What sellers need to know about valuations

What sellers need to know about valuations

There is no shortage of motivated buyers on the lookout for great online businesses. While the stock market is highly volatile, there is increasing enthusiasm for investment or purchase of online businesses. So, the potential appetite for buying is enormous. However, by far the major brake on buyers committing to a final purchase decision is their uncertainty about pricing. There is little understanding of sound valuation principles and buyers are wary of what they see as pricing based on an arbitrary multiple of net profit. Not to put too fine a point on it, buyers believe that sellers generally over-value their businesses and they find it hard to define a reliable and objective valuation method. The outcome is that too often an enthusiastic and highly motivated buyer fails to follow through with a final purchase because of the understandable anxiety about paying more than the business is worth.

How to value an online business

Typically with an online business, there will be little or no inventory to value and only a very limited if any physical asset base. Accordingly, the business will generally be valued almost entirely on the projected profits, calculated on the basis of current and relatively recent past profits.

While there are various alternative techniques for valuing an online business, including the traffic valuation method for sites with high traffic as a business asset but with no or incomplete monetization, many of these methods are highly technical and yield disputable outcomes. They are often suitable only in highly specific situations, depending on a precise definition of the particular revenue model, current and projected OR you are the next Facebook which is highly unlikely.

For that reason, online businesses are almost always sold on a negotiated value based on an earnings multiple or a price to earnings ratio. While it is very common to define the ratio in terms of a multiple of average net monthly profit, it is simpler for most purposes to quote the ratio as a multiple of annual net profit. Using this basis, average asking price multiples have increased from 2.4 in 2010 to around 3.4 now (sourced from our good friends at Centurica), with final selling prices typically at around a 10% discount to the asking price. This suggests that generally speaking sellers who value their businesses realistically can expect to achieve a sale outcome within reasonable range of the asking price. But putting a realistic value on the business is complex and there is an understandable tendency of business owners to over-value their business.

The average net profit multiple varies markedly from one kind of online business to another and also depends greatly on the specific market niche. However, the absence of highly consistent profit ratios can cause buyers to be both surprised and sceptical about the valuation proposed by a vendor. On objective grounds SaaS and e-commerce businesses sell for a significantly higher profit multiple than content-based or media businesses, because of the higher reliability of recurring income in the former models and the generally much higher operational time demands in the latter cases.

As an example, a currently listed relatively small SaaS business (not on Flippa) with a claimed $55k net annual profit has an asking price of $250k, a hefty earnings multiple of 4.55. You would expect that ratio level to make any buyer hesitate. Let’s assume it doesn’t have rocket ship growth (doubtful because they are selling) a buyer simply will not pay that amount.

Vendors who are seeking to sell at an earnings multiple above the prevailing average need to factor in the understandable buyer nervousness and be sure that the audited income and expenses figures are going to stand up to serious interrogation. While there is never an absolutely guaranteed success in any investment decision very few buyers overall, and virtually none in the six and seven figure range, are interested in taking a wild gamble on getting value for money.

The valuation factors that buyers will weigh up

Because it goes without saying that buyers generally regard sellers’ asking prices as inflated, it’s important that the vendor has realistically priced the business having regard to all the considerations which the prospective buyer will be factoring in.

The income figures must be accurate and cover the duration of the business operation, including only those income streams which will fully transfer to the new owner with the sale. Gross and net income trends will be crucial to the buyer’s assessment. All expenses must be transparently declared in detail, including all payments made to service providers and suppliers of goods and expertise. It is vital to new owners that they will be able to maintain all of the necessary business operations within the same cost structure, or ideally achieve some savings where possible. Any outstanding expenses or other debts transferring with the business obviously must be declared.

Absolutely all operating expenses need to be disclosed, not disguised, by the seller and discoverable by the buyer. Often overlooked, the full value of any unpaid work which has been invested in the operation of the business will be accounted for in the buyer’s own valuation of the business. The predicted cost of the new owner’s time, and any specific technical expertise required, will significantly affect the buyer’s business valuation. It is absolutely essential to the prospective buyer to be able to rely on an honest declaration of the time and expertise required to manage the business, as the new owner will need to put a dollar value on this expense.

The prospective buyer will need to analyse all the financial indicator trends over the longest time frame for which the figures can be produced. Sources of customers and the cost of gaining them will be important factors for the buyer, as will the effects of any changes to attracting traffic such as Google algorithm changes or even penalties which may affect search traffic.

The buyer will need to assess how competitive the niche is and whether there are barriers to the entry of competitors, which raise the business valuation, or the likelihood of increased competition in the absence of any significant barriers to entry, which will lower the valuation. It is crucial to the buyer to ensure that any licences required are fully transferable, or readily obtainable by the new owner, and that any branding, trademarks or other unique advantages will transfer with the sale.

The seller needs to appraise the business through a buyer’s eyes

The seller will be keenly aware of the time, energy, money and vision which has brought the business to its current status and positioned it for a successful sale. Naturally the vendor wants to achieve the highest possible price. However, seller over-valuation is the prospective buyer’s biggest turn-off. It really enables the sale process if the current owner evaluates the business using the same valuation indicators that the buyer will be applying.

It is worth mentioning that some buyers will apply a discounted cash flow (DCF) measure in their valuation. This is a somewhat less relevant consideration in an era of low inflation as at present, but put simply the principle is that a dollar of profit now is worth more than a dollar will be in the future, so a formula is applied to compensate by lowering the notional future profit value, given that the buyer will be paying in advance the equivalent of some years of projected net profit.

The bottom line for the buyer is that the online business acquisition must be fully transferable, it must be sustainable, it must have scalability, and above all it must be purchased at a reasonable earnings multiple. While it is still relatively unusual for an online business to be bought using funds from an institutional lending source, lenders may place a ceiling on the multiple, determined by the actual business model and specific market niche.

