Long ago, I wrote about economic rents in insurance. It was actually my first insuretech post. I have to say it has aged very well. If you weren’t a reader back then, I humbly suggest, you go back and check it out.
Today, I want to expand on it. Because while the main theme still holds – that all the rents from innovation go the consumer, not the insurer – the last few years have shown there are others who benefitted too, largely as a result of misallocation of capital and poor incentive structures.
I will reveal some of those misguided incentives at the end, so make sure you stick around for the punchline (there’s even a fun chart!). The teaser is while you’ve likely heard of the Prisoner’s Dilemma, you may not have heard of the Founder’s Dilemma.
The Concept of Rents
Let’s first do a quick review of economic rents from the earlier piece for those who don’t remember your Econ 101.
Rent is a proxy for profit. It basically is profit above a market norm.
If you produce a commodity like corn and you sell it at the market price and your production costs equal that of the average farmer, you have created no rent. If you used technology to lower your production cost, that difference means you have created rent while your neighbor farmer still has none. Similarly, if you can find a way to sell above market, you have created rent (think of the gas station owner who raises prices before the hurricane hits).
Most good businesses have created rents. They either can produce cheaper or sell at a premium. Perhaps they have a distribution advantage or a popular brand.
If, on the other hand, your business produces no excess profit, this means all the rents went to the customer. Think of a business that introduces a new feature, but isn’t able to raise its price. In this case, the customer captured the rent.
As we all now know, most of the original insuretechs didn’t create a lot of value for investors. They did create a lot of value for others though!
While my original article explored how economic benefits are competed away over time, so that little sticks to the insurer, a new form of rents also emerged. This one was straight wealth transfer.
Think of delivery services underpricing their service to gain market share. This land grab was all a straight transfer of rents from business to consumer.
One way to characterize it would be to say innovation creates rents that are competed away, while irrational growth plans create rents that are given away.
I think it’s fair to say, in insuretech, more rents were given away (thanks to free capital!) than competed away.
With that background, let’s assess who captured the rents from the insuretech value chain.
The most obvious beneficiary was the consumer, as I previously predicted. However, it didn’t occur in quite the same way as I expected.
I expected most of the rents to come through consumers finding value in the products being sold or the service being provided without having to pay more for it (i.e. competed away). Instead, we saw rents flat out given away through underpriced product as startups went on a land grab for market share.
This, unfortunately, muddied the value proposition of the innovation. Did customers buy because they valued the improved offer or because they got a crazy cheap price? Given the retention rates (especially after attempts to raise price in response to belated recognition of their mistakes), it certainly appears most customers were in it for the unsustainably cheap deal rather than belief in the value proposition.
Let’s not forget the other beneficiaries of cheap capital. As I’ll discuss at more length in the Founder’s Dilemma section, insuretechs raised a lot of free money they didn’t know what to do with. Some of this went to buying less than necessary products from service vendors.
It would be interesting to know how much of some of these vendors sales came from startups with cash to burn. One thing we saw after the first tech bubble is when the dot coms crashed, a lot of the service vendors crashed too because they lost their customers.
Will the same thing happen this time? I know B2B is now in vogue with insuretech investors but could they be facing an unpleasant surprise? This definitely bears watching.
Some founders were able to cash out some of their holdings before everything went funky. The most high profile examples were the Lemonade founders selling around the last stock offering and the recent disclosure that the Metromile founder got a big payday before the company sold out to Lemonade.
I guess we would call this misalignment of interests? Regardless, some founders found ways to capture rents from their companies.
Next is the group that has gotten the most attention of late: the employees. All the headlines about insuretech layoffs get a lot of reaction and for good reason. It’s obviously unfortunate when people lose their jobs.
Fortunately, we’re still in a pretty good hiring environment where people will hopefully land on their feet pretty quickly. That said, there was pretty obviously a hiring bubble that went along with the valuation bubble.
Much of the money raised went to adding employees, many of whom were never really critical to the business. The revenue per employee at insuretechs was abysmal by any standard and should have been a giant flashing warning sign.
I know I can’t be the only person who has heard stories from friends at startups who would say “I don’t know what half these people around here do all day”. I mean wasn’t tech supposed to create efficiencies? Shouldn’t tech innovation have resulted in fewer, not more, employees?
The truth is people were hired because founders had to tell investors why they needed more money. Unfortunately, the growth in headcount was a side effect of the valuation game I’ll describe momentarily. Many of these new employees were chess pieces used to improve valuations.
That may sound crass, but that does not make it less true. People’s futures were no more than game pieces on a board. But hey, at least they got paid well while the ride lasted! I’m not sure that is much condolence to them.
A Broken Game
If you’re wondering, how come nobody stopped this irrational behavior? Well, for one, people can be irrational and not be aware of it. But, the bigger reason is that it was short term rational for those playing the game, namely the investors and the founders.
It all goes back to the fatal flaw in how insuretechs are valued. The big secret is nobody has any idea how to value them because they have no profits or, in most cases, prospects thereof.
We have tried silly alternatives like revenues, customers, founder ego, and other nonsense, but the truth is insurance companies need to be valued either on book value or earnings.
Given the lack of a coherent valuation approach, often what happens is something equivalent to backsolving. Founders figure out how much money they need to keep growing. They then look at what the typical dilution is for the next round and back into a valuation (by dividing the raise size by the percentage of the company they expect to sell).
Which brings us to the Founder’s Dilemma. If that valuation is too low, they have two choices:
– tell investors they will sell a smaller piece of the company and ask for the valuation they think they deserve or
– decide they will raise more than they need to look more “normal” and justify the valuation.
In other words, if you say you only need $25M, you’re not going to get valued at $1B. You’re just not. If you say you need $100M, then you probably will.
This is the crux of our problem. The incentive is to raise money that will ultimately get destroyed.
And yet, you can guess most founders pick the top left quadrant as it’s easier to convince investors to believe your buffed up spending plan is legit than to convince them they should buy a smaller stake. Once they commit to this path though, they have to explain why they need all this extra money.
And that’s where you get all the faulty decisions laid out above. They either underprice the product to subsidize sales, they hire more people than they need, they buy third party products that are nice to have, not need to have, and so on.
In other words, they forget the key lesson of the Hare: if you are going to focus your business model on cheap capital, you need to spend that capital wisely to accelerate your development! If you waste it all on things you don’t need, you missed the whole point of the exercise!
Choosing the higher valuation and hoping for the best is not a strategy. It’s a gamble. And when the dice don’t fall your way, there are consequences.
Unfortunately, those consequences are often borne by the employees who were largely naïve to these games going on behind closed doors and didn’t realize their jobs were more tenuous than they appreciated when they signed on.
Rent Creating Innovation
I will finish with the thought that I ended the original piece with.
True innovation is the willingness to do something different and hard rather than copying what everyone else tells you is innovative but nobody can explain why it actually matters.
If you do that, you will create rents and those rents will lead to profits. And then, lo and behold, you can be valued based on your merits, rather than how much you commit to spend.