The Zenefits Guide to Disrupting & Dominating a Vulnerable Market

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Zenefits has been getting a lot of attention lately. Some of this is for the large amount of money it has raised ($583.6 million) and for its high valuation ($4.5 billion pre-money); and some of it is for its business model and speed of growth.

If you have not been following the story, Zenefits offers companies a free HR platform that carries out basic HR functions that all companies must provide. It makes money by taking a cut from benefits providers.

Zenefits pricing

Why should this matter to you?

Any software that creates enough value for enough users will get commoditized. We sometimes use the phrase ‘it’s a commodity’ to disrespect a class of software. But in fact it is the highest form of praise. Commodities provide the greatest value to greatest number of people. We should all be so lucky to create a category of software that over the course of time becomes a commodity.

How do you know when a class of software has been commoditized? Once almost everyone uses it (it has passed through “the tornado,” to use Geoffrey Moore’s term). There is a standard set of functionality that everyone uses and everyone expects. Once there are enough users and a common set of functionality, open source alternatives come on the market and prices collapse.

The collapse in prices is the main problem. In fact, prices will trend to variable cost of adding another user, and for most SaaS businesses, that cost approaches zero. Ouch.

This is the catch 22 for large and successful software companies, the more successful they are the less pricing power they have.

Examples abound. Once upon a time Oracle was a relational database company and databases were highly differentiated and very expensive systems. Oracle is now an ERP building applications and delivering services on top of its databases. Databases are a commodity. The same thing seems to be happening in the CRM space. Just a few years ago CRM was one of the main drivers of innovation and it was that really made the SaaS model mainstream. Today? There are good open source options and the cost per user for a basic CRM is declining rapidly.

The same thing is happening in Human Resources software, the basic functionality is getting commoditized. Some evidence for this?

The big players can obscure this as HR software is often rolled into the larger ERP systems. In the adjacent market for talent management prices are sliding from the already low $6 per user per year (that is $0.50 per month) to $2.50 per year (only $0.25 per month). What we are seeing is the commoditization of talent management and an unbundling of the space.

The basic functionality of HR software is well understood. Zenefits provides as good a description of this as any.

Typically, there have been two responses to commoditization. Zenefits is showing that there is a third.

Most companies have responded to commoditization by adding new modules and searching for differentiation. Generally, companies have claimed that this differentiated functionality (often acquired by buying smaller companies) is generally applicable. In fact, the more differentiated a function the more likely that it is most suited for a narrow market segment. So there is a tension between the broad appeal of the core, commoditized software, and the highly differentiated modules that companies use to justify their prices.

commoditized market diagram

Over the past decade or so, a second alternative has been to move from proprietary platforms to open source. When you see an announcement that a company has decided to open source its software, or you notice the emergence of an open source alternative, look for other evidence of commoditization.

Zenefits is taking a different approach. They are offering commoditized HR software to the market at no charge, and they make their money by acting as a channel to benefits providers (health insurance and retirement plans to begin with, but there are many other potential benefits ranging from education to financial services).

Zenefits model

Basically, Zenefits has built a two-sided market that connects the buyer of benefits with the providers and improves information flows.

I have seen the company described as a fancy PEO (Professional Employer Organization) that gives away software as a gimmick. And some of the sharper analysts in the talent management and HR space are skeptical of the business model, and the valuation. They say this is a crowded space that will have lower operating margins than a conventional SaaS model. But is this an accurate description of what Zenefits is up to?

There are three pieces to the Zenefits business model:

  1. Create a classic two-sided market
  2. Provide core, commoditized software for free
    (monetize the sellers and not the buyers)
  3. Use data collected by the software to make the marketplace more efficient

It is point three that is important. I am not sure exactly what data Zenefits collects and how it aggregates and analyses this data. But that is the key to a differentiated business model. It is what Amazon has done in ecommerce and Google for SEM. In an era where big data is providing value in all sorts of unexpected places, this model is going to be hard to beat. We should be looking for other places where this pattern exists and high-growth disruptive businesses can be launched. Here’s what we’re looking for:

  • A commoditized enterprise software
  • That collects lots of valuable data
  • That makes another service, sold to the same buyer, more valuable

A conventional business model cannot compete against a two-sided market. So if you are a B2B software vendor, and you are under commoditization pressure (like CRM or learning management systems, or content management systems, the list goes on…), beware of someone connecting a second market, monetizing that market, and obliterating you in your own market. Because that is what is happening in the core HR software market, and Zenefits is creating a lot of wealth doing it.

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  • campbellmacdonald

    I think this a good summary of what is going on. Their main hack is free software to build users (and lower CAC) and their model is either a 2 sided market or basic lead gen. I actually think it is lead gen model, but if people stay with Zenefits and continue to buy through it, then the 2 models converge.

    Two concerns I have: 1 (which you mention) is that it may turn out to be a low margin business. The second (which is only anecdotal) is that Zenefits is not that nice a product to use. To which I think: compared to what? I suspect the bar is quite low for decent HR software.

    • Yes, well the assumption is that there is a layer of common HR software that is commoditized and the Zenefits can execute well on that layer. If they can’t then the value proposition is compromised. Or if there is still a lot of room for innovation in functionality they will also have trouble unseating the incumbents (which is what I suspect the incumbents will say). The margins don’t bother me. Amazon is a low margin business. Any commodity business is a low margin business. But commodities businesses are also large volume, and the benefits space is huge.

  • Will be interesting to watch. Your analysis could be right. Or this could be another bubble symptom and Zenefits may not survive.

    • I tried to stay away from the valuation question and focus on the business model innovation that is happening here. Zenefits does have some pretty compelling traction. The valuation number does make one swallow and wonder how much more upside there is. I think there is a larger trend where private investors are are capturing more and more of the value of companies before they allow them to go public.

  • For those following the Zenefits story, this post on The Starr Conspiracy sheds some light on the current kerfuffle between ADP and Zenefits.

  • An interesting twist, the CEO of Zenefits has resigned as the company has been using unlicensed brokers to sell insurance. Even disruptive companies have to follow some rules!