Overall, to achieve a reasonable pool of potential buyers interested in undertaking onerous due diligence and finally negotiating a fair sale price, sellers need to keep their initial asking price close to buyer expectations. Avoid ambit claims with the view that eventually you will negotiate down. The process of carefully considering a purchase is time-consuming for the prospective buyer. The factors outlined above will determine where the buyer expectation sits in terms of an earnings multiple. There are so many variations in play that the ratios will vary between around 2 and 4. There would have to be exceptional circumstances taking a selling price outside this already wide range.

Know exactly why you have decided on your own seller valuation, and understand what the buyer will be factoring in. Your initial asking price should not be more than 10% higher than you believe on reasonable grounds the buyer will consider fair after all due diligence and consideration of all the factors covered here.

It is very clear that a reasonable seller valuation is always the key to a successful sale.

 

Why buy an online business if you can build it from scratch?

Why buy an online business if you can build it from scratch?

Many potential buyers ask themselves this question when they are considering the seemingly high cost of an online business purchase. The average monthly net profit multiple is affected by many different factors, but as a general guide the purchase price is usually around a 30x multiple. As a simple illustration, an established online business generating a dependable monthly net profit of $10,000 will typically sell for around $300,000.

This multiple equating to, in some cases, as much as three years of the foreshadowed profit naturally causes buyers to pause for thought. Why not invest a much smaller amount building a business in the same general niche from the ground up?

It’s a lot to do with time

Yes, the short answer is time, in two different senses. Firstly, there is the significant period involved in building the business from scratch given the basic requirements for clarification of the niche and precise product or service focus, establishment of the site, the creation of content, the development of relationships and formal agreements with suppliers and content creators, the building up of a critical mass of customers or subscribers and the attainment of a recognised brand presence with a reputation of trust. During this lengthy establishment period there will still be significant outgoing investment, although obviously lower than the alternative of a straight-out purchase price, and with initially little or no cash flow in return. Secondly, the establishment phase will also require an enormous input of the developer’s time on which it is essential to place a dollar value. This valuation will depend, of course, on the individual circumstances of the business owner. For investors whose time is scarce or of high value if deployed elsewhere, then starting a business from scratch makes no sense at all – unless the vision for the business is highly original with virtually no existing equivalents.

Advantages of buying an existing business

By contrast, there are numerous advantages to buying an established business. Provided the business can demonstrate reliably audited income, expenses and net profit figures, along with levels and sources of traffic, then there is proof of concept from the outset of the acquisition. This certainly doesn’t apply to any totally new business, regardless of the level of confidence the developer may be feeling. An existing business when acquired should come with the primary domain, all files and codes including product or service codes, transfer of agreements with product or service suppliers including content producers, verified email accounts of customers or subscribers, and marketing methods including social media accounts.

The expertise of the seller as support during the transition period should also be part of the purchase agreement. If an earn-out provision is negotiated this will provide additional confidence in the viability of the underlying business performance and in the continuation of the seller’s active support for the agreed period, as well as somewhat reducing the payment required outright at the transfer date.

Barriers to success if building from scratch

Unless your online business concept is genuinely very highly differentiated from existing businesses in the space and you believe on reasonable grounds that it will meet a significant unmet need or want, then it makes little sense to invest some of your money and more importantly enormous amounts of your time to build the business from scratch. There may also be significant barriers to successful entry into existing niches. ‘Copycat’ barriers are largely informal but nevertheless effective through searches favouring established businesses and those with existing agreements or affiliations with the larger service suppliers. Industry registration standards and other regulations or terms of service agreements can effectively put a moat around well-established online businesses against which you would be attempting to compete, so that it becomes more difficult to simply enter the field and replicate their offerings.

The only good basis for building an online business from scratch is that both of these two following conditions apply. Firstly, the concept is unique and not simply an emulation of an existing successful business. Secondly, you are confident that you have the expertise and most importantly the time to build it. The actual cost of this time, which could be spent on alternative pursuits, needs to be realistically valued. If your primary reason for building a business from scratch is that you simply cannot afford a purchase, then it’s important to ask yourself whether you can afford the long hours, the delayed cash flow at the same time as the necessary establishment costs are invested, and the perhaps exciting but nevertheless highly stressful processes of establishing your website and systems, sourcing product or service inventory, developing a customer or subscriber base, creating business relationships, developing fulfilment systems and building a brand and its social media presence. Sure, it’s initially a lower financial outlay but a massively greater time and effort investment, with little or no cashflow for a prolonged period and no guarantee of success.

The case for buying

On most counts it’s clearly better to buy than to build from scratch. And of course this doesn’t exclude building further on the existing business performance so that the asset continues to grow in its eventual resale value. If feeling a little daunted by the seemingly high purchase price of an established business, never overlook what is taken for granted by traditional investors: it’s the potential capital gain value on eventual resale which is as important as the regular profit returns. Additionally, while a greater outlay is required for buying than for building from scratch, a financial loan if required is generally much easier to source for an established and proven business than for a new and unproven online business proposal.

As always when buying any business, whether traditional or online, doing the due diligence is essential. It’s not just a matter of checking on the revenue, expenses and profit figures. It’s equally important to thoroughly evaluate the agreements and systems already in place. It may be difficult or even impossible to change unfair agreements or inefficient systems which are in place once you have taken control of the business. So, ensuring that the level of control over change which you will have is sufficient for your plans for the future is a vitally important detail, although one which is often overlooked in the intense excitement of an online business purchase. Just a little extra time invested here will allow you to sit back and enjoy your income stream and future capital profit with confidence and, if you wish, little ongoing time demand after settlement and transfer is completed.