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Pre-Paid Legal

Services Inc.
Case Analysis

Alen Kokalovski & Tom Thipcharoen
Sales Compensation Programs
Business Analysis
Analysts Views
Financial Analysis: Capitalization vs. Expensing
Group Discussion

Pre-Paid Legal Background
Founded in 1972 by Harland Stonecipher
Company went public in 1979 and grew rapidly
as many began to subscribe to legal service
In 1999 it began trading on the NYSE and had a
market Cap of $740 million
Between 97 and 98, revenue grew by 59%, net
income by 71%
At 1999, PPLS had 648K active members that
was growing at 40% per year
Family Plan
Accounted for 94% of all memberships
Legal services covered include: wills, defense of
traffic violations, IRS audits & employer
Excluded services: domestic matters,
bankruptcy, deliberate criminal acts, business
matters, alcohol or drug related matters
Open vs. closed panel memberships
Premiums: $229 per year or $19 per month

Sales Generation
24% sales generated through insurance and
service companies
76% sales generated through existing members
who become sales associates and are able to earn
Membership persistency was approx. 75%
Compensation Program
Prior to 1995: sales associates earned 70%
commission of the 1st year and 16%
commission for subsequent renewals
After 1995: sales associates earned 25%
commission for the first and subsequent
renewals, they were advanced commissions for 3
years worth of premiums.
Why did PPLS change commissions policy?
Mixed Analyst Opinions
Some Analyst gave strong buy recommendations
due to consistent earnings growth, ability to
generate positive cash flows and expectation of
an alliance with a major insurance company
Others recommended short selling due to
inappropriate methods of accounting for
As a result of uncertainty, stock price fluctuated
from $14 to $41 from 97 to 99

Business Analysis
$1 Rev - $0.33 Cost - $0.25 Comm=$0.42 Profit
No substitutes other than pay-per-use
Abundant amount of law firms to choose from
No brand distinction; no threat of backward
Sales channels are key to the success of the

Operating Cash Flows
Capitalizing Advances
Expensing Advances
Group Discussion
Break up into 2 groups
Discuss pros and cons to capitalizing vs.
expensing of commissions
Arguments For Capitalizing
Companies subscription base is their key asset
Primary activity of company is to manage this
asset base
Company can reasonably estimate renewal and
Better looking numbers on the book (Net
Income & Assets)
Arguments For Expensing
At best, commission advances is an intangible
asset - dependent on renewal rates, therefore it is
not guaranteed.
Concern over whether managers can accurately
estimate renewals/cancellations
Defer other expenses: tax provision, profit
Effects of Expensing
Accounting Adjustments:

Year Balance Sheet Income Statement
Assets =liabilities + RE Expenses Net Income
1996 -18381 -18381 +18381 -18381
1997 -22891 -22891 +22891 -22891
1998 -28142 -28142 +28142 -28142

Effects of Expensing
Balance Sheet Effects:
Commission advances on balance sheet represent approx.. 50% of
the total assets in 1997 and 1998

Income Statement Effects:
Year 1998 1997 1996
NI with no adjustment $30186 $17523 $10263
adjustments (page 4-56) -$28142 -$22891 -$18381
NI with adjustments $2058 -$5381 -$8133

Red Flags
% of new memberships to total memberships is
growing; lead to lower persistency rate (10-K)
No disclosure of how commission advances are
No disclosure of how allowance for
uncollectible advances is calculated
The allowance for estimated uncollectible
premiums decreased from 97 to 98
What Happened?
In 2000, PPLS changed to more conservative
method of recognizing commissions
SEC ruled that estimation was too difficult and
needed to expensed instead
Shareholders sued for misleading accounting for
commission advances
In 2001, SEC investigation concluded that the
accounting not consistent with GAAP
In Aug 2001, Auditors resigned indicating that
they disagree with SEC ruling
PPLS - Now
Income Statement