IPO – Legal Zoom (LZ)
Legal zoom recently came onto the stock market as a public company on 6/30. And I’ll be honest I was excited to see the name as I have actually used their product and formed my LLC through their website (which I did have a pleasant experience with due to speed and ease), so I am familiar with the company.
But I’ll be passing on this one based on all my findings (which can be good lessons for you guys to look for in other IPOs that I don’t cover or how I think) which I’ll cover in detail below along with a visual YouTube video.
The company operates an online platform for legal and compliance solutions in the United States. The company’s platform offers products and services, including business formations, creating estate planning documents, protecting intellectual property, completing certain forms and agreements, providing access to independent attorney advice, and connecting customers with experts for tax preparation and bookkeeping services.
Their main customer is small businesses and that is exactly what I used them to make sure I didn’t miss anything when forming my LLC. But the truth is that all the documents needs to be filled and submitted can be done on your own for free (you just have to hunt and peck which governmental websites to use in order to find the correct files).
I’ll admit, I paid for the convenience to have it streamlined and in a central location but I’ll also say that Legal Zoom doesn’t feel like it has a large moat. They exist because the government doesn’t care to make the process simple for businesses online.
The rest of their operation I’m not as familiar with (individual, continuing business operation, and intellectual property),
Now the company was supposed to IPO around a $5 Billion valuation. They are currently trading around $7.5 Billion.
Now you saw my statement at the top, but let’s go over some of the positives.
Looking at the the financials provided in the S-1 Filing we see that the company actually turned a profit of $10 million in 2020, so they are at least making money! Well for now, as they actually state in the S-1 that it is entirely possible to reverse:
“We will need to generate and sustain increased revenue levels in future periods in order to maintain or increase our level of profitability. We expect our operating expenses to increase in the future as we expand our operations. Furthermore, as a public company, we will incur additional legal, accounting and other expenses that we did not incur as a private company. If our revenue and gross profit do not continue to grow at a greater rate than our operating expenses, we will not be able to maintain or increase profitability. We may incur significant losses in the future for a number of reasons, including without limitation the other risks and uncertainties described herein.“
I know that is partly legal talk, as they can’t come out and say they are going to be making billions in profit guaranteed in the next few years, but reading through some highlights in the S-1 there were a couple things that concerned me.
They highlight a mixture of 2020 FY highlights along with Q1 metrics
I think the biggest red flag to me was the revenue growth as they constantly highlight the 2021 Q1 growth vs. 2020 Q1 growth which was at 27%, but if you look at a full year 2019 vs. 2020 (in which they should have see multiple quarters of Covid related increase in revenues being a online marketplace and seeing increased demand) it was only 15.2% growth.
Now at this stage I would say this company is a growing software as a service company based on their high gross margins and close to break even profits. I like to use price to sales ratio as a valuation method to determine whether or not the company is trading at a reasonable valuation.
With 2020 revenues at $470 million and a valuation at $7.5 Billion, that puts the company around a 15.9 P/S ratio. Which that is above the median SaaS P/S ratio ( Source: SaaS Capital).
Also the company fails the rule of 40 which is growth rate plus ebitda margin needs to be above 40%, which if you use 2020 it was 15.2% + 19%. If you use 2021 Q1 it is 27% + 2.7%.
The big question is what will be the real future growth rate going forward, as I feel like that would have the biggest impact on our decision. Let’s look at some other snippets in the S-1 that worries me to not use 27% for a yearly increase in 2021 and going forward.
Revenue Slowdown Concern
“We have seen accelerating revenue growth in our business, increasing from 4% year-over-year growth in the three months ended March 31, 2020 to 27% in the three months ended March 31, 2021. This growth has been driven by accelerating business formations, coupled with efficient customer acquisition. Business formation growth accelerated from a decline of (3%) for the three months ended March 31, 2020 to an increase of 51% for the three months ended March 31, 2021, as compared to the comparable period in the prior year.”
If a majority of their revenue growth is coming from business formation, I looked up the number of business applications on the US census website: https://www.census.gov/econ/bfs/index.html
Notice how there is a huge dip in Q1 2020 and a large increase in Q1 2021?!? Well since a large % of their revenue comes from business formations, I would say using that quarterly comparison may be a bit of cherry picking their revenue growth. Maybe I’m just cynical.
Subscription $ is King
When you form a LLC you need to have someone as a registered agent, which you can select yourself for free (but you have to reveal your address publicly). I feel that lots of people including myself sign up for this subscription as part of the package, but looking around online I think I’ll be switching to a cheaper service for less than half the cost next year. And this registered agent revenue is around 60% of their subscription revenue!
“Our registered agent offering comprised approximately 60% of our subscription units as of December 31, 2020 and March 31, 2021.”
Below shows the expected growth for online legal services which hasn’t seen the same type of adoption as other areas like ecommerce and financial products.
- H&R Block
- Jackson Hewitt
- Law firms
- Solo attorneys
Not to mention there are other competitors that are in the field or offer a piece of what legal zoom offers through their partner program. I just don’t personally see a large moat with the company.
With all that said I would be more comfortable with using the 2020 YOY growth of around 15% revenue growth, but that also may be inflated due to the pandemic.
With a P/S ratio of 15.9 and only a more conservative 15% revenue growth rate, I just don’t love the PSG ratio over 1. I would like to see a full year revenue growth rate in 2021 vs. 2020 to make sure there isn’t seasonality in the revenue spike in Q1 YOY.
I was also going to mention the company has a larger amount of debt, but looks like the majority of the IPO proceeds are going towards paying off a big chunk of that to increase their future financial flexibility.
I enjoyed the experience I had with legal zoom and think they have a good product, but they are more expensive than there competition along with questionable growth rates for a company that has a higher than average P/S ratio.
For all those reasons, I’m out.