Whether you’re selling an online business or you're in the market to buy one, putting a value or price on the enterprise is often the trickiest phase of the project.
Upon first glance, an online business may not appear to have a clear set of assets to evaluate. But dig a bit deeper into any substantial online business and it will become obvious that there is more to take into consideration than the domain name and the website.
At this point we’ll go out on a limb and state quite clearly that there ought to be no difference in the valuation method used for an internet business and a traditional ‘bricks and mortar’ business. In fact, there is often a tangible ‘bricks and mortar’ business behind the scenes at an online company. At the very least there will be someone managing the business, incurring real costs in the process. There may be staff at the same location, or spread out geographically. If it is an ecommerce business selling non-digital goods, there will be stock if it’s not an affiliate site; there will be a fulfilment operation somewhere, either owned or utilised on a contractual basis.
The distinction between a traditional business and an internet business is gradually fading. Who doesn’t have a website these days? That company that went bust last week! All businesses will ultimately be technology businesses in the future.
Businesses seem less tangible viewed from a mobile or PC screen. But they may well have a significant infrastructure in place. They may also have valuable proprietary intellectual property. But as with any business, you need to spend time sifting through accounts and statistics to ensure you are getting what you want and that you are paying or receiving a fair price for it. Business valuation has been called a black art for the reason that you’ll seldom get two identical valuations.
But by and large, advisers (accountants, business brokers, corporate financiers etc) will use two valuation methods, the Market Approach and the Discounted Cash Flow approach.
A third, the Asset Approach, looks at the balance sheet of the business and subtracts liabilities from assets to give a residual value. But the problem with this approach is that not all assets are recorded; usually only those that have been paid for. This method is usually reserved for larger, asset-rich businesses.
A fourth method, Entry Cost, is a derivation of the asset approach and asks this question: ‘How much would it cost us to create this business from scratch?’ implying that anything less than the answer represents a value proposition. This intrinsically takes into account the intangibles, including IP and is favoured by firms looking to expand quickly into foreign countries. But it is also used by entrepreneurs who want to set up a website quickly to address a market demand, where the price of the target online business is less than the cost of creating one from the ground up.
The first popular valuation method is the Market Approach. Simply, what are other similar businesses actually selling for? This looks at the real marketplace to give you a ‘going rate’ for your type and size of business. I mention size because it is a fact that the bigger a business is (by sales or profits), the higher the value of the business relative to its size. This is true up to a level that is way beyond the size of business you will be looking at. A price earnings (P/E) ratio for a business with profits after tax of £100,000 might be 2.5, giving a price earnings valuation of £250,000. A price earnings (P/E) ratio for a business with profits after tax of £10m might be 9, giving a price earnings valuation of £90m.
You can do this comparative value research yourself, but you may need the help of an adviser who has access to deal transaction data. Some industries have different ‘rules of thumb’ valuations based on particular factors. Examples include EBITDA, sales, barrels of beer consumed per annum, No. of mobile airtime customers. Buyers of web hosting companies use sales as a factor (as the industry is relatively standardised and costs are a known commodity), currently valuing at between .8 and 1.4 x annual sales.
The second method, which may also be used in conjunction with the first, is the Discounted Cash Flow (DCF) approach. This is a technical approach that basically states that a company is worth all of the cash that it makes in the future. Cash flow is ‘Discounted’ because cash far in the future is worth less than cash in the hand today or expected tomorrow. In previous articles we have given detailed examples of how DCF valuation is calculated, so we won’t go into specifics here. Just be aware of it as a valuation method and that it is very useful for larger internet business valuations where it is not possible to get comparative deal data. A key factor in deciding whether to use this approach is to what degree are you confident that the profits, or cash flows, in the following few years will match the forecast and/or the profits of the current and previous years.
If the target business is very small, perhaps run by an individual, predicting cash flows is just as important. However, because the numbers are smaller, and the fact that the owner often writes off personal benefits as business expenses, something called Seller’s Discretionary Earnings is often used. Basically, this is all the profit and wages paid to the owner combined with the value of any perks (i.e. portion of mobile phone bills, personal fuel paid for by the company etc). Add back in any depreciation and amortisation costs. A multiplier is used on the SDE, often averaging the last year, current year and next forecasted year) to estimate the business value. Right now, we’re seeing SDE multiples of between one and two for small online businesses.
Here are some practical tips to help smooth your journey of buying an internet business.
Tip 1. It might seem obvious, but get a real figure on actual cash received by the business in the last year and for the current year. Plot it by month, look at the trend. What’s the cash forecast for the next year? Don’t be fooled by the buyer to pay a price based on ‘potential’.
Tip 2. Where does the web traffic come from? Ask to see the web analytics account for the business. Ideally you want to see a broad range of referrals from the major search engines and other sites. Is there one site that has been passing across a particularly large amount of traffic? Look into it – it’s not an uncommon practice amongst ‘site flippers’ to artificially build traffic before a sale, leaving you wondering what went wrong as you look at a flat-lined visitor graph the day after you transferred the money. If they used email marketing, where did their lists come from and have they been spamming?
Tip 3. Examine market trends and externals. Don’t buy on the backside as NewsCorp did with MySpace, buying for $580 million in 2005 before selling to Specific Media in 2011 for just $35 million. Social media was on the up, but MySpace failed to keep up with market and technical trends in order to keep itself current. The early signs were not picked up by NewsCorp. Current performance does not necessarily translate into future performance, so examine trends and other external factors that may affect the business you are buying into. You may see a profitable e-cigarette business on the market and think, “Hey, that’s a good deal. I’ve looked at the market and it’s growing by the month!” But sellers are usually not fools and in this case may want to exit the market before legislation hits in 2016 that reclassifies these products as medicines.
Tip 4. Have a techie on board to examine the programming on the web site. Is it open source? If not, are you buying the rights to the code? Is it a mess that needs thousands spent on it to re-code? Is there someone who has worked on the site available to do some work for you as the new owner? What is involved in switching the card processing over?
Tip 5. Never take the word of the owner when they tell you the business only takes them four hours a week to run. Understand everything there is to know about how the business operates. Call a sample, or even all, of the customers up before you buy the business – use the pretext of a survey if you have to – to gauge the current level of satisfaction. You don’t want to be paying for customers that are about to leave.
Tip 6. All businesses have a culture – make sure you fit. Don't make the mistake of thinking that just because a business predominantly operates online, it has none of the traditional office issues to deal with. Even if workers are based remotely, they are still there and how they operate will have an influence on the future profits of the business. Talk to the staff, make sure you are all working to the same plan and that they are happy, especially key people.
Choose your online business with as much diligence as buying a house or choosing a life-long partner. You may end up spending more time with your business (!) and remember, businesses are easier to get into than out of!
Turnkey shopfitting specialists providing a complete package with services including consultation design (2D 3D visualisations and walkthroughs) procurement contract management joinery manufacture and installation of all elements. The company operate...
This well known and successful business, set up over 38 years ago, provides a comprehensive workshop service for motor vehicles/cars and light commercial vehicles and within the busy Surrey and South East region and has been in the current vendor’s o...
LEASEHOLD
The company specialises in producing furniture from a wide array of materials, allowing it to act as a one-stop shop for private and commercial clients. Operating nationally, the company caters to 20 active industrial and commercial clients, all of w...
LEASEHOLD