Guest Post: Lessons learnt from the FBA aggregator mania – for software rollups

Introduction

After several years of red-hot expansion, the FBA aggregator industry is going through a painful period of rationalization, as evidenced from mass layoffs, debt restructurings, and mergers. While hindsight is 20:20 and it’s easy to dismiss this phenomenon as a COVID era fad, a) it’s not and b) there are lessons to be learned. The software rollup space has not experienced the same degree of hype as the Amazon aggregator sector did, but it seems inevitable that both interest and funding will flow into the sector once the investment returns delivered by this model are widely recognised. To prepare for this, it is helpful to consider some of the lessons from the Amazon aggregator sector over the past few years.

This article was written by Taliesen Hollywood, a Director at Hahnbeck, an M&A sell-side consultancy that focuses on software and ecommerce businesses, and Nathan Lapsley,  a corporate lawyer and the founder of the specialist corporate law consultancy 458. Law, a trading name of Excello Law.

What’s the investment case for Amazon aggregators?

Both the Amazon aggregators and the new breed of software rollups  focus on acquiring small targets, which is relatively new. The Amazon FBA “aggregator” companies target smaller brands than would typically be acquired by big CPG (think Unilever, P&G, L’Oreal and the like). Similarly, the new wave of software rollup companies are not competing directly with the likes of Constellation Software for acquisitions – their focus is on bootstrapped companies (or those with only early-stage funding) where the founder is typically still heavily involved in all facets of the business.

Both focus on acquiring profitable companies, with multiple arbitrage the primary driver of value creation. Loss-making, fast growth, pre-profit (or pre-revenue) businesses tend not to be within the acquisition criteria for both e-commerce and software rollups. Whereas VC will often fund outstanding pre-profit DTC or SaaS businesses in the right circumstances.

Both models offer target founders a transparent exit process with relatively quick timelines.

Modelled returns to investors are very strong in both cases, arguably even more so in the software rollup case.

Thrasio’s very public early success drove awareness of the potential returns driven by the Amazon FBA rollup model, resulting in a wave of both new investors and new competitors entering the space. The same hype has not been a feature of the software rollup space, at least not yet.

Challenges faced by Amazon FBA aggregators

• The e-commerce aggregator model attracted high-calibre talent and high-profile investors

• Almost 100 of these firms raised more than $16B including both equity and debt

• In such a fragmented market, consolidation was always expected. Not all of the players would be able to exit in a high-profile sale to a strategic or an IPO

• However, the sector has faced a number of challenges, some of which have been publicised in the media recently. While some of the Amazon FBA aggregators are still on a stable footing (and a few have reached net profitability already), many are currently in a less desirable position with respect to the debt covenants they have with their lenders. Distressed sales and forced consolidation are the order of the day. While some aggregators are opportunistically seeking to merge to achieve scale, others are being forced into strategic moves by their investors. In short, the sector is currently struggling

• While there will certainly be winners in the e-commerce aggregator space, the overall landscape is currently (July 2023) not in line with expectations from a couple of years ago. Even the aggregators that are performing well have experienced challenges. There are a number of lessons that can be learned from the e-commerce aggregators’ experience so far

Insight #1: Underestimating COVID Tail Winds

What happened?

Many of these firms were founded, and were most acquisitive, during a period when COVID-related restrictions were providing an artificial boost to the earnings of their acquisition targets. It was incredibly hard to spot this at the time of course – everyone from consulting firms like McKinsey to equity analysts were describing the e-commerce boom as a “step change”, i.e. an upwards shift in e-commerce penetration which would not be reversed. To everyone’s surprise, this shift did in fact retreat, with e-commerce penetration in the west returning to its previous trajectory. This reversal of fortune, combined with an acute supply chain crisis, meant that the second half of 2021 and most of 2022 were characterised by very difficult trading conditions for almost everyone in e-commerce, with sales falling and costs rising simultaneously. 

The aggregators – who had quickly become large e-commerce businesses in their own right – were completely exposed to these challenges. Online retail had become a difficult place to be.

Not only did the trading environment worsen, but with public market comps so depressed, the exit scenarios for privately held online retailers (including the aggregators) began to appear significantly less attractive, reducing investor interest in the sector just when it was needed most.

Lesson for software rollups

It sounds obvious, but externalities can affect the performance of acquisition targets and large macroeconomic shifts can affect entire industries. Consider the potential that such externalities will impact the profitability of your targets. There is no equivalent in the SaaS space to the industry-wide impact that the post-COVID trading environment had on the e-commerce sector, but consider sector-specific trading conditions and the impact of economy-wide phenomena such as recessions.

