The repricing is, in effect, a form of settlement agreement with the company's preferred stock investors.
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.
One interesting fact this analysis is missing is that the board that must have approved this deal is mostly series c investors. Even if the deal is a good way to right past wrongs, it is still an instance of a board paying itself. Still, very nice thoughts. I agree that this is likely what happened.
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.
You appear to be factually incorrect when you say that their board is mostly Series C investors. The board makeup pre-deal was (i'm pretty sure):
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)
Good point. But Andreessen also put a lot into the series C round. I don't have all the numbers handy to do the math on whether approx. doubling their series C interest cancels the dilution of their series A and B interest. I just kind of assumed that it did. Sorry if I am wrong.
I did find it very surprising that a16z was getting their stake increased here. They were on the board for years. Whatever happened, happened on their watch. Highly unusual.
The primary value of boards is a sanity check for the top layer of management. As an investor you want a board looking after the investors interests. You can find plenty of company's that where gutted by overly permissive boards handing out ridiculous compensation packages for example.
PS: You can compare the performance of public companies with various board makeups, it's not a meaningless topic.
The purpose of a board is to look out for owner's interests. That is not exactly the same thing as investor's interests. That is why boards aren't made up of just investors.
I never said that was their purpose, just what you want as an investor.
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.
Now, no direct conflict of interest, but you can see the issue. Especially when CEO of company A also sit's 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.)
That's very likely what occurred and I've been pretty impressed with how the Co has handled the turnaround however---
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).
Sacks is the perfect person to figure this out. Lawyer, consummate CEO, keen product mind, huge network. He's got a product that touches 100% of employees and can be given away for free and still make $1000/head. After Yammer he could easily of retired.
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 am so glad Pied Piper Inc. didn't raise the Series B based on the uptick from the click farm in Bangladesh, or else they could be in the same situation.
Excellent analysis as usual! If this type of rewriting the cap table is legal, then what is/are the defining factors of illegal manipulation of the cap table?
It could have happened anyway because the Series C investors could have sued. The company (obviously) didn't disclose any of the fraudulent behavior when they raised the C round (= they can get sued). Doing it like that is cleaner and makes sure that the company has a future.
Interesting. I had a hunch that this was what they were up to since it wasn't a market based repricing. You spell it out much more clearly. The company would die if there was a protracted investor suit. Many companies can't survive proven fraud. This shows that the CEO is on his game.
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 was about halfway through reading this comment without noticing who wrote it and thought to myself "This is a very insightful comment, I bet grellas wrote it".
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.
Which means the employee has to realize income tax on the stock immediately under an 81-b or after vesting, correct? That would be an annoying and surprising tax bill, if the employees are mostly familiar with ISOs or NSOs.
Despite all the turmoil around the company, I've been using them for payroll and looking into more HR stuff through them, and it works really well. Much better than Intuit, certainly (which has cost me a fortune in late filing fees and other stuff, because they don't automate tons of stuff that ought to be automated and invisible to the end user, and I suck at doing taxes).
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?
Zenefits works well until it doesn't. They botched a commuter benefit payment to me, and it took either four or five phone calls and me being pretty rude to the last couple employees to get it fixed. I couldn't understand how correctly crediting me my $80 was so difficult, particularly since it had repeatedly worked before.
Exactly this. In general they're great but when you have a problem it's a giant pain. One of our employees had a lot of trouble getting his spouse insured. It took them months to work it out.
> 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.
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.
It's worth noting that the rules in question here were specifically designed to protect incumbents from competition. It was very clear regulatory capture.
Regardless of how true that is or isn't, a business built on breaking the law is not ok. 59nadir is right, you can build a great product while following the rules. Disruption is awesome, but 'disruption' is not - and it worries me how often the latter gets unabashed praise.
I'm comfortable with the idea that people can distinguish between rules designed to protect society and rules cynically implemented to protect entrenched interests that have cozied up to government. The latter deserve to be flouted. That's how we eventually get rid of them.
There is a reason that pg looks for "naughtiness" in founders.
> I'm comfortable with the idea that people can distinguish between rules designed to protect society and rules cynically implemented to protect entrenched interests
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.
Naughtiness, rule bending, finding loopholes...there is a lot of gray area that we can all debate endlessly about.
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.
AirBNB broke rules to get where they are (craigslist spam comes to mind)
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.
