Lemonade’s Secret Ingredient: Financial Engineering

Most people think Lemonade is really good at marketing, particularly self promotion. While they are, this is mainly a distraction to obscure you from figuring out how the magician does the trick.

Lemonade’s real trick is financial engineering. You may recall how they were the poster child for the original Hare thesis of maximizing cheap capital over maximizing profit.

While that trick is no longer available, that doesn’t mean the magician doesn’t have something new to surprise you with.

Lemonade’s newest trick is hiding things in plain sight. Much like the magician who makes the assistant “disappear”, Lemonade hides operating expenses by disguising them behind creative financing!

This has the beneficial effect of overstating EBITDA leading investors to applaud the quicker path to “profitability”.

But just like the magician, this is all an illusion. Ultimate profitability and cash flow are not altered by this sleight of hand.

Paying For Distribution…Or Not

Lemonade announced two interesting transactions in recent months. First, there was the distribution relationship with Chewy to sell pet insurance. Recently, they announced they borrowed money from General Catalyst (GC) securitized by premium revenue.

What is ironic about these transactions is they structured the Chewy relationship for distribution as a financing transaction, while calling the GC financing a distribution relationship. Bizarre!

I will review each below but the takeaway is they both do the same thing – keep expenses outside EBITDA so they can report better margins.

Chewy

Last October, Lemonade announced its partnership with Chewy. Left unmentioned was how much they would pay Chewy in commissions for each sale.

That’s because they aren’t paying, at least not in cash. Was this an act of generosity by Chewy because they find Lemonade delightful?

Unfortunately, no. If you read the 8-K filed separately from the press release, you would find Lemonade gave Chewy 3.35M shares. At the time this was worth ~$75M (though now closer to $50).

That’s an awful lot of compensation for distribution. Presumably, Lemonade expects something like 1M new policies out of this to make the numbers attractive? We don’t know because they haven’t told us.

But that’s not relevant at the moment. What is relevant is by giving away shares rather than paying cash commission, Lemonade gets to grow sales at a 0 GAAP acquisition expense ratio!

For a company struggling to achieve a profit, this is a very fortuitous development. Of course, there will be an increased share count which will, in theory, lower earnings per share…but that’s only if there are positive earnings in the future.

In the meantime, Lemonade gets to show better CRs and EBITDA which is of far more importance to investors. Will any of them notice the missing commission expense? C’mon! You know the answer to that!

General Catalyst

Last month, Lemonade announced its transaction with GC to borrow at 16% securitized by future commission revenue. You can think of this like a Shark Tank deal where Mr. Wonderful takes a royalty from the overmatched founder in lieu of equity.

However, that might look desperate, so Lemonade created a story to make it look like something else. CEO Daniel Schreiber called this a “synthetic agent” where instead of paying commissions to an agent they pay it to GC instead.

There’s one problem though. Lemonade originates most of its business directly. This means they don’t actually pay commissions!

The whole point of the direct model is to lower lifetime acquisition costs by frontloading the expense, but not having to pay renewal commissions. Now, Lemonade is agreeing to pay recurring “commissions” instead.

Why would they do this? There’s only one obvious reason – to lower near term cash burn. As Schreiber describes, the borrowing – sorry, “synthetic agent” – helps fund the strain from having to spend upfront to acquire customers.

Direct acquisition is a very difficult model for a company with high cash burn. So, the transaction with GC makes sense on that level.

However, why misrepresent it as a “commission”? And is it worth paying 16% for?

If Lemonade truly believes this is a commission expense, then they will report it as such and lower their EBITDA. I suspect they won’t do that.

Rather, they will call it interest expense – because that’s what it is. In doing so, they can continue to report the same level of EBITDA.

Cash Burn

Lemonade’s actions speak louder than its elegant words. The Chewy and GC deals make plainly clear the company’s top concern is cash burn – which it should be.

There is nothing wrong with structuring creative deals to preserve cash. It is actually a wise thing to do. I might quibble with the terms they agreed to, but I support what they’re trying to accomplish.

I’ve long preached insuretechs need to prioritize cash burn above growth. However, Lemonade, in its public comments, has shown the utmost confidence in their cash position.

If that were true, why would they agree to these deals given the high cost of capital? Clearly, their actions are sending a different message than their talk.

One lesson I can share as an investor is that companies who match what they say with what they do trade at higher multiples than those who try to obfuscate. Perhaps Lemonade should take this to heart?

Transparency

One of the nice things about a glass of lemonade is you can see through it. When it comes to the financials of Lemonade, it’s more like coffee than lemonade – dark and hard to know what’s been mixed in to it.

Lemonade, unlike most insurers, measures itself on EBITDA, not operating income. Actually, they use their horse**** “adjusted” EBITDA but I’ll ignore that for simplicity and call it EBITDA.

That means they would prefer expenses to come out of interest or depreciation rather than the combined ratio. A typical insurer is largely ambivalent (while true a lower CR helps the multiple that multiple is applied to total EPS).

Both the Chewy and GC transactions keep costs out of EBITDA. I’ll let the reader judge whether this is a motive for the structures or just a consequence.

Regardless, there is a simple way to address this: more disclosure.

It would be very easy for Lemonade to report pro forma commission expense as if they paid Chewy a traditional commission.

Similarly, the cost of the GC financing should be broken out each quarter. If they believe this truly is commission, then also add it to commission expense. Otherwise, show the interest expense and how much premium was financed each quarter.

For a company devoted to making the buying of insurance simple and clean, why do they go through so much effort to obscure the understanding of their financials?

Why not just be straightforward with people? “We entered into a transaction with GC to better manage the cash burn related to customer acquisition”. That’s it. No need to hide the shell.

When you assume your investors are stupid, smart investors will think that you think your customers are stupid too. And treating your customers as if they are stupid is not a smart way to build a company.