Insight #2: Leverage and Overhead 

What happened?

These trading conditions presented even more risk to the aggregators, because they were more highly leveraged than typical e-commerce businesses of their size (having used debt to fund most of their acquisitions), with greater corporate overhead. They were building out the infrastructure needed for continued rapid acquisition and integration, the systems needed to realise the potential of the data they held, and the C-suite executive teams needed in anticipation of an eventual IPO or strategic sale

• Note that many of the aggregators also had substantial cash reserves from equity raises, which allowed them to weather the storm, but their survival became a function of their burn rate

Lesson for software rollups

Leverage and overhead both increase risk. Acquisition targets in the bootstrapped SaaS space tend to have stronger margins than e-commerce targets, providing more of a cushion. But leverage still adds cost, and risk. It is unlikely that every acquisition will be an instant success, so where leverage is used, thought should be given to the impact a sub-optimal acquisition will have on covenant compliance and the ability to raise further funding. Staying lean and avoiding unnecessary overhead also makes sense, particularly in a difficult funding environment (for example, can more expensive human capital be replaced with equivalent talented staff based in lower cost jurisdictions).

Insight #3: Losing Founder Talent

What happened?

Typical Amazon FBA aggregator deals, especially from 2020 to 2022, required the founder/s of the business to stay on for only a brief handover period (sometimes as short as 30 days). Their thesis was that the young product managers they had employed would be able to operate these brands even more effectively than the entrepreneurs who had built them. This was disastrously short-sighted and contributed significantly to the underperformance of many of their targets post-acquisition.

Lesson for software rollups

Keep founder talent on board for longer, and those that are identified as A+ founders, for as long as you possibly can. Managing a growing portfolio of software tools is challenging – the more experienced “hands on deck” you have, the better. Eventually the founders will want to transition out of the company, but the longer you can keep them incentivised to stay, the smoother the integration will be. Use deal terms and other equity incentives to keep founders aligned with the growth ambitions of the software rollup, and provide founders with a defined role post-acquisition as part of the closing process to make sure they are focused on what they need to do and what they get for doing it. 

Insight #4: Too Many Small Acquisitions, Too Quickly

What happened?

Integrating dozens, in some cases literally hundreds, of small brands into one portfolio is as difficult as it sounds. The complexity involved in managing thousands of SKUs has proven to be challenging.

Note that the aggregators’ race to acquire as quickly as possible in 2021 was driven by their investors, many of whom viewed the environment as a race to achieve scale as quickly as possible, taking the stability of the acquired brands as a given. This approach caused a number of Amazon FBA aggregators to acquire too many brands, too quickly, while lowering their acquisition criteria and paying too much for targets that didn’t meet their ideal brief.

This is despite the fact that the total addressable market of acquisition targets for the Amazon aggregators is enormous: there are almost 2 million third-party merchants on the Amazon platform. SaaS acquirers have far fewer potential targets, so the risk that competition will force up valuations (or force acquirers to start looking at businesses that don’t meet their criteria) is even higher. However, they should resist the temptation to acquire “at all costs”.

Lesson for software rollups

Focus on quality over quantity. If deals are competitive, don’t be tempted to lower acquisition criteria in order to hit goals – better to bid strongly on the assets that best fit your criteria. 

Sound diligence is key. Fixing a bust deal – particularly for legal reasons – is an expensive, time consuming and emotionally draining exercise. Think about all factors when deciding on acquisition targets and ultimately whether to close. In extreme situations, don’t be afraid to walk away and allocate the capital to another target with a lower risk profile. 

Insight #5: Target Selection

What happened?

Hindsight is 20:20 so it is easy to criticise retrospectively. However, most Amazon aggregators can now list several brands in their portfolios that they would not acquire, given the chance again. They have faced criticism from some quarters for buying products rather than brands, not being focused enough on defensibility and intellectual property, and being too category-agnostic rather than specialising in specific categories. The aggregators’ evolving acquisition criteria suggest that many of them have come to agree. 

Naturally luck plays a substantial role in this too – consumer behaviour can be difficult to predict, and the performance of a particular category or a particular brand within that category can frequently surprise, both to the positive and the negative. 

