The Zenefits Scandal Is What Happens When Start-ups ‘Disrupt’ a Highly Regulated Sector

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The Holy Grail of Silicon Valley start-ups, the truly special “unicorn” into which investors want to dump millions of their dollars in hopes of making billions, is a company that promises to overturn an entire industry’s way of doing business. But the game plan of replacing people with a combination of software and different people (who get paid less) is much harder to execute when the business you want to disrupt is heavily regulated. According to a revelatory BuzzFeed report, Zenefits — which aimed to revolutionize the insurance and human resources businesses — just found that out the hard way.

Zenefits is basically a pretty, user-friendly interface that employers can use to complete onerous HR tasks, the most important of which is signing their employees up for insurance. Therefore, the main money-making function of Zenefits, the thing that justified its $4.5 billion valuation and huge investments from firms like Andreesen Horowitz, was getting companies to use the software.

But dealing with the insurance industry meant Zenefits also had to navigate annoying legal regulations that could have slowed down their march toward making billions. Confronted with this problem, BuzzFeed reports, Zenefits solved it in typical Silicon Valley fashion: by using software to get around the regulations. Instead of going through the required 52 hours of training to get California health insurance broker’s licenses, some Zenefits employees used a software “macro” that made it appear like they were logged in while they were actually doing other things.

Here’s BuzzFeed:

Newly hired sales reps, who often lacked an insurance background, used the macro as early as 2013, the year Zenefits launched, and as recently as last year, former employees say.

When the cheating became apparent last week, Zenefits co-founder Parker Conrad — who, according to BuzzFeed’s sources, actually wrote the macro himself to save time in the company’s early days — was forced to resign.

The new CEO, David Sacks, released a scathing memo condemning the company culture Conrad had created in the name of rapid growth:

The fact is that many of our internal processes, controls, and actions around compliance have been inadequate, and some decisions have just been plain wrong,” Sacks wrote, “As a result, Parker has resigned.”

California’s insurance commissioner has since opened an investigation into the company’s compliance issues, and whether its salespeople were legitimately licensed.

And the controversial macro apparently wasn’t the only shortcut Zenefits took to speed its expansion and make more sales. Two former employees told BuzzFeed that salespeople were encouraged to achieve only the minimal passing grade — 60 percent — on the state brokerage exam. Studying for anything higher was considered a waste of time.

D for done,” was the motto among managers at the company, those employees said.

Apparently, this all worked extremely well — until it didn’t. BuzzFeed describes a rapid-fire, fast-paced sales environment where office drinking was common and big scores were celebrated with booze, in terms that bring to mind journalists’ accounts of Washington Mutual’s loan department just before the housing bubble burst in 2007.

But once the sales were made, customers weren’t especially happy with Zenefits. It turns out that the automated process of signing up for insurance only appeared to be automated. Behind the scenes, a large number of employees manually did all the data entry for clients, keeping up an expensive Silicon Valley illusion.

The back office is really heavy in terms of bodies,” a former Zenefits employee told BuzzFeed. “It’s really archaic. It just seems automatic to the customer.”

Most health insurance carriers and several payroll service providers, including ADP, have no automatic link to the Zenefits system,” BuzzFeed added.

The great disruption really wasn’t.

The Wall Street Journal’s coverage of the story suggests the fall of Zenefits — which was valued at $4.5 billion last May, and marked down to $2.3 billion in September — can be attributed to its environment, the “move fast and break things” culture of post-Facebook Silicon Valley.

Zenefits’ problems were caused by intense pressure to “hit ambitious revenue targets and to retain employees,” justifying its high valuation, the Journal reports.

But the new CEO, Sacks — a former PayPal and Yammer exec and self-described “hypergrowth addict” — isn’t discussing the problems in terms of the constant pressure for ever-greater growth. He’s just blaming them on the old guy, Parker Conrad, and on those pesky industry regulations.

This paragraph from the Journal says it all, really:

Our culture and tone have been inappropriate for a highly regulated company,” said Mr. Sacks, who is changing the company’s motto to one that will likely please regulators: “Operate with integrity.”

The saga of Zenefits is truly insane, and yet not at all surprising. Silicon Valley plays by its own rules (or maybe just one rule: growth), and this is what happens when it rubs up against an industry with a more stringent set of regulations. And Zenefits certainly isn’t alone — Uber is actively fighting regulation in the taxicab industry, while Airbnb is ignoring it in the hotel business.

But these regulations all have a purpose, and despite what start-ups would have you think, that purpose is not always “protecting an entrenched industry’s profits from innovators.” Sometimes it’s ensuring employees get paid a fair wage, holding companies accountable for what happens to their customers, or making sure the people selling you insurance actually know what they’re doing.

As long as there’s money to be had by challenging or skirting regulations, the cycle will repeat itself. It can only end when start-ups finally move fast enough and break everything, or decide the payoff for conquering some industries just isn’t worth the headache.