eCommerce entrepreneurs often ask me what profit multiple they should use to calculate their business value. Profit multiples are a valuable tool to find a direction or a range of selling price but you can’t rely on them to determine exact value of your business. You will regret if you simply use rules of thumb profit multiple to calculate the selling price for your eCommerce business. If I get a call from an internet entrepreneur asking me how much he can sell his business for if he was making a net profit of $X a year, I would not be comfortable giving him a valuation without having a discussion and getting more information about the business and how net profit was calculated.
Before you begin to apply any rule of thumb to calculate the value of your company, you must first look at the viability of your ecommerce business in the future. You were doing great when you started your business 6 years ago because no one else was selling the products you sold. You were unique and it was easy for your customers to find you in search engine results. Not so lately. For past couple of years, hundreds of internet stores have mushroomed that sell the same products that you do and at prices that are unbelievably low. You are forced to lower your margins to survive and as a result your business is trending down. It is getting more and more difficult to get noticed in a crowded internet space with large online retailers like Aamazons and eBays of the world. If you feel this applies to you, you are not alone. Three in every five web based business I review are affected one way or the other due to dwindling economy and increasing competition. Financials are a representation of the past and only give a possible indication of the future. Your business must have some uniqueness to it so it can survive successfully in a highly competitive internet space. Your revenue and profit numbers over the years tells a lot about viability of your business and buyer look at them first to filter those that do not fit their expectations.
When using rules of thumb to arrive at value of your company, it is important to arrive at an accurate profit number, also known as Sellers Discretionary Earnings (SDE). Usually this number is arrived at by adding business’ taxable income ( EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization ) plus the owner’s benefits and discretionary expenses charged to their business (owner’s salary, write off of a company car, health insurance, country club membership, boat, contributions, any personal expenses hidden under various expense account etc.) – the resulting number is typically very much larger than the company’s taxable income or net profit shown on a P & L. Any non-recurring one time expense can also generally be added back. In addition, if you have any income that is not reported on your P & L statement should also be added back (e.g. payments made by check or money order that you forgot to include in your P & L). This SDE, when multiplied with industry specific rules of thumb multiple will give you a selling price that you adjust based on number of other factors discussed below.
Another observation – If you are in early years of growth and you have increasing revenue year to year but you are investing all of your profit back into your business to grow it, you may not show positive bottom line but your business may be the best investment buyer can make. That is why such one-time expenses done to grow the business (e.g. purchase of an order fulfillment or inventory management software) can be added back with appropriate explanation. Many “first-time” business buyers who are in the market to buy internet businesses are sometimes too much possessed with the net profit number and you can’t always assume that they will appreciate the difference between operating expense and such one time expense.
Most businesses are valued at a multiple of SDE and adjusted up or down based on factors that affect the value. This is more an art than a science and this is where you need help from an experienced intermediary. Examples of factors that bring business value up are increasing sales/revenue, profitability, repeat customers, having B2B and B2C clients, solid natural search engine ranking and page rank, strong face book and twitter following and referrals, higher back links, strong market position, existing long term contracts, seller’s willingness to finance some portion of the purchase price (shows seller confidence) and upside potential for business. Businesses that can be run without too much involvement from the owner also demand higher price. Some buyers also have preference for drop ship business because they don’t like to manage inventory. Factors that bring business value down are declining revenue and/or profitability, increasing competition, declining Google analytics (i.e. unique visitors, lower conversion rate) lack of longer history (i.e. newer business) , increasing Google Adwords expenses to maintain the revenue, lack of natural search rankings, lack of owner financing and lack of well maintained books etc.
Before sharing multiples of SDE that applies to eCommerce businesses, I would like to emphasize that it is important to note that size matters. Amazon stocks (NASDAQ: AMZN) trade at 86 times the earnings – will you be able to sell your business at that multiple? You know the answer and answer is “No”. So, how much does a size of a company affect its valuation? “Significantly” – as it turns out. Larger companies have strong brand name, higher liquidity and are considered less risky. It is easy for them to obtain financing and they enjoy higher multiples. Using data from a study of thousands of small business sales across different industries: average SDE multiple for companies up to 1 million in revenue was 2.2, and for companies with revenue between 1 and 5 million was 2.9.
As it turns out, data for internet business sales is not all that different from the overall “main street” businesses. From a comparison of 2009 internet biz sold data we have, for businesses with SDE of 200K or more were sold at an average multiple of 2.18 with a mode of 2.9. That number for businesses with SDE between 100K and 200K was 2 with a mode of 2.65 (The mode of a set of data is the value in the set that occurs most often). Since some businesses were sold at exceptionally low ratio bringing the average down, mode is a number I would use as a starting point and adjust it upward or downward based on factors discussed earlier.
As per LoopNet Inc., one of the largest companies that tracks privately held business sales transactions, Business for sale market “closed” business transactions bottomed out in the third quarter of 2010 with sellers dropping asking prices to get the deal done and has recovered to a level not seen since the Second Quarter of 2010. The median sale price for businesses sold increased 3.3 percent from the First Quarter of 2010 to the First Quarter of 2011.
As you can see, knowing the value of your company’s worth is the first step toward maximizing your sell price. What questions come to your mind when you begin to value your business?