I have been tracking a sector since middle April that has been gaining momentum. The acquisition of Fulfillment by Amazon (FBA) businesses by venture-backed companies or PE investors seems to be the 2020 fad.

In 2017-2019, the B2C e-commerce sector saw direct-to-consumer e-commerce investment at scale. It has cooled down to a degree, as questions over sustainability, vertical integration, and real impact became normal. In 2020, venture and private equity believe that rolling-up many FBA businesses into a holding company are the solution. I am not so sure about that.

The risk and delusion

I have had a few inquiries from PE investors looking into this sector, and the reasoning I heard was something like this:

Amazon’s third-party seller opportunity is $330 billion (number varies by investor group). There is only one Seller in the $500 million in annual sales range, and thus its an opportunity we want to venture in. Then within five minutes, a few Amazon questions from me, and the lack of understanding is crystal clear. 

The FBA Business Risks

• The biggest red flag is platform risk. Amazon’s terms of service are clear; users cant sell accounts to third-parties. “Amazon will not clamp down on this current practice, in our opinion?” (I was mind blown at first, but this seems like an over or under bet with millions of dollars at risk, and the belief is that Amazon will do the right thing).
• Fit – I was on a call recently where an investor made it clear that roll-ups only work when they complement each other. Is the idea to buy FBA businesses in one category or in categories that are similar in buyer behavior? (I have heard a variety of theses here and was in cases given silence on pertinent questions such as replenishment rates, item sizing, etc.)
• The need for product development. Having seen the movie before, investors need to understand that at one new product per quarter is table stakes. (The current product portfolio should get us into 2021. Have the businesses planned for festive season 2020? silence)
• The Amazon Tax. One of my favorite three-word questions? When I ask investors whether they know what the Amazon Tax is, I get all kinds of answers. It boils down to the following – for every dollar spent on the marketplace, how much of that is going to Amazon and not to you? When I mention a quarter or 45c for every dollar, I hear scribbling and panic).
• Competition on Amazon is at an all-time high with incumbents, capitalized DTC businesses paying the man. So how do you plan to reach new consumers without running afoul of Amazon’s marketplace rules? (What are the rules to sell on Amazon?)
• How do you drive traffic to these listings, and what does that cost? (We use Facebook, Instagram, and Pinterest, but the CAC is reasonable.. how do you calculate lifetime customer value?) 
• What is the diligence you do before signing a check? (We ask for Seller and vendor central access and view data? What about account violations, and when did they happen? ).
• How are you finding companies to buy? Third-party platforms, founders getting in touch or scouting via a thesis? (Silence, we have had plenty of inbound interest, and the companies are all showing the right metrics.)
• What are your price point and terms for sale? (Why are you asking about the conditions on our contracts? Is that not confidential?)

The only benefactor in this current gold-rush are entrepreneurs who are looking to exit their FBA businesses. 

Private equity has a reputation that does not meld with FBA businesses. It is borderline exclusive in that these businesses need staff and capital. You cannot run a $25m ARR business with less than ten people. When you have businesses between $250k or $1m who are early to be looking for an exit, it needs at least three people. There are 24 hours in one day, and missing a critical notification from Amazon could have dramatic long term impact.

A look into the future

I know of a handful of PE firms that are sitting on large amounts of capital looking for their next big win in e-commerce. These firms may be doing diligence on FBA businesses. They believe the opportunity to buy premium assets/brands at a discount is not on the horizon but closer.

The uncontrollable challenges

2020 might have accelerated consumers’ usage of marketplaces, but it also has shown weaknesses in areas such as the supply chain. 

Where are the products made, and where are they shipped from? Does the brand have diverse manufacturing partners to be able to spin up new partners to cope with demand or trade costs changes?

The headwinds created by the US and China trade scuffle has made shipping and import costs higher. How is it shipped to Amazon warehouses, and what is the trade status of the local area? How can these items find their way to a port or airport (much more expensive)? The point is until things are in an Amazon FC, its a financial liability that can only increase in size.

The need for relevant skills

Amazon is a large part of the US commerce sector (even with their funny math), its still a significant enough opportunity that requires a skill-set not found. The leadership of this new-entity must have Amazon experience (this is non-negotiable for me). If not, the founders of the businesses must have an incentive to stay and help the company grow as a full handover is a train wreck waiting to happen.

Retail as we knew it before COVID-19 will not return, and the importance for PE and VC investors to return ARR of at least 100% is getting harder. When PE funds use the courts to get out of buying a distressed lingerie brand, it highlights the importance of sophisticated diligence and providing firms an out if things are not as they seem. Have I seen anything like that for these FBA roll-ups? If only. 

If it sounds too good

The FBA roll-up idea sounds good in principle but requires delayering of business to unit economics and granular data such as cohorts. What I have been seeing since mid-April reminds me of the need to open new stores in retail to grow the business. It’s a great strategy until the music stops and black-swan events hit. Buying any business is hard but even riskier if its an FBA business. The number of opportunities for Amazon to impact your business is not low, and they do not care which brands they close for no apparent reason.

If the DTC endgame is anything to go by, then I think the prudent investors have already made their acquisitions. Spending investor capital should be a responsibility and not throwing spaghetti against a wall.