Ultimately, a combination of intrinsic and extrinsic factors caused some of the aggregators’ acquisitions to underperform relative to expectations. A degree of underperformance is inevitable and the diversification that their business model allows is one of its strengths. But their success is determined by the aggregate performance of all of their brands. Most aggregators would state that in retrospect, they would have made different acquisition choices, especially in the first year.

Lesson for software rollups

It’s impossible to know the future and it’s extremely difficult to make every acquisition a home run success. But where possible, taking the time to develop more confidence in a business before deciding to acquire it will pay dividends. If you intend to specialise but have not yet chosen which vertical/s your rollup will focus on, deciding this sooner rather than later, where possible, will obviously enable more of your acquisition choices to be in line with the ultimate strategy.

Insight #6: Platform Risk

What happened?

One of the strengths of the Amazon FBA aggregator model is the fact that the targets are all operating on the Amazon FBA platform, enabling some uniformity in operations and in many cases completely removing the need to manage functions like fulfilment. However, relying so heavily on one platform comes with risk: both from changes that affect Amazon, and changes made by Amazon. Over the last two years Amazon’s fees for both advertising and fulfilment have risen substantially, squeezing margins for third-party sellers across the board and demonstrating the risks of channel (or platform) concentration.

Lesson for software rollups

Specialising has advantages, but be aware of concentration risk if a large portion of your portfolio is dependent on one platform. The same is true of a single customer, a single sales channel etc. too of course.

Insight #7: Not Maximising Synergies & Efficiencies (Yet)

What happened?

Most of the Amazon aggregators have not yet fully leveraged the potential synergies that are available between their brands. Most report that while there are substantial revenue and cost synergies to be realised, they have not come close to fully exploiting these, having been busy with other priorities.

Lesson for software rollups

Sharing best practices from each acquisition across the organisation, rinsing out cost and revenue synergies – while obvious, these benefits are not always achieved quickly post-acquisition. In an environment where new acquisitions are constantly being added, taking the time to leverage these benefits is not always the highest priority. Software rollup companies should be aware of this risk and seek to mitigate it.

Insight #8: Despite These Challenges, The Model Works

What happened?

An encouraging fact is that, despite all of these issues, the Amazon FBA rollup model is working. A small number of these firms have reached net profitability already, which is impressive given the challenging environment. Many others report that they are profitable at a contribution margin level and only need scale and greater efficiency to reach breakeven.

There is a lot of variance among the aggregators’ fortunes and inevitably there will be more failures, but that is to be expected in any fragmented industry. In a sector that has experienced the roller coaster of fortunes the Amazon aggregator sector has, a higher degree of failure than normal would be expected, but so far this has not played out. These are diversified businesses in an industry with a natural underlying growth rate (e-commerce penetration in the West continues to grow at pre-COVID levels). They have far more expertise, and data, than they had two years ago and are starting to leverage this. If their investors give them sufficient time, many of the FBA aggregators will become sustainable businesses and some will achieve good exits.

Lesson for software rollups

This lesson is a positive one. The early stage SaaS market is more diversified than the Amazon FBA sector and is not exposed to the same risks (although acquirers who focus on SaaS a particular sector clearly face some industry-specific threats). Gross margins are far higher for software companies so net profitability obviously grows much more quickly as these businesses scale. There are many challenges of course, but if the model of rolling up small targets has worked in the Amazon FBA sector despite an extremely tumultuous few years, then it will certainly work in the SaaS space.

Key Takeaways

• Since 2020, ~100 ecommerce aggregators have raised over $16B in capital, most of it deployed in the acquisition of Amazon sellers. The industry is now in rationalization mode, as evidenced from mass layoffs, mergers and debt restructurings 

• While the software rollup industry has not (yet) attracted the same level of hype, it is on an upward trajectory, with both talent and capital (some speculative) pouring in. The winners will surely heed the lessons from the FBA mania

• These lessons include: overestimating the persistence of the COVID tailwind; a combination high leverage and high overhead; operational expertise lost due to founder attrition post-closing; lots of small, low quality acquisitions made amidst the rush to deploy capital; the flipside of specialization is the reliance on a single platform / ecosystem – which can turn on a dime; and and not front-loading synergies efficiencies

• Despite the widely-reported challenges faced by the Amazon aggregators, the model is not a failure. Many of these firms will build sustainable businesses and some of them will achieve good exits. If acquirers of early-stage SaaS businesses avoid the pitfalls experienced by the Amazon aggregators, while leveraging the benefits inherent in their model (software vs online retail), their future will be bright indeed