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The Disruptive Benefits of Zenefits (and Lemonade Stands)

· July 22, 2015

You may not have heard of cloud-based business HR and insurance provider Zenefits, but the folks at industry giant Automatic Data Processing Inc. (ADP) certainly have. ADP recently shut off Zenefits’ access to client information needed to run payroll, charging that the startup was gleaning this information in an unauthorized manner and posed a security risk. Zenefits countered with a blog post claiming that ADP was actually shutting off access because it had developed a competing service to Zenefits. ADP took issue with that accusation and then filed a lawsuit against both Zenefits and its CEO Parker Conrad.

The Zenefits story is fascinating, both ADP’s snarky legal reply and the unusual circumstance of a disruptive entrant challenging a de facto monopolist (or duopolist). The two largest U.S. payroll processors — ADP and Paychex — combine for some 40% of the payroll market, which indicates that their share of outsourced payroll services is probably far higher. Analysts have also noted that both firms share lock-in advantages, raising entry barriers, and enjoy what one market observer terms a “rational duopoly,” with ADP focusing on larger businesses and Paychex targeting smaller concerns. The firms are able to lock customers into long-term deals and “consistently raise prices.” And both companies have strong brand identities that help them against upstart, unproven competitors.

As a competition matter, of course, a 40% share does not qualify as monopoly power for antitrust purposes. On the other hand, when a dominant firm uses the legal process as a tool to intimidate or retard the growth of new, upstart rivals, it faces some serious antitrust risks. So while the details remain to be disclosed, the glimpse inside the dynamics of payroll processing provided by ADP’s libel litigation suggests something possibly untoward.

According to Zenefits COO David Sacks:

“When a large market incumbent feels threatened by a competitive product, the incumbent tries to throw every legal roadblock they can…. The old economy is all about telling people they can’t have their choice and that’s exactly what ADP did. When we then complained that ADP was taking these actions ADP sued us for defamation.”

If accurate, that’s called raising rivals’ costs by antitrust theorists, because this sort of conduct is not procompetitive or efficient, i.e., it is behavior which does not help the dominant firm’s products or services, instead only functioning to lay roadblocks against share and margin erosion from competition.

There is good reason to project that ADP’s lawsuit will fail, largely because U.S. law and the First Amendment, unfortunately a distinct minority view among nations, immunize factually true statements and opinions from liability for defamation. So if Zenefits is indeed right, the only consequence of ADP’s lawsuit will be to deplete Zenefits’ financial coffers and distract it from expanding its cloud HR customer base.

But that is precisely the point. By forcing Zenefits to spend massively to defend itself in court and prevent a disabling judicial injunction, ADP has substantially raised costs for a new and disruptive rival, impugned its integrity — obviously a key sales criterion in outsourcing sensitive business information and processes — and thrown fear, uncertainty and doubt (FUD) into Zenefits’ commercial future. Many in the industry “have developed the belief that ADP is threatened by Zenefits, and other new players for that matter, and is trying to push them out.”

As Forbes discussed, growth has made Zenefits “a darling of Sand Hill Road investors,” who poured nearly $600 million into the company at a valuation of $4.5 billion. The lofty figure helps the startup gain credibility with potential customers and recruits. It also “puts a target on the company’s back.” That accelerated growth has also pushed it into some regulatory faceoffs with the established HR industry, including insurance brokers, because Zenefits wants to disintermediate all business processes and hence sell insurance policies to its HR clients. Nor does the startup shy away from poking the giant’s nose, escalating the ADP squabble by offering 850 mutual clients $1,000 to switch to a different payroll provider.

Whether Zenefits succeeds in upending the ADP-Paychex duopoly — with honorable mention to trailing third-place firm Intuit — is not the point. (Salesforce.com, for instance, has not yet upended CRM software providers, but its success with cloud-based solutions pioneered a new business paradigm for customer relations management.) The genius of American capitalism is its embrace of innovation and its protection of new business models against predatory actions by dominant incumbents. That predation can, for instance, take the form of below-cost pricing, exclusive contracts or regulatory constraints. Unlike Uber and Tesla, which as we have frequently observed are saddled with wide-ranging regulatory battles simply to gain the right to compete, Zenefits faces more of a fight for the hearts and minds of potential customers than a battle against antiquated legal rules sheltering incumbents. The economic and competitive effect is the same, however.

Which leads us to a story from the sad-but-true department. Last month local officials in Overton, Texas shut down a lemonade stand run by seven- and eight-year-old sisters for lack of a business (“peddler’s”) license and health permit. The girls wanted to raise $105 to send their dad to an amusement park for Father’s Day and the permit involved costs $150. That’s not an isolated instance, either, with localities from Salem, Massachusetts to Claremont, California doing the same thing — even for the sale of venerable Girl Scout cookies. As one could predict, the Texas girls have now become a cause celebre, and plan to set up their stand in Austin at the capitol building on August 4th to lobby for a new law that would address lemonade sales

Our economy, and society, certainly do not need to force pre-teen children into starting lobbying campaigns, laudable as such youthful civic engagement may be. Yet common sense is as much needed with respect to children being saddled with licensing requirements applicable to adult businesses as it is for corporate payroll and business process outsourcing. As Larry Lombardi, business development manager for the City of Norfolk, Virginia — where kids are still free to hawk a cold cup of sunshine on the front lawn — says, while regulations for street vendors have their place:

“A little common sense would be nice to see in these situations. Somebody in these situations needs to give a little leeway because it crushes the entrepreneurial spirit… The most common sense move they could make in Texas now — after the mayor waived the fee — for a little good will, would be to see a line of officers there buying a cup of lemonade from those little girls on a hot day out there in Texas.”

For the sake of both ADP and Zenefits, one can only hope common sense will likewise prevail. Compete in the marketplace, not with tort claims, and may the best service win. Have a cool drink of lemonade, chill out the lawyers and leave little girls alone.

Competition

Some, if not all of society’s most useful innovations are the byproduct of competition. In fact, although it may sound counterintuitive, innovation often flourishes when an incumbent is threatened by a new entrant because the threat of losing users to the competition drives product improvement. The Internet and the products and companies it has enabled are no exception; companies need to constantly stay on their toes, as the next startup is ready to knock them down with a better product.