Startup Review

Zappos.com Case Study: Why shoes are great for e-commerce … yes, really

written by Nisan Gabbay, posted on September 17th, 2006

Why profiled on Startup-Review.com

Zappos.com is an e-commerce retailer that has successfully built a strong online brand and shown impressive revenue growth since its founding. The gross revenue numbers basically speak for themselves: 2000 $1.6M, 2001 $8.6M, 2002 $32M, 2003 $70M, 2004 $184M, and 2005 $370M.

I think that Zappos.com makes for an interesting case study because they found a winning formula for e-commerce in general: acquire customers cost effectively through search engine marketing (SEM) and make them happy enough with their experience to keep coming back. The Zappos.com details on this formula I think are worth reading.

Interviews conducted: Can’t get any better here. Zappos.com founder Nick Swinmurn and Tony Hsieh, early investor and current CEO. Nick left Zappos.com in February to start a cool, new venture called Stagr, an online service for customizing clothes. Special thanks to Startup Review reader Brian Townsend, who provided me with Nick’s contact info. Introductions like these is what keeps the quality of the case studies high, so please check the “Contribute” page to see how you can help out.

Key success factors

Shoes turned out to be a great product for e-commerce

When Nick founded Zappos.com he was turned away by almost all VCs because no one believed that shoes were a good product to sell online. Afterall, who would buy shoes without being able to try them on first? However, Nick stuck to his guns, backed by the fact that shoes are a $40B market in the US with $2B sold via mail order catalogs. So why did Nick turn out to be right?

Most importantly, shoes turned out to be great for SEM for several reasons. For one, people search for shoes by brand. Zappos.com didn’t need to spend advertising dollars to build the Zappos.com brand; they only needed to get a consumer to click on an ad for Rockport or Vans shoes. Zappos.com also didn’t need to educate consumers about their product – people knew shoes. Furthermore, shoes are high ticket items with good margins. The average order on Zappos.com is ~$100 and gross margins on shoes are ~50%. This leaves a lot of wiggle room for SEM campaigns. In addition to SEM, the high ticket price and brand loyalty associated with shoes also lends itself to successful affiliate marketing. Zappos.com has 17,000 affiliates driving traffic and shoe sales to their site.

When Zappos.com was founded in 1999 there was no search engine marketing, hence it was nearly impossible to know this would become such a key factor in their success. Zappos.com was smart to recognize and capitalize on the emerging SEM market. Zappos.com may still have been successful without SEM, but I doubt that it would have grown as quickly without it.

Repeat customers through superior customer service

Both Nick and Tony attribute the Zappos.com success to the company’s near maniacal focus on customer service. Great customer service is what helped the company build a loyal customer base. Approximately 50% of Zappos.com orders are from existing customers, and an additional 20% are from new customers that were referred by existing customers.

So what did Zappos.com do to keep customers coming back? The key policy was nearly automatic upgraded shipping to next day air. Sounds kind of simple, but it was based on an astute observation. Zappos.com realized that they were competing with offline shoe retailers and not just online shoe retailers. So while the competition was sending shoes 5-7 day ground, Zappos.com decided to do it far better – next day air for free. Zappos.com was also clever in how they rolled out this policy. They didn’t just announce free next day shipping on the site, they surprised customers individually. So when a customer thought their shoes would be coming in 3-7 days, they got an e-mail that said they’d been upgraded to overnight air because they were a valued customer - a small gesture that really makes an impression on the consumer. This one shipping policy strongly impacted return purchases.

** Update: Correction to the above paragraph. Tony Hsieh, the CEO of Zappos.com, e-mailed me to clarify the upgraded shipping policy. In Tony’s words: “I just wanted to clarify that we don’t actually do the surprise upgrade to next day air for all customers.
Instead, we semi-randomly upgrade orders for most of our repeat customers. There are a few that get next day air, and many get 2nd day air. Our long term goal is to get to next day air for everyone, but we’re not quite there yet.” **

The other key policy Zappos.com implemented was their returns policy. Zappos.com helped ease consumer apprehension around buying shoes online by offering free return shipping and a 365-day free return policy. Zappos.com’s 2005 net revenue was ~$250M, while the gross was $370M. That’s a huge amount of returns. Consumers are clearly taking advantage of the Zappos.com return policies, helping to build trust and satisfaction in the service.

The toughest decision that Zappos.com had to make around customer service was eliminating drop shipping of shoes. Around 2003, Zappos.com reduced the amount of drop shipping of shoes from nearly 25% down to zero, risking a substantial portion of their revenue base. The company went through the extra expense of warehousing all their shoes themselves to better control the fulfillment process, thereby improving customer service.

