Tension between CEO, Sequoia preceded Zappos sale

VC-backed Zappos put a happy face on its sale to Amazon.com last week, but two sources say it was not very long ago that the online shoe seller’s CEO was advocating that the company remain independent.

Amazon last Wednesday agreed to pay more than $900 million, mostly in stock, to buy Zappos. The startup had previously raised $49.1 million from venture investors, primarily Sequoia Capital, according to Thomson Reuters (publisher of PE Week).

Following a report on peHUB (a PE Week affiliate) about conflict between Zappos CEO Anthony “Tony” Hsieh and Sequoia GP Michael Moritz over the company’s future, Hsieh issued the following statement:

“The articles and rumors of Sequoia forcing us to sell are simply not accurate. Nobody was forced to sell to Amazon. The Zappos board was united in believing that joining forces with Amazon would be in the best long term interests of our employees, customers, shareholders, and other stakeholders.”

The statement continues: “The Amazon deal got us the best of all worlds: we can continue to run independently and grow the Zappos brand and culture, our small and larger investors are getting rewarded for all their contributions to Zappos over the last decade, and we don’t have to deal with the headache and overhead of running a public company.”

Hsieh did not respond to PE Week’s request for comment about remarks made by two sources that at one point this year he wanted Zappos to remain independent, but Moritz wanted to sell. Moritz also did not respond to a request for comment.

One of the sources, a Zappos shareholder who says he has seen the company’s capitalization tables, says Sequoia had a 3x or 3.5x liquidity preference associated with the shares it purchased.

Liquidity preferences of 3x or greater are extremely rare, according to a recent survey of deal terms conducted by law firm Fenwick & West. The majority of all liquidation preferences fall below 2x, the study finds.

“When Mike [Moritz] came in, he came in at a high valuation, but he countered that with a very high liquidation preference,” the shareholder says. “It puts management on one side of the table and investors on the other. Then there’s always pressure to sell the company.”

The source adds that Zappos was financially strong enough to wait for the IPO market to recover. The source, who says has seen the company’s income statement, says the company reported more than $1 billion in gross revenue in 2008 and had EBITDA greater than $40 million.

Sequoia had potential allies on the Zappos board.

A Zappos regulatory filing dated May 2007 indicates that the company had five board members at that time: Hsieh; Moritz; Alfred Lin, Zappos’ COO and CFO; Michael Marks, a member of buyout shop Kohlberg Kravis Roberts & Co. and formerly CEO of Sequoia-backed Flextronics; and Ann Mather, former CFO of Pixar and currently a member of the board of Google (which was venture-backed by Sequoia).

Hsieh said in a letter to employees that Zappos has more than 100 shareholders.

The company, founded in 1999, raised its first venture capital in May 2002, according to a venture database maintained by Thomson Reuters. Draper Richards and Venture Frogs, an investment vehicle controlled by Hsieh, invested $5.7 million at that time. The following year, Draper Richards and Venture Frogs put in another $500,000.

Sequoia made its first investment in the company in October 2004, joining with Venture Frogs in a $20 million round. (Moritz joined the board as part of that investment.) Less than a year later, Sequoia, Venture Frogs and an undisclosed firm put in another $20.5 million. Then, in October 2006, Sequoia and Venture Frogs chipped in another $2.4 million.

Finally, Millennium Technology Ventures, a secondary investor, was involved in a round for an undisclosed amount in April of this year.

Thomson Reuters shows that Sequoia’s first two investments were made from its 11th fund and its third investment came from its Franchise Fund.

Amazon announced last Wednesday that it agreed to buy all of the outstanding shares of Zappos and assume its outstanding options and warrants in exchange for return for 10 million shares of its common stock. In addition, Amazon said it would give Zappos employees $40 million in cash and restricted stock. That gives the overall deal a value of close to $928 million, based on Amazon’s closing price of $88.79 a share last Wednesday.

Despite the sale to Amazon, Zappos expects to retain its identity and independence, Hsieh wrote in an open letter to employees.

“We are planning on continuing to run Zappos as a separate company,” he wrote. “From a practical point of view, it will be as if we are switching out our current shareholders and board of directors for a new one, even though the technical legal structure may be different.”