember are assumptions. We don't know for sure what was and was not in the disclosures. And, thinking back on the news about the actual software program, I don't remember that it "facilitated and attempted to cover blatant regulatory violations." Didn't it just run down the clock on an online course but NOT go through any material or take tests? Maybe it was not as obviously material as it seems now.
David Sacks (CEO)
Laks Srini (co-founder & CTO)
Lars Dalgaard (Andreessen Horowitz - Series A)
Bill McGlashan (TPG - Series C)
Peter Thiel (Founders Fund - Series C)
Antonio Gracias (Valor Equity - Independent Seat)
So are founders. They own a huge stake of the company. Board representation is how their interests as owners are maintained.
Why would that be sketchy?
PS: You can compare the performance of public companies with various board makeups, it's not a meaningless topic.
You can have a board focusing on balancing public good with profit, if that's what the companies charter says. But, that's probably not a great investment.
CEO and CXX of company A is on company B's board.
CEO and CXX of company B is on company C's board.
CEO and CXX of company C is on company A's board.
So, yea on it's own the co-founders on the board is not a big thing. But, looking into the board should be part of due diligence.
PS: You can also see issues when VC's make up the majority of the board, but that's less common with public companies. (Let's buy up little company X that my firm invested in.)
for readers that don't know what a RSU is
http://www.calstartuplawfirm.com/business-lawyer-blog/restri...
In a nutshell I think the main diference of RSUs is they compensate based on the full value of the stock, whereas NSOs (Nonqualified Stock Options) only compensate on the stock's appreciation in value.
With RSU you can't opt for 83-b and you only pay tax when vested. I am just an entrepreneur not o Tax advisor :)
But, how is it that the company still exists at all? Should it have not been deprived of its licence to operate / sell insurance once the fraud was discovered?
How is it that its competitors didn't try to make it happen / sue it out of existence, even if the regulator was lenient?
I suspect that the value of the stock will fall even further. They're cutting a tremendous amount of people, and many of those are revenue producers. I've been flooded with Zenefits resumes, including people who stayed after "The offer". They haven't hit the bottom yet.
I'm surprised they need 900 employees to do what they do, though. But, I guess a huge part of their business is interacting with decrepit old systems used by insurers and states, and often require humans and fax machines and other such nonsense.
This is a pretty astounding turn of events; it's not something I've ever even heard of happening. It's certainly better than exploding under the pressure of investor lawsuits, I guess. But, aren't their still regulatory issues being investigated and so catastrophe is still possible?
Well, a huge part of their business was to have hordes of people selling stuff faster than they could get people to that point legitimately. Presumably, the hordes are still employed.
As a general point, as a consumer you can have a great time using a product no matter how many laws they break along the way, of course. My general counter-reaction to the romanticizing of "disruption" at HN is that I hope they get stuck with massive fines that drive them down to the ground. They could've had a good product and followed the rules.
There is a reason that pg looks for "naughtiness" in founders.
Likely the automated test software they made falls in that area - and isn't what concerned me personally.
Willingly using unlicensed or wrong-state-licensed brokers though? Lobby for reciprocal/no licensing, work on a study course to make time-to-license faster, or just, you know...get your people licensed. As a business you follow laws even if you don't like them. Your hand waving an acceptance of fraud by zenefits - when they could and should have been in compliance - seems very worship-y and disruptors-know-best.
Uber broke rules to get where they are (spamming Lyft drivers with fake requests, operating in markets where a Taxi license was required without doing the paperwork or paying the fees, picking up people in taxi-only areas (like Chicago airports) ).
The sad thing about all of this is that punishments are often so weak, the game theory optimal play IS to break the rules. If you break the rules, succeed, and get caught.. you still end up winning. If you follow the rules and fail, you are still failed.
To make game theory sense of this problem, you would need extreme punishments. Like founders in jail for 20 years or executed. The problem with this, is clearly some new businesses broke rules by accident. Opps you accidentally sold 1 insurance policy in a state you didn't have a license, let's execute you - not cool.
