Will Lemonade’s IPO be sweet or sour?

Renters and homeowners insurance company has yet to book profit

Lemonade co-founders Daniel Schreiber and Shai Wininger
Lemonade co-founders Daniel Schreiber and Shai Wininger

To investors, Lemonade bills itself as the evolutionary successor to the old insurance guard.

Instead of luring established customers with the “I switched-and-saved” value proposition, Lemonade hooks them when they’re young. The armies of apartment renters will eventually become homeowners, the thinking goes, and they’ll turn to Lemonade for pricier insurance policies. The insure-tech startup says this strategy can achieve 10x and even 100x gains in revenue.

And by issuing policies in mere seconds through the use of computer scripts and big data (instead of human salespeople), Lemonade says it is uniquely positioned to capitalize on a $5 trillion annual global insurance market currently dominated by All-State, State Farm, Progressive, Berkshire Hathaway and Liberty Mutual.

There’s a catch: While Lemonade has seen a substantial uptick in revenue and a growing suite of products, it does not make a profit. And, as it gears up for its public debut in early July, it has no timeline to do so, which could be deeply problematic for investors who have become increasingly wary of money-losing tech companies.

Lemonade –  which is roughly 27 percent owned by SoftBank and heavily leans into its status as a public benefit corporation – hopes to sell 11 million shares, raising between $245 and $283 million, according to its amended S-1 filing. But even if reaches its target, Lemonade will achieve a valuation of about $1.3 billion, well below the reported $2 billion valuation it sported in 2019.

An analysis of the company’s S-1 filing with the SEC shows that while financially healthy in some respects, such as a lack of debt on its balance sheet and over $300 million in cash-on-hand, Lemonade is turning to the public market to keep the doors open.

Currently, Lemonade believes it can generate enough cash by selling insurance policies to cover its financial obligations — mainly paying customer claims — for the next 12 months. Beyond that, it will have to tap its cash reserves.

Furthermore, Lemonade’s charitable giving falls well short of what one might infer from company statements, possibly jeopardizing the trust it claims to build with customers. The company also admits its own claims about behavioral economics are “untested.”

“Insurance companies typically look 20 to 50 years down the road,” said Miles Thorson, president of Thorson Insurance, a third-generation family-owned insurance provider, who has followed Lemonade’s rapid rise through the insurance ranks. “You can’t say as an insurer that your ability to cover customer claims depends on your next funding round.”

In Lemonade’s case, it might.

Getting squeezed in a down market

Backed by $480 million dollars from VC’s including SoftBank, Lemonade has spent aggressively on acquiring new customers. In 2018, it spent twice as much on sales and marketing as it earned from its customers, ending the year with $52 million in losses. In 2019, the sales/earnings ratio improved, but money paid to insurance claims and doubling administrative costs increased its operating loss at $108 million, more than double the previous year.

As a result of those losses, Lemonade says shares purchased at its target of $24.50 will have a book value of $15, which may signal to some investors the target price is overvalued. Following the IPO, SoftBank is forecasted to own 21.8 percent of all shares. Co-founders Daniel Schreiber and Shai Wininger will retain majority control with 60 percent of shares divided evenly between them.

Disappointing valuation aside, Lemonade now finds itself selling into a property market shocked by furloughs and layoffs, with 61 percent of its business concentrated in three states: California, Texas and New York. While the company boasts in its S-1 of capturing seven percent of New York City’s rental market, the shockwaves of the coronavirus pandemic have sent vacancy rates to a 14-year high in the city.

In Texas, a resurgent virus has caused a spike of Covid infections, reaching a peak of 5,589 new cases on June 24. Gov. Greg Abbott has postponed the state’s reopening plan, closing bars and reducing restaurant capacity. According to Texas A&M Real Estate Center chief economist Mark Dotzour, lucrative real estate markets in Dallas and Houston are likely to suffer as residents flee to the suburbs.

Cases in California have also surged, peaking June 23 at 5,793 new cases. Los Angeles County now has the highest number of infections in the nation. Across the state, a mix of historically low mortgage rates and chronically short housing supply paint a complicated picture, according to the California Association of Realtors, which foresees savings on 30-year mortgages combined with higher purchase prices.

