The Zephyr is only in the "unstable" 1.1rc. If you install the "stable" SDK, it isn't there. (so now, I have both.)

I think you missed a line in the instructions

export DISPLAY=127.0.0.1:2

Also,

If you are new to Linux, that ampersand in

$./start-xephyr.sh &

is critical.

You may want to make the user in the scratchbox a member of the "users" group.