Zenefits _knew_ they were breaking the licensing laws and had a huge number of violations. It wasn't accidental, which would a totally different discussion.
And sadly, even if 5% of us don't follow the companies that break the rules - the company still wins. I am a rounding error to them.
I'm not. Or rather, I'm not comfortable that some player won't explicitly break rules while trying to use "But the rules are cynically implemented to protect entrenched interests!" as cover. Why am I not comfortable? Because I've met several of these people throughout my life.
Of course they'll want the protections when it's in their best interest.
The extra kicker is investors signing up for the free shares agree to waive all claims... except against Conrad. Wow, that's vengeful!
It's a little different in that there may have been misrepresentations about Zenefits' fiscal health to the investors and actual illegal wrongdoing, while in Saverin's case, Facebook just felt that they could do better.
Imagine if the management of a company voted to void some arbitrary 10% of the shares -- the ones held by people they didn't like, merely to claim more of the company for themselves. That would absolutely not be kosher.
But then (assuming the grandparent's description of what happened is accurate), Zenefits is doing exactly the same thing by more roundabout means. Surely the laws on this aren't so easily circumvented? And even if not, isn't this as a big red flag to future investors?
This includes new classes of shares. It's not "standard" practice, but it's also not uncommon--to get rid of people they want to get rid of, they can dilute them out (issuing new shares and everyone except X gets new shares), issue new classes of shares with preference, etc.
I'm sure there are laws around this, but it's also a private company so it can be tricky there. Stock in a private company is much more difficult to hold, since there are many, many ways for the company to manipulate it to the company's advantage.
The same logic of fraud applies to employees. The argument would be that they were thinking the company is doing more amazing that it actually is doing and thus "wasted" time of their life working there under false assumptions. Why do they get a worse deal?
Is that really true? Maybe if a company had NO HOPE of growing. Zenefits has clearly shown some huge growth. The market is huge. Just being not profitable and not growing for the short term does not mean you are guaranteed dead... just that you are default dead and need to get working on it, which they seem to be.
Edit - and if truly a company was never going to grow again, I would value them at something like cash on hand + ((total rev - min expenses to stay afloat) * 3) or something... In your example if someone had ARR of 100 million, min expenses to keep doors open of 300 million, and cash on hand of 1 million.. you would value them at 101 million, I would value them at - 599 million.
This is the golden line in the article, with the "bend the rules" mantra VC's have for their founders I suspect we'll be seeing more of these come to light in the future. Thinking this to be an isolated incident could be very wishful thinking.
Even if AH expects every Unicorn to go through a similar event in the near future they wouldn't say as much to the press, there is no benefit for them as VC fund.
If this is the public slash they are announcing, how bad do you think reality is looking on the inside? Just imagine the spin masters trying to spin this to their employees.
I can't help but chuckle a little. Kids.
That being said, I'll add that there are certainly aspects of this that are not funny at all. Real people lost their jobs due to the tomfoolery of others. I feel for them.
edit
Are you saying that all 100 people got the generous severance package?
On the other hand, Zenefits is an unprofitable startup with huge internal problems. Clearly, expecting them to provide such sorts of benefits would be beyond unreasonable.
That's the "dotcom" part, but yeah.
https://techcrunch.com/2016/06/14/zenefits-is-laying-off-ano...
https://www.buzzfeed.com/williamalden/129-zenefits-staff-qui...
>>“This is a unique situation, we’ve never seen it before and we don’t expect to see it again,” said a spokesperson for Andreessen Horowitz.
What's the advantage for the company?
The article makes it seem like this was David Sacks' decision and he's trying to coerce existing investors into signing off on this "new deal," making it even more strange.
(Not ragging on them, but lots of these things go in cycles of 8-12 years or more and if your firm is 7 years old you may well have never seen the tough times. And as Buffett likes to say, it's only when the tide goes out that you see who's been swimming without trunks)