In every location, the longer the pandemic drags on, the more long term effect on personal earnings will be seen. As 2020 graduates enter an economy in recession with unemployment at its highest since the Great Depression, the National Bureau of Economic Research estimates a nine percent loss in annual earnings, and that losses will persist for a decade. This will hurt Lemonade more than the entrenched powers of Big Insurance.

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Lemonade says the average age of its customers is 30 years old, who pay about $60 annually for insurance, and that only a “handful of customers” currently pay premiums of $6,000 per year. In short, the pandemic has disproportionately struck Lemonade’s customer base, and its ability to “graduate” customers to more expensive plans may be blunted — perhaps for up to a decade.

In order for Lemonade to achieve the 10x revenue gain it predicts in its S-1 filing –– nevermind its 100x predictions –– it will need to graduate its average 30-year-old customer paying $60 a year to one paying $600 a year, which the company predicts is possible over 10 years.

While it has $311 million in cash and investment securities, and has yet to go to debt markets, even optimistic projections of company revenue strain to escape spiraling debt.

Having lost $108 million in 2019, it is upside down for Lemonade to name companies like Allstate, which made $4.8 billion in profits last year, as a competitor it seeks to disrupt. And yet it does, alongside Farmers, Liberty Mutual, and other giants of the industry. The disruption narrative is financially attractive, but Lemonade’s characterization of older companies might border on corporate ageism.

“It’s not that difficult to build an app to sell insurance,” says Thorson, who admits the industry could be more efficient, “especially in the back office.” He understands Lemonade’s goal is to disrupt, but at what cost? “Losing money for the sake of disruption? Is that worth it?”

Betting on the algorithms, and trust

Lemonade may ultimately not be too eager to disrupt. It is an insurance company, after all. For anyone who can steal their eyes away from the piles of cash given it by SoftBank, Lemonade plays pretty conservatively. Its chief insurance officer, John Peters, hails from Liberty Mutual, and McKinsey before that. And instead of paying customer claims itself, it relies on reinsurers, giving them 75 percent of customer premiums right off the top.

Sacrificing that much premium is more common for companies insuring Ferraris and almond-sized diamonds than a 30-year-old’s $60 renters insurance plan, especially for a company that claims it engenders customer trust through charitable giving.

By using reinsurers, Lemonade has removed the volatility of the weather (say a hurricane destroys all of someone’s possessions) as well as the volatility of its own technology.

Computer scripts pay one-third of claims made by Lemonade customers instantly, according to Schreiber, which raises a somewhat philosophical question. Can computers catch a lie? Any uncertainty about that question represents a risk to Lemonade.

The FBI estimates that fraudulent insurance claims total $40 billion each year, and the Insurance Information Institute has said based on interviews with claims adjusters that 10 percent of property insurance claims may be fraudulent.

Beyond hundreds of millions in SoftBank cash, Lemonade co-founder and CEO Schreiber says “artificial intelligence” and “behavioral economics” set it apart. To get insurance coverage from Lemonade, customers use its app to interact with computer scripts and avatars — Lemonade has given them human faces, and named them AI Maya and AI Jim — rather than people making a sales commission.

Besides insuring itself against losses by passing customer premiums onto other insurers, what about Lemonade’s charitable giving meant to discourage bad behavior (such that filing a fraudulent claim would rob a charity chosen by the customer)?

Lemonade declined comment on this story, but discloses in its S-1 filing that fighting fraud by donating to charity is “untested”; it would be something of a revelation if people otherwise inclined to commit insurance fraud restrained themselves for the sake of charitable giving. But perhaps Lemonade’s public commitment to give “up to 40 percent” of its unclaimed premiums to charity might really inspire honesty.

It turns out “up to” does some heavy lifting, and that trust is still a two-way street.

In 2018, Lemonade donated 2.7 percent of its leftover premiums to charity, totaling $162,000. In 2019, that increased to 3.5 percent when it donated $631,500. And given that the company has never not lost money, Lemonade’s investors seem the generous ones, standing by while their money is given out to charity.

Meanwhile, Lemonade executive salaries totaled $1.5 million in 2019, and total executive compensation came to $6.3 million, a 10x amount compared to its charitable giving.

There is no provision in the prospectus obligating executives to make charitable contributions, just investors’ money, and if the company ever makes a profit, just its customers’ money.

Charity for thee, but not for me, may leave a sour taste behind.

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