Zappos Deal Shows VCs Hate Entrepreneurs

The title here might be a bit sesationalistic, but the deal certainly shows how VCs can act in a way that is counter to the wants and needs of the entrepreneurs and management teams.  The news yesterday that Zappos sold to Amazon has been circulating with many emotions.  CEO Tony Hsieh wrote an amazing letter to his employees, which laid out the deal and what it would mean for the company.  Read it if you haven’t already.

Unfortunately, when the press and journos report on a sale, they focus on the topline number, and it is rare that they report much beyond that.  As most of my readers are in the tech industry workers or entrepreneurs, the topic that is of more importance to them is “what did the shareholders who weren’t VCs get?”  That’s a great question, and one that is usually difficult to answer without access to the funding docs of the various rounds.

In the interview that I did with Andrew Warner of Mixergy, I touch on this topic of trying to create a structure that has the interests of both the entrepreneur and the investors aligned.  This morning I was reading the peHUB account of the Zappos deal, and there are a couple of things which pop out at me:

  1. Zappos management didn’t want the deal – the management team wanted to remain independent.  It’s a well reported meme that Zappos has a culture which is very unique, but has generated a booming repeat customer business, and one that has grown quite nicely, even in these tougher economic times.  Being part of Amazon will certainly change that.
  2. The sale was forced – it appears from the reporting that the investors were able to force the sale of the business.  That’s their right if they own more than 50% of the business, but it could also be their right if they had what’s called a protection right in the security in which they invested.  These provisions allow for a great many things, including the ability to force a sale at a valuation of X times the value of the round invested.  That takes the decision out of management’s hands, and clearly not always in their best interest.
  3. Not all liquidity events are created equal – the total investment in Zappos, according to peHUB, was $49.1 million.  Most casual observers would think that this is all that must get repaid before the employees/entrepreneurs start seeing money.  This is not the case, as it would depend on whether or not the different rounds of investment were made as common stock, convertible preferred stock, or, worse, participating preferred.
  4. VCs will screw you – the most interesting line of the whole article is the peHUB quote attributed to a shareholder about Sequoia: “…came in at a high valuation, but he countered that with a very high liquidation preference.”  The high valuation is meant to give the entrepreneur the sense of relief associated with keeping more of their baby, but that liquidation preference (3 or 3.5X!!) is meant to ensure that no matter what, Sequoia actually gets a guaranteed return.  I would love the opportunity to invest is a repeat successful entrepreneur with a 300% return guarantee.

The liquidation preference issue is moot depending on if the security was a convertible preferred and if the valuation of the round at which the money was invested would be low enough such that the shares converted.  Regardless, this serves as a great example point of how investors can create situations where the entrepreneurs are not being looked after, nor are the interests of management and investors aligned.

Tony is a super succesful entrepreneur, with one exit in the late 90s for almost $300 million, as well as successful investments out of his own fund.  If Sequoia took him to the woodshed like this with the liquidation preference, and the forced sale, imagine what they would do to the unseasoned entrepreneur.  As an entrepreneur today, you can do so much more with so much less.  See what you can get done before taking money from the large fund investors who “need liquidity” rather than what’s best for you.  If you take money from a VC, caveat emptor.

UPDATE: I got an email from Dianne at Kel & Partners (presumably Zappos’s PR firm) explaining to me that the story is false and that she cannot say anything else for legal reasons (which is true).  Unfortunately she called me Brian, which is not going to endear me to you.  The email was pretty impersonal (probably a form letter) and leads me to believe that this meme has upset someone and the PR firm is in damage control mode.  Whatever the actual reason for selling, I am happy for the Zappos management team if this is the exit they indeed wanted.

  • That explains a lot. Last time I saw Tony he talked about all the industries Zappos could change with their customer-centric culture. I think he even mentioned the airline industry.

    I couldn’t understand why a guy with goals like that would want to sell so suddenly.

  • Brandon Watson

    Agreed…Tony seemed very committed to his cause. Having a sale forced upon you is never a fun thing.

  • Greg

    I’m not privy to the details behind the deal, but this post doesn’t ring true to me. First, any time someone says “certainly,” “obvious,” “of course,” etc., it’s not really certain. I think Amazon will be pretty hands-off, but regardless, the jury’s out. Making predictions is fine, but please don’t pretend it’s a foregone conclusion.

    Second, the founders made the choice of a higher valuation with a liquidation preference. They could have gone with a different investor or negotiated a different deal.

    Finally, as for what the non-VC shareholders got, they got capital. TANSTAAFL.

  • Brandon Watson

    Greg, those are good points. I can say that most times, when a company is acquired, the culture invariably changes. Management leaves, or sticks around only as long as they need to, and the lower level employees feel abandoned. Amazon is a very, very different culture than Zappos.

    The choice to enter into a contract was certainly not foisted upon Zappos, and they made their own mind. However, it could also be that Tony didn’t really understand all of the provisions of the contract. I doubt that, but it’s possible. Investment documents are very long and complex, and even a seasoned entrepreneur can agree to something that they don’t fully understand.