Other measures that Zappos.com took to create a company culture centered on customer service included:

- 24/7 customer call center in Las Vegas, at the company’s headquarters
- 24/7 shoe warehouse operated in Kentucky by the company
- 4 weeks of customer service training for every new employee (2 weeks at the call center and 1 week at the warehouse)

In Tony’s words, customer service is all about to what extent you are willing to please the customer. If Zappos has run out of inventory on a particular shoe, the customer service rep is encouraged to provide the customer with links to purchase the shoe from other online retailers. While many customer call centers measure customer call durations, Zappos scores all calls on how helpful the customer service rep was in servicing the customer.

Management flexibility in re-defining strategy and brand

Another thing I found interesting about the Zappos.com story was how they adapted their strategy and brand the more they learned about their business. Many times I think people fall in love with their initial strategy and don’t properly read the clues the market provides them. When Zappos.com got started they thought they would win based on providing the greatest selection of shoes. The company initially launched as ShoeSite.com – a good name to fit that strategy. However, Nick and Tony found that it was actually really hard to provide a large selection of shoes. Not all shoe manufacturers wanted to work with a small company selling online, so it was going to take years to build a large selection and secure inventory. That is when the team decided to focus their efforts on providing the consumer with the best possible customer service. As such, they focused the company’s strategy and culture around service and re-launched as Zappos.com. This was a risky move considering Zappos was a two syllable word with no meaning to people, but one that would allow them to extend their brand into other product categories and build an independent brand around service. This decision would become an important factor in the Zappos.com success.

Launch strategy

Zappos.com did a fair amount of offline advertising in its early days to help establish its brand with shoe manufacturers. Shoe manufacturers were apprehensive to work with a young company like Zappos.com and were concerned about how their brand would be perceived via the online channel. Thus, Zappos.com’s initial marketing investment was only partially aimed at consumers; it was more to impress suppliers. Once Zappos.com had secured some shoes to sell, they could use cost effective online marketing (SEM, affiliates) to attract consumers. Philosophically, Zappos.com chose to invest in superior customer service rather than marketing. Something like 15% of their revenue is spent on customer service and another 15% spent on marketing. For most e-commerce companies, this ratio is skewed significantly towards marketing.

Exit analysis

Given that Zappos.com had ~$250M in net revenue in 2005, it is somewhat surprising that they haven’t gone public yet. The most plausible explanation is that Zappos.com believes it can significantly increase its value by proving the success of its model in other product verticals (handbags, accessories, apparel). This would make for a much more compelling growth story for the public markets and prove that the Zappos.com brand really does stand for customer service rather than shoes only. An IPO is probably in the horizon, but more likely in 2-3 years.

I would be curious if anyone can offer a perspective on the M&A and IPO market for pure play e-commerce retailers? What are the exit opportunities for e-commerce sites in the $10M - $50M sales range? How are they being valued? Please see my post on NewEgg for more analysis on this specific topic.

In terms of current valuation, I have no personal insight into the value placed on Zappos.com by the late stage Sequoia Capital investments. However, according to Silicon Beat the initial $20M investment was done at a $200M post-money and the next $15M in July 2005 at a $300M post-money. I would take these numbers with a grain of salt, but using some very rough math, that basically translates to one times revenue. Zappos.com’s first VC round of $1.1M was provided by current CEO Tony Hsieh (the former founder of LinkExchange and founder of Venture Frog Incubators) in 2000. That initial $1.1M (plus several more million from Tony) and some large credit facilities was enough to build Zappos.com to $100M+ in revenue, at which point Mike Moritz and Sequoia made their initial investment in October 2004. Zappos.com decided to take this late stage funding to invest more in their product inventory (once again, to improve upon their customer service). It’s interesting to note that Sequoia was one of the firms that turned Nick down back in 1999.

Food for thought

As a former consultant, part of my training was to try to put things in simple frameworks, so forgive me if my insight is too obvious. However, it seems to me that a successful formula for starting a retail e-commerce site is to sell a product that is great for SEM and have a sound strategy as to how to garner repeat business. For Zappos.com it was great customer service, but for other sites it might be community features or other enticements to keep people coming back. Are there any other examples of successful e-commerce companies built on this formula?

Reference Articles

There are a number of good articles that document the story of Zappos.com. I have listed those that I found to be the best below.

Reference For Business is a site I have now used for several case studies. They provide some great company history articles on ~600 private and public companies. They have an excellent time based chronology of the Zappos.com story here.

How I Did It: Tony Hsieh, CEO, Zappos.com, Inc.com, September 2006
I’ve summarized most of the content from here. This did provide the source for the 2005 net revenue numbers however.

Focusing on Service: Nick Swinmurn’s Key Move, StartupNation
StartupNation has some great content for any entrepreneur.

A Shine On Their Shoes, Business Week, December 2005

The Shoe Fits – Fast Company, 2005

E-retailers must excel in customer service, Zappos founder says – Internet Retailer, February 2004

The Zappos Story (on the Zappos.com website)
This has a few good points on the Zappos.com customer service policies.

If anyone has some other links with more insight into Zappos.com, please leave a comment below.

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