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:
- 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.
- 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.
- 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.
- 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.