FBA Aggregation Model: How to Make a Problem Harder

There are two major flaws in the FBA aggregation business model:1) replacing hungry entrepreneurs with hired guns not incentivized the same way; and 2) a focus on “Goldman Sachs” like financial engineering that makes the numbers look good on paper while not really improving the business’ performance. In my previous bite-size 5-min read I focused on the first one. Now we will talk about the second one and how it makes the first one far harder to resolve. 

If you want exhibit "numero uno" of what a Goldman Sachs like focus on financial engineering looks like, you don't need to look further than the laughing stock that is WeWork. It took in $23B (yes billion) in funding, has a market cap (as of this week) of $1.4B and continues to burn through billions of dollars every year. The entire company is worth about 5% of the total funding it received! In fact, the company had negative cash flow of $4.3 billion from July to September this year, per The Wall Street Journal. But Adam Neumann walked away with almost a billion dollars along with several other insiders who did very well. On some level, it's an impressive legal hustle! 

Side note: Unless you like overpaying for cheap kombucha, you can rent much nicer co-working spaces elsewhere for a fraction of what WeWork charges for its spaces (with real walls not useless glass walls with no privacy) and buy your own higher quality kombucha more cheaply at your local Costco with the money you save. 

The FBA aggregator business model is, in its purest sense, a financial play. You might see claims to be tech companies... but WeWork made the same claim ('nough said). They're not technology companies in any sense of the word (caveat emptor if you don't do your due diligence). The business model is faux-private equity that uses borrowed money (either equity or debt) to purchase a business and scale it up. The only difference is they are buying successful businesses (not distressed ones) and they are - theoretically - pouring expertise into those businesses instead of cutting (bloated) costs. This is where reality says adios to theory and where we will discuss how the FBA aggregator business model makes a problem harder.

The problem was highlighted in the previous article: an aggregator buys a successful business and the founders of those businesses leave with the most valuable thing about the business: the experience and knowledge gained in growing the business and truly understanding the product segment. The aggregator replaces the founder with its own employees. The theory is seductive: The typical FBA brand founder is smart, hardworking but not an expert in marketing, supply chain, logistics, technology, product, design and so on. And no matter how smart or hardworking, there are only 24-hours in a day. The FBA aggregator will scale up the brand because its employees are experts in those areas and because the aggregator can afford to spend more on those areas in both time and money to achieve a better result. 

The theory is wrong. First, being an expert in marketing from years of doing it does not immediately translate into expertise in marketing the brand just purchased. It's like 20 years of experience in technology will not suddenly make you an excellent choice in coding Infrastructure as a Service (IaaS) in Terraform. You will know the right questions and how it should work... but not how it actually works. The aggregator can build up that experience but that takes time and money. Second, more people does not translate into better results. This fact is the genesis of Amazon's "2-pizza" team rule for effectiveness in managing a product (a discussion for another time). The replacement of 1-2 brand founders with a team of employees has another negative side-effect: decisions take a lot longer and cost a lot more money in salaries.

So, for at least a period of time the aggregator will struggle to manage the brand effectively as it tries to re-gain the experience and knowledge that left with the brand founder. This is where the second flaw (i.e., a focus on "financial engineering") makes a hard problem even harder. 

Consider that in purchasing the successful brand you had to leverage it with debt at a 3 - 6x ratio to its EBITDA. Let's assume you are ambitious and want to get to $100M in revenue for your FBA aggregator in 12-months with a 20% profit margin. All you need to do is find enough borrowed cash to do 10 deals at $10M in revenue with the entire pool averaging $2M EBITDA per deal... but buying those FBA brands will involve spending $8M per deal if we assume a 4x multiple. Now you've loaded up the entire portfolio of brands with $80M in debt (you'd avoid debt if you use equity but that would leave you with no cash to invest in your own employees and no cash to invest in scaling the brands). That is a lot of debt to pay down and make a profit for your equity investors while still investing in the brands to scale them (e.g., investing in hiring those experts you need as employees, investing in new products for those brands, investing in new marketing and creative, and on and on).

When the Federal Reserve was giving away money for free at essentially 0% interest rates, you could take on lots of debt and it would not matter. But once interest rates started to rise towards 5% and counting, that $80M in debt on $100M in revenue and $20M in EBITDA starts to look like a real anchor around your neck and it gets much harder to do debt financing as well. So, if your DNA is Wall Street what do you do? You start cutting costs and this is what you saw initially at FBA aggregators like Thrasio in May 2022. They will not be the only one or even the last FBA aggregator to do the same. 

Notice from this (somewhat dated) news article that the major backers of the largest FBA aggregators are a "whose who" list of Wall Street players (e.g., Goldman Sachs, Deutsche Bank - apparently they found time to invest in something other than Jeffery Epstein, Softbank - which is a sure sign of catastrophe, and so on). FBA aggregators led by Wall Street will natural revert to their learned behavior, which is to focus on financial engineering (e.g., WeWork gimmicks). Later on we will highlight how businesses led by seasoned technology entrepreneurs will handle the situation very differently - using both Thrasio (an FBA aggregator) and Flex (in logistics) as examples of "what to do" if you want to be successful (hint: think counter-cyclical).

Cutting costs at the same time that you lost the valuable experience and knowledge from the brand founders is not a recipe for success. But it gets worse. Remember that the entire FBA aggregation business model depends on an important premise: you can do better than the brand founder by pouring in expertise in every component of the brands' business value chain (e.g., marketing ,supply chain, logistics, technology). But that expertise requires... money. And very good expertise requires... a lot of money. There are ways around this of course like hiring cheaper talent (e.g., less experienced or based in cheaper geographies) but cheaper comes with tradeoffs and in some areas like technology, cheaper is still 6-figure salaries. But even in cheaper geographies you still can't avoid the basic math that an FBA aggregator replaces 1 - 2 brand founders with an army of hired talent (and that army will in aggregate cost more than the founders replaced) that has far less experience running the acquired brand than the founders (and will take time to gain it). 

So far I've distilled my thoughts on the FBA aggregation business model around the negatives. But it's not all negative. There are strengths and there are strategies that I suspect will lead to success. So, in the next installment I will circle back to expand a little bit on where I see changes to the FBA aggregation business model would yield improved results. 

Part 1: Flaws in the FBA Aggregation Business Model

Part 3: Cheap Replaceable Products Don't Make for a Happy Aggregator!