How this $4.5 billion benefits startup plans to keep its dominance

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Parker Conrad of Zenefits Takes Your Hassles Away

Zenefits came up with a winning solution for cloud-based HR that's helped it lead the field. Now questions remain as to whether it can keep up the pace.

Often the best opportunities for startups lurk in long-overlooked markets.

For Zenefits, the cloud-based human resources provider, that opportunity surfaced amid the slow-moving world of employee benefits, where sales of health care plans via brokers have played a critical role for decades.

Now, two years after its 2013 launch, health insurance brokers, by the company's own account, are running scared. Meanwhile, Zenefits' model of cutting out the middleman for HR services via the cloud seems to be catching on. But questions remain as to whether it can continue its torrid pace of growth, particularly as high-flying valuations for some privately held tech startups come under pressure, and more competitors enter the space.

"We've grown so quickly that the world of insurance brokers is freaking out," co-founder and CEO Parker Conrad told Inc. in an earlier interview. "They're losing customers."

More specifically, Zenefits, co-founded by Conrad and Laks Srini, is known for its "hub and spoke" system, whereby it offers small businesses core services for free, like payroll processing, 401(k) administration, and employee self-service portals. It gets paid a commission if your company buys a health insurance plan from Zenefits, which the company then manages for you.

That strategy is paying off. The San Francisco-based company has grown from a handful of employees to approximately 1,600 today. It also now claims to have 10,000 small-business customers with 100,000 employees, and annual recurring revenue of about $80 million.

Zenefits also zoomed to the top of this year's list of unicorns for 2015, thanks to a staggering $500 million Series C venture capital round, which increased its value from $500 million in 2014 to $4.5 billion today. In total, it has raised $589 million from prominent venture backers including Fidelity Investments, which led the last round, as well as Andreessen Horowitz and Venrock.

Conrad told Inc. in March that he got the idea for Zenefits when he was researching health care benefits for employees at an earlier startup, and because he is a cancer survivor with an ongoing interest in health care coverage. The rollout of the Affordable Care Act (ACA), which occurred the same year as the company's launch, also suggested to Conrad that health care benefits would be an important niche.

"I started talking with insurance brokers; the consensus was that [the ACA] was going to chill their business ... [and they would] stop working with small companies," Conrad told Inc. earlier this year. "I figured there was a big opportunity for someone to come in and do this with technology."

Clearly Zenefits is focusing on a space that has a lot of growth potential, industry analysts say. The majority of the roughly six million small businesses in the U.S. have fewer than 50 employees, and they haven't been shown a lot of love by benefits providers.

"Generally it's been the case that there isn't much out there by way of HR solutions for these small businesses, and what is out there tends to be more about payroll," says Lisa Rowan, a vice president at IDC Research, a market research and advisory firm.

Meanwhile, Zenefits can benefit from an atmosphere where health care continues to be a top concern for most entrepreneurs, who worry about cost and are looking for access to opportunities, various studies show. Even firms that fall below the 50-employee threshold that requires companies to offer qualified plans under the ACA want to offer health care to stay competitive with their hiring.

Mamoon Hamid, co-founder and general partner at venture capital firm Social Capital, of Palo Alto, California, says broker-led health insurance sales to smaller businesses are probably worth up to $150 billion. Yet the cloud world of startups hoping to tackle the sector is probably worth only $100 million, and Zenefits has the dominant share, Hamid says.

Certainly there are plenty of small cloud-HR competitors, including at least one other "Zen"-monikered outfit, like ZenPayroll, now called Gusto. Others include Namely, Justworks, and Lumity.

And beyond the rapidly filling competitive landscape, there are the challenges any fast-growth company has in scaling rapidly, such as managing its ever-growing staff. This year it grew so quickly, it has reportedly added employees in 150-person increments for several months.

"When you hire [more than a thousand] employees quickly, there's the question of how you scale and keep customers happy, and all of the stuff that is very operational in nature," Hamid says.

Fast growth also tends to attract controversy. For Zenefits, this has included a lawsuit with payroll processor Automatic Data Processing. In the spring of 2015, ADP sued Zenefits following highly critical remarks Conrad made on the company website regarding Zenefits' use of ADP's information as part of its own benefits provisions. (In October, the two companies settled, and ADP dropped the suit.)

Simultaneously, Zenefits has encountered problems with regulators in at least one state. In 2014, Utah temporarily banned the company from operating because, state insurance regulators reportedly argued, its free services are equivalent to a rebate meant as an incentive to purchase insurance. Such rebates are forbidden by the state. In April, Utah officials overcame their objections and lifted the ban.

More recently, Zenefits has had to prove itself in other ways as market sentiment has shifted regarding high-value private companies. In the past few weeks, it's been caught up in the valuation write-downs by mutual fund company Fidelity that have involved more than one multibillion-dollar unicorn, including Snapchat. From July through December, Fidelity reportedly reduced the value of its Snapchat holdings by 25 percent. In October, Fidelity reduced the value of the Zenefits shares it holds in its portfolio by 48 percent. And in addition to its valuation concerns, it now appears that Zenefits will miss its stated goal of getting to $100 million in revenue under contract by January 2016.

Zenefits did not have a comment about the write-down or the revenue-target miss, but Kenneth Baer, a company spokesman, said it is unfazed by the competition, and will keep on innovating in the year to come.

"There will be more and more competition entering ... our space trying to catch up to us," Baer said in an email. "Our challenges are the same: [to] keep innovating and improving our product for our customers; and be able to reach out to the thousands of small businesses who want their HR burdens ... to be done automatically, and disappear."

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