Funny you mention airbnb and uber, two of the worst offenders that I avoid because they won't follow the rules. You are 100% correct on the punishments not having impact for the winners, a scaling system of some sort is probably needed and smarter people than I are needed to figure it out. It's also frustrating because the end goal - in uber's case, I can't stand 99% of taxi services and they deserve to lose business even in locations the regulation isn't an outright racket - is noble.
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.
At least for me, it's less about worship-yness and more about disdain for what I see as overregulation. I certainly can see how others disagree with me here though. shrug
Can't imagine this is legal. It sounds like they are trying to dilute out Conrad specifically by significantly repricing the earlier rounds and then covering existing employees with new grants. Anyone out of the good graces of the current management sees massive dilution and everyone else is untouched. How is this not just stealing Conrad's shares?
The extra kicker is investors signing up for the free shares agree to waive all claims... except against Conrad. Wow, that's vengeful!
Management must have represented to investors that they were in full compliance with state regulators. I wonder how serious of a fraud this "release of claims" protects them from.
That's kind of the point of shares, isn't it? They're super manipulatable and for just this reason: you can get rid of people you don't like. They can fight in court all they want, but a private company will probably win.
Wait, what? I though the whole point of shares (per GP) is they're all (within the same class) treated equally, regardless of holder, specifically to prevent these kinds of shenanigans!
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?
That's one way of looking at it, of course. I think another is to say that the concept of stock as compensation (especially in a private company) is to give the company maximum flexibility. They (presumably) don't have cash, so they give stock as a proxy for that. However, if they hit hard times, they can issue as many new shares as the BoD will allow to any new investors they want.
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.
FWIW, this reminds me a lot of the Facebook/Saverin case. Saverin eventually won back many of his shares; enough that he's worth about $7B now. (And then renounced his American citizenship to avoid paying taxes on it, go figure.)
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.
That's how many shares he had at the time of the IPO. They underlying source is correct for its time (2012), but whoever wrote the Wikipedia is misrepresenting it as being from 2015.
So employees get roughly 25% extra shares (RSUs, vesting in 12 month) and the C series investors get >50%?
Just out of curiosity, could the employees sue (and are they also releasing their legal claims if they accept the deal)?
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?
The hard truth is it's not about the legal problem in Zenefits. Zenefits is not growing from last October. ARR remains the same 60M for last 10 months. If the company is not growing and it's burning more cash than revenue (way more in Zenefits case), the company should be valued at (cash in hand + ARR) which is 700M. No idea how Zenefits still gets 2B valuation.
> If the company is not growing and it's burning more cash than revenue, the company should be valued at (cash in hand + ARR)
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 a unique situation, we’ve never seen it before and we don’t expect to see it again,” said a spokesperson for Andreessen Horowitz.
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.
This may be isolated in the sense of how very clearly against the law/regulations the behavior was, and some of those laws/regulations appear to have teeth if regulators wish them to.
Not a huge surprise given the events of late, especially considering they laid off more than a hundred of their employees.
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?
At the end of the article it states that they offered their employees a chance to leave if they wanted with a generous severance package and that 10% took it. Doesn't sound like they forced them to leave.
It's only generous in dotcom terms. My mom took an early-retirement package from Kaiser Permanente as a bog-standard phone-room nurse: free no-copay health insurance for the rest of her and my dad's life. Free treatment, free prescriptions, free equipment. Free everything, for life.
That's a great deal for your mom, I'm glad she was able to get such an amazing deal.
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.
I strongly beg to differ. That's just every startup in general. The dotcom days were way more debaucherous and perverse than what's going on today with startups.
Sorry, my mistake, I was using "dotcom" for the larger movement beyond the 2000 crash, including today. I was there, I can see the differences and similarities.
I have a friend who worked at Zenefits and told me about the offer. Everyone in the company was offered two months salary and paid COBRA health benefits for four months if they wanted to leave. According to him more than 10% left.
Amazing that repricings like this are so rare that even investors like A16Z never / rarely see it:
>>“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.
Yeah I don't get it. Is the company offering investors more equity in order to prevent a lawsuit for failing to disclose the shady stuff they were doing?
Saying "even investors like A16Z" haven't seen it glosses over that A16Z, founded in 2009, is a babe in the woods as a venture firm, and has not been through even a single cycle yet.
(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)
I think we'll find David Sacks is going preserve his blue chip reputation by leading the crippled Zenefits into the safe harbor of a rich insurance conglomerate or PE firm. Getting these investors paid out would be the ultimate amends.
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.