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For those that love Lemonade, this is for you
While your cliché VC fund buys a stake in a business and advises its portfolio companies through various stages of its life, the VC fund General Catalyst is taking a unique approach. While General Catalyst has participated in Lemonade's Series B fundraising round in late 2016, according to an article, General Catalyst is now willing to invest $150 million in Lemonade's Synthetic Agents program (source) to finance 80% of Lemonade's customer acquisition costs in exchange of 16% of the premiums generated from the insurance policies.

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For background, Lemonade created the Synthetic Agents program as a way to improve its cash flow situation. Being a young insurance startup, Lemonade is encountering cash flow issues as it has to continually invest huge sums of money into acquiring customers. To better describe the situation, Lemonade says:

"It takes Lemonade ~24 months to earn back our initial CAC, and in the meantime that money is spoken for. A dollar spent today to acquire a customer, in other words, won’t be available for the acquisition of the next customer for two years."

In the past, Lemonade had to dilute shareholders by raising equity to fund their operations. Now, with higher interest rates and a low stock price, Lemonade needs to find a new avenue for raising cash. That's why they made the Synthetic Agents program. Remember, Lemonade is an insurtech business, not your average insurance business. In a traditional insurance company, the insurance agents are the ones going out and finding customers. They take on most of the customer acquisition costs themselves in exchange for 10-20% of the premiums as commission. For Lemonade, as an insurtech, they want to steer away from the agent-mediated business model because:

  • agents commoditize Lemonade's brand
  • relying on agents reduces Lemonade's opportunities to collect more data on customers
  • agents usually take as much as half of the gross profit of the customer, reducing the lifetime value ("LTV") of their customers

By going direct-to-consumer ("DTC"), Lemonade gets to make more profit per customer and provide customers with better service. However, as we've seen with retail startups like Allbirds $BIRD and Warby Parker $WRBY, running a DTC business is difficult. $ONON pushed more into relying on third-party sellers and they were able to do far better than Allbirds and other DTC shoe brands. Going DTC means having to do more of the marketing work yourself, leading to higher customer acquisition costs. Whether it's worth paying more for customer acquisitions in exchange for higher profit margins is something each startup needs to think about. For most DTC startups, sacrificing some margin for far lower customer acquisition costs is the way to go.

Now back to Lemonade. Since $LMND won't be recruiting insurance agents like your typical insurance business, it is recruiting Synthetic Agents, which is a financier that finances the customer acquisition costs of a customer in exchange for commissions on the insurance premiums. Instead of the insurance agent handling most of the customer acquisition work, the Synthetic Agent will finance the customer acquisition costs. Instead of the insurance agents taking 50% commissions, the Synthetic agent will get 16% commission on premiums paid. For Lemonade, here are the benefits of working with a Synthetic Agent:

  • payback period collapses
  • capital-light growth without ceding half of our gross profit for the lifetime of the customer
  • cash flow benefits of agents, without their downsides
  • ownership of the customer while having someone else pay for the customer acquisition costs
  • instead of paying the agent commissions on premiums paid over the entire life of the policy, Lemonade only pays a 16% commission on premiums on customers acquired only for the first two to three years of the policy's life

An interesting way of summarizing the benefits of Synthetic Agents would be:

"One way to think of Synthetic Agents is as time-shifters, funneling customers’ future gross profits backwards in time, so customers effectively finance their own CAC before we’ve even met them. Such time travel not only breaks the tenet 'growth-depletes-cash,' it actually reverses it."

We will analyze how the ROI for a Synthetic Agent at Lemonade will look further down the memo. Remember that for Synthetic Agents, it's purely a finance play. There's no overhead, interactions with customers, and licenses needed. While there is risk, since insurance is a high-retention business, Lemonade believes he risk is low and the rewards are high. From a financial modeling perspective, $LMND notes that with Synthetic Agents, the internal rate of return (IRR) on their customer acquisition costs will jump to ~90%. When including the fact that interest rates are higher than ever before and Lemonade has performed poorly since its IPO, Synthetic Agents are necessary for Lemonade's growth. Thanks to Synthetic Agents, Lemonade could achieve profitability by 2026.

With insurance being a capital intensive business (wherein there's both regulatory and working capital to worry about), having partners with symbiotic business models is key to Lemonade being able to overcome challenges like slowing growth, idling cash, and continued delays in profitability. With the partnerships Lemonade has with its reinsurance partners, the regulatory capital burdens are relied through their quota share program. With Lemonade's partnership with General Catalyst in the Synthetic Agent program, Lemonade's working capital burdens are relieved.

For the growth investors reading this, Lemonade could 10X its business and and State Farm would still be 10x bigger than Lemonade. If Lemonade 100X its business, AXA would still be double the size of Lemonade. With Synthetic Agents, we should expect Lemonade to fire on all cylinders and show scalability as a whole.

Now, let's look into the math from both Lemonade's and General Catalyst's perspective on the Synthetic Agent-Insurtech relationship.

The Math

We are assuming:
  • customer acquisition costs (CAC) are $213 (source)
  • average premium paid per customer annually is $362 (source)
  • General Catalyst finances 80% of the CAC and Lemonade finances the remaining 20%
  • Once the commission revenues pay General Catalyst its original capital plus 16% of capital it contributed, the rest of the commission revenue goes to Lemonade for the rest of the policy's life

With General Catalyst paying $170.40 (aka 80% of $213) for a customer, it will receive $57.92 (aka 16% of $362) annually. By Year 3, General Catalyst has made $173.76 in commission total and will receive a maximum of $23.90 in commission in Year 4. Year 5 is when Lemonade starts taking in all the premium for itself from that customer. In the deal, it looks like General Catalyst is receiving an average annual return of 4%. If the commission revenue met the cap within 3 years, the average annual return would be 5.33%. For a venture capital firm that currently holds 1% of $LMND and that recognizes a need "for a source of capital that is not beholden to equity valuations and allows companies to continue to invest in growth without negatively impacting their balance sheet," choosing to participate in a unique program like this is considered reasonable even though the returns match what one can get from buying treasuries.

Meanwhile for $LMND, it would be spending $42.60 in CAC and will receive $304.08 in premium annually. Already, it has made $261.48, or 6.1X its money with a new customer (excluding any costs associated with onboarding the customer) in Year 1. In the process, it didn't need to add more debt burden onto itself and it did not need to dilute shareholders to acquire new customers. The cash-on-cash returns for the Synthetic agent program is attractive for Lemonade, who's offering this program to investors. If ever investors demanded higher commissions and higher returns in the program, Lemonade has plenty of room to facilitate those demands.

Overall, the math looks very attractive for Lemonade (who needed a big change in their cash management) and for General Catalyst, who's hoping that this deal will reignite growth for Lemonade and allow the firm to cash out at a more attractive level.

Additional Reading

Here's a cynical take on "Synthetic Agents" (source)
Lemonade's 'Synthetic Agent' Nonsense | Insurance Thought Leadership
Desperate for growth, Lemonade produces another howler: A lender receiving a 16% interest rate is presented as a (synthetic) agent.||Recently, Lemonade entertained us with their last pyrotechnic: "the synthetic agent." That follows a long list of shining and exotic concepts, which have been as essential in their DNA as their bloody combined ratio (for each dollar written, they have consistently spent more than $1.40).

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