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How the credit crisis affected Zappos

Anti-bailout sentiment certain runs high these days, and I think it’s because people don’t see the effect that the credit crisis in the fall of 2008 was having on non-financial businesses. In an article in Inc explaining why he sold the company to Amazon.com, Zappos founder Tony Hsieh talks about the effect of the credit crisis on his company:

At the time, Zappos relied on a revolving line of credit of $100 million to buy inventory. But our lending agreements required us to hit projected revenue and profitability targets each month. If we missed our numbers even by a small amount, the banks had the right to walk away from the loans, creating a possible cash-flow crisis that might theoretically bankrupt us. In early 2009, there weren’t a lot of banks eager to give out $100 million to a business in our situation.

That wasn’t our only potential cash-flow problem. Our line of credit was “asset backed,” meaning that we could borrow between 50 percent and 60 percent of the value of our inventory. But the value of our inventory wasn’t based on what we’d paid. It was based on the amount of money we could reasonably collect if the company were liquidated. As the economy deteriorated, the appraised value of our inventory began to fall, which meant that even if we hit our numbers, we might eventually find ourselves without enough cash to buy inventory.

These are the problems most businesses were facing in late 2008. You can oppose the bailouts on principle, but doing so is a luxury afforded by the practical effects of those same bailouts.

11 Comments

  1. Rafe, it looks like your post isn’t quite finished and your link is broken.

    This story highlights our problems with debt as a nation. . While debt may be a great way of quickly growing a business it comes with SIGNIFICANT risks.

    Although I’d financed much of Zappos myself during its early days, we’d eventually raised tens of millions of dollars from outside investors, including $48 million from Sequoia Capital, a Silicon Valley venture capital firm. … Our investors at Sequoia made $248 million.

    I have no idea how much profit Zappos’ investors, I certainly doubt they lost money. The bailout you say was needed just rewarded a very risky business strategy. Relying on a $100 million line of credit to OPERATE is risky. Privatized reward, socialized risk.

    This article does nothing to change my opinions on the bailouts. While I agree SOMETHING needed to be done, it certainly wasn’t to write a blank check to all the banks.

    On the face of it, Zappos should have been a casualty of the recession/meltdown.

    Just my $.02 worth.

  2. truncated post? seems like you ended in mid sentence.

  3. Jeff, I’m not sure your conclusion makes any sense at least as it applies to Zappos. They didn’t receive bailout money but they were suffering from the credit crunch.

  4. Jeff, I think you’re misapprehending how companies like Zappos use short term lines of credit.

    Nearly all businesses finance their business on a day to day basis using short term credit, simply because it allows them to decouple paying their expenses from their cash flow. I have a friend who works in accounting for a utility company, just about the most stable kind of business there is, and they were in the same boat during the crisis. Even though their future revenue is very predictable, they use a line of credit to pay payroll and whatnot, and those lines of credit were drying up.

    Sorry about the truncated blog post. My internet connection cut out while I was composing it and when I went back and re-saved it, some of it was lost. It’s fixed now.

  5. “Nearly all businesses finance their business on a day to day basis using short term credit, simply because it allows them to decouple paying their expenses from their cash flow.”

    Yeah, but one might ask whether this is actually a desirable state of affairs. Not only does it let the bank skim a significant part of the profit of the business in interest and fees (they wouldn’t do it otherwise), it leaves the business vulnerable to the credit markets in a way that they wouldn’t be if they had a cash cushion.

    For a rapidly expanding business like Zappos I can see why it makes sense. For stable businesses I think there is a good argument that sitting on a couple of month’s payroll is better than paying to borrow it every month and taking the risk that a credit crunch will crash their business through no fault of their own.

  6. Perhaps. I’ll ask my friend the accounting genius why businesses do it that way.

  7. Jacob hit on my point. I understand the what, but the why doesn’t make sense. You’ll note my first sentence, “This story highlights our problems with debt as a nation”.

    We as a nation live on debt. This is not a good thing. When a business needs credit to make payroll, this is not a good thing.

    While Zappos was not directly bailed out, if part of the side affect of the bailout was to save businesses that operate at extreme risks, then yes we did indeed bailout Zappos and their investors who made a much higher profit than if they had to slash business or put on a fire sale.

    This is one reason I think the pain for our economy isn’t over. Too much debt. Too much private sector, too much public sector and too much personal deb.t

  8. I disagree that debt is, by definition, a problem, especially short term debt. I put most of my expenses on my American Express card over the course of the month and pay it at the end of the month. It’s paid off every month (it has to be, it’s Amex), but it’s still debt. It just makes it easier to make the budget work with my pay schedule. I don’t think that’s a bad use of debt, or even a very risky type of debt to carry.

    I am also not against long term debt if you can use it to make money. If you can borrow money at 5% and earn a return of 10%, borrowing that money makes good financial sense.

    Obviously we’ve seen a lot of misuse of debt — people using credit to live beyond their means, people buying houses that they couldn’t realistically afford, and so on. And we’ve seen entire industries built around taking advantage of people who want to live that way, lending money to people knowing that a fair number of them won’t be able to pay it back.

    But being against “debt” as a rule doesn’t make a lot of sense to me.

  9. Even accepting that some amount of credit is necessary even for a responsible business, it doesn’t justify the bailouts given that the banks haven’t responded to the bailouts by opening reasonable lines of credit to responsibly run businesses. They’ve still shut down lines of credit, and companies like Zappos still went under.

    And now we (the tax payers) have run up an enormous debt to save the banks from the consequences of their own irresponsible practices, i.e. going out of business the way they’ve forced companies like Zappos to do.

  10. Rafe, let’s say your AmEx isn’t available next month, can you still pay your bills? Let’s say your income drops by 25% next month, can your AmEx bill still get paid? There is a difference between using credit for convenience and using credit as a necessity. My guess is if you lost your credit cards tomorrow, you’d be ok. Judging by the article, if Zappos lost them, they’d be up **** creek without a paddle.

    I am not against debt, but a company that is reliant on debt to survive is not healthy.

    That’s great if you can borrow money to earn a greater return, but that also exposes you to more risk. Assuming that greater risk for greater reward should not make it my problem or the public’s problem.

  11. I agree with that. If you can’t service your debt, you file for bankruptcy. The policy question is whether it’s cheaper in the long run to spend money to stem a crisis or to let companies suffer the consequences of their risk taking. There is no doubt in my mind that AIG, Citibank, and everyone else we bailed out deserved to default and file for bankruptcy. But the consequences to the economy of doing so would have been severe. When it comes to economic policy, I care less about justice (such as it exists) and more about what’s good for the economy in the long term.

    What’s been frustrating to me is that we still haven’t reformed financial regulations enough to greatly lower the probability that we’ll go through this again.

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