  • Great post…certainly when you factor in that Zappos is hitting stride 10 years after inception, and a VC horizon is 7-10 years, Sequoia would be very eager to cash out and not wait the additional years it may take Zappos to really reach its true potential. The fact that Amazon agreed to let it remain an independent entity is probably making lemonade out of lemons in this situation (since they *had* to be sold, the mgmt team probably insisted on independence or they would be very reluctant collaborators which would sink the deal).
    @Greg – yes, the Zappos team obviously agreed to the terms when they raised. Without knowing the details, but knowing that they were founded during the dotcom heyday and had to raise money during the bust, one can imagine them having to take the most money possible to ensure survival at the cost of more favorable terms. I’m sure despite Tony being a repeat entrepreneur with a stellar track record, in the early 2000’s, a young online retailer trying to make it through the recession still does not have a ton of leverage.

  • Tom

    Er, I think you mean “caveat venditor”, not “caveat emptor”. The entrepreneur is the one selling equity in return for cash payment, the VC is the one buying. Hate to nitpick, but if you’re going to close with that phrase, use it appropriately.

  • Tom

    Also, when you take VC money, you take it knowing that you’ll need to return it within 5-7 years. This post is really unfair to the VCs — they have a fiduciary responsibility to their investors (who are mostly pensions and endowments) and they have a right to utilize the terms they negotiated with the management team. That doesn’t mean they hate management, that just means they have their own objectives and they structured the deal thusly.

  • It’s funny because a lot of VCs that I’ve heard speak lately have been very open and honest, and spoke about this very issue. They encourage us to put off taking VC funds for as long as possible, because as soon as you do, you’re basically in their pocket. There are always a lot of strings that come with such funding and if you can bootstrap it yourself, then you should for as along as possible. Nice post. David

  • Brandon, another solid post – and another example of why entrepreneurs/founders need to be represented by strong, experienced corporate counsel who will be watching their back. Indeed, the vc documents are complex and tricky, and a good lawyer will push very hard to protect his client and will sit down with him/her and will explain all of the terms and then run the math (i.e., create models/spreadsheets to show what happens and how much money the founder(s) will get under different sale scenarios). The entrepreneur must understand that this is all business – and unless he retains strong counsel, he will generally get steamrolled.

    Scott Edward Walker
    Walker Corporate Law Group, PLLC

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  • Brandon Watson

    I think I will disagree. Caveat emptor. The entrepreneur is buying capital with stock. They are making a purchase decision just as much as the VC is.

  • Without question entrepreneurs should take their company as far as possible before entertaining VC…certainly cash flow neutral or better.

    From Wikipedia:
    “A VC will agree to a higher valuation if it is accompanied by a participating preferred security—essentially challenging the company to earn the upside of the higher valuation.”

    Agreeing to this deal would forever put pressure on the company to liquidate…

  • Brandon Watson

    Agree that they have a fiduciary responsibility. Not just to themselves, but to the shareholders of the company (since they are board members). Let me be clear – I am completely speculating as to the motivations, and have no inside knowledge of the proceedings. However, it’s not unreasonable to think that a public offering would have actually been a better outcome for the common shareholders.

  • Brandon Watson

    Thanks for the kind words. As usual, I have some people who aren’t as convinced that I have an opinion worth discussing. Oh well, I can’t make everyone happy. I think the hardest part about being an entrepreneur seeking capital is that there exists and information asymmetry with the VCs, and the entrepreneurs will likely act in an emotional way (it is their company after all), which can yield a bad outcome.

  • Brandon Watson

    Scott, I totally agree with you. Even though I supposedly knew what I was doing, my emotions and deal heat landed me in a position of making a bad decision, one that I own up to and blame only myself for.

  • This is a very interesting post, thanks for writing it. I’m a bit unclear about why there’s a sentiment that Amazon will change Zappos’ culture. I know that’s what tends to happen in many acquisitions but I think Zappos’ culture was one of the reasons that Amazon is interested in the company. Why would they change it if it’s working as well as it is? Also, I think there are more similarities than differences between the two cultures and philosophies.

  • Brandon Watson

    @Michael, I haven’t ever worked for Amazon, so I go only on those accounts read and related to me by friends. Same with Zappos. They are very different cultures, and if Zappos can stay located where they are (physically), there’s a chance that they don’t change much. Acquisitions generally (certainly more often than not) change the culture of the purchased company.

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  • Jamess

    I think the common misconception is that Zappos is like any other company. What you’re seeing at the heart of Zappos is a programmer who was tired of seeing small companies with great ideas, being bought out, re-arranged, and spit out (If you know Tony’s history you’d understand this isn’t your typical VC business offshoot). I think everyones in for a big disappointment when Zappos isn’t rearranged to “Amazon for Shoes” later down the road.

  • Great post, I know that Zappos culture was one of the reasons that Amazon is interested in the company.

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