Buying a Web Based Business
Web Businesses for Sale
The lure of web retailing is strong and now there is a relatively large number of web based businesses for sale. Web based businesses have some important differences that must be taken into account. Fortunately, there are very easy ways to validate revenue, gross margins and monthly expenses. Most potential purchasers can gain strong visibility into the site, the technology, its customers, site visit statistics and it’s operations very quickly and easily. For non-technical purchasers, evaluating the soundness of the site’s infrastructure may be challenging. If your due diligence provides comfort in these areas, and you can confirm a net income and a sound operation, then you might offer one to two times net income for the business. In this article, I will explain how to conduct due diligence on a web based business, why it is only worth one to two times net income and why it may be better to start from scratch rather than pay any type of a premium to acquire a web business for sale.
Background
Today, there is an abundance of web based businesses in play. There are several benefits to evaluating web based businesses. At the same time, there are several important things to watch out for during you r due diligence.
Web based businesses are just like brick and mortar businesses, with the exception that many have focused on the Internet as a single market channel. Typically web based businesses have low barriers to entry. Relatively speaking, it does not cost a great deal to establish a presence on the Internet and begin offering products or services for sale.
The flip side of the low barrier to entry is that most of the web retailers are undercapitalized and find it difficult to earn reasonable profits from their web stores. Web based retailing is very competitive and like all businesses marketing, operations and execution cannot be taken lightly.
Getting Comfortable with Reported Revenue
When you are looking at a web based business, you must start by evaluating their cash flow. One of the big benefits of performing due diligence on a web based business is that most, if not all, of their transactions occur via electronic means. Most web stores accept credit cards and/or Paypal. Online retailers that are set up as real taxable entities must procure a gateway and transaction processor that links them to Mastercard, Visa, Discover, American Express and others. Paypal offers individuals the opportunity to collect credit cards as well as direct bank drafts. The value here is that the transaction processor will produce statements, both online and on paper, detailing every transaction that the web retailer processed. As a potential business buyer, you can have a clear view of all revenue the business produced by examining these transaction processing reports. These will provide you with a clear view of the revenue.
Next, ask to see the order logs from the website. Every order on the website should correspond to one of the transactions on the payment processor’s report. Be careful here. Many website do not have integrated payment processing capabilities. In other words, the web store may have a list of purchases made, but the transaction processor’s report has a much shorter list. Many sites create a “shopping cart” for the customer. The customer selects items and completes their cart. Some information is gathered from the web site’s customer and the total purchase price for all selected items is computed. The customer approves of the purchase. At this point, the website will mark this interaction as a completed order and assign an order number. However, the customer will get re-routed to a gateway processor, like Verisgn. Thus, the customer actually leaves the original site and goes to Verisign’s site. There Verisign, or similar gateway, will securely collect the customer’s credit card information and complete the transaction. Here is the important point. The customer can quit at the gateway’s site and the transaction will be invalid. In other words, the web store, www.buystuff.com, recorded a transaction, but the customer never actually finished the important part – paying for the items.
Many web retailers whose businesses are for sale will gladly show you their order logs from the site, but you must reconcile these with transaction processor’s reports in order to understand which transactions are real and which were discontinued.
Validating Gross Margins for the Web Business for Sale
Once you have determined that the business you are evaluating for purchase has a revenue stream you can be confident in, the next step is to determine the cost basis for the products sold.
Determining the cost basis for the products sold can vary based on the business model. There are two major ways the web businesses manage orders.
The first and very popular is drop shipping. Drop shipping usually involves a large distributor who agrees to ship out individual customer orders for small web retailers. These drop shippers will carry large inventories and provide catalog content to their web retailers. Web retailers will erect a site and post the content. As the collect orders, they will notify the drop shipper who will pick, pack and ship the items directly to the customer. The customer receives a package that indicates that the web retailer actually shipped the product and the web retailer pays a fee to the drop shipper, above and beyond the item’s cost to ship. If an item is $5 at wholesale, the drop shipper will charge the web retailer $5, plus another $5 to $10 as a handling fee, and another fee for the shipping itself. The cost to the web retailer is the culmination of all these fees, and they pass these along to the customer in their markup. The customer pays the web retailer and the web retailer pays the drop shipper. This is real common because it reduces the cost and the risk associated with buying and carrying the inventory for most small web retailers.
When evaluating a drop shipping based business, look for the distributors catalog and price list. Usually the item numbers are consistent between the retailer and the wholesaler. Take several months of transactions from the payment processor’s report and match them to the order logs from the web retailer’s site. Finally, match the cost of each item sold to the price the customer paid. Add in the cost per order of handling and shipping and you will have your gross margins. Usually, the drop shipper will charge everything to a single credit card for the web retailer. Thus, you can request that these statements be made available for you due diligence.
Drop shipping is common in industries where the products do not change quickly. More advanced web retailers will buy and carry inventory. This is more common is rapidly changing industries, especially items of a technical nature, like computer parts, digital cameras, etc. In the industries, the web retailer cannot rely on drop shippers, because the quantities of each item are fairly small and changing regularly. Thus, the web retailer will struggle to meet customer demand if he cannot be sure that he has in stock what the customer ordered over the web. The only way to be sure is to hold every item offered in inventory.
Inventory based businesses, whether online or offline can be evaluated in a similar manner. You need to determine whether the products in inventory are actually relevant any longer. You must also determine how often the inventory turns. In my opinion, inventory isn’t normally worth anything, because the business for sale is still a function of its income, not its inventory. One thing to keep in mind with inventory businesses is the cost associated with renting space for storage and paying all the utility and tax bills associated with the rented space. These costs are fixed and must be deducted from the gross margin. Many internet based businesses for sale often indicate that they can be run from one’s home, lowering the costs of running the business. If the business you are investigating requires inventory, you must determine if you have the space in your home to store the inventory or do you need to make ongoing investments in rental space and associated utility costs.
Care and Feeding Costs of the Web Business for Sale
At this point, you have become comfortable with the actual revenue stream and the gross margins of the web business for sale. In order to validate the monthly costs, you need to consider the following categories, including:
1. Costs associated with hosting the site. The range on these costs can be considerable as there are many alternatives to hosting. Some hosting solutions run as low as $5 or $10 per month, while others can run more than 1,000 per month. Be sure to get a copy of the invoice from their hosting provider and understand the options that the current owners are paying for.
2. Any costs associated with advertising the site. There are three major ways to bring traffic to a website, including:
a. The most difficult method is called natural search results. When someone goes into Google and searches for “grape juice” Google will return a list of web sites that have something to do with grape juice. The higher ranked sites will be closer to the top of the list. If the web business or sale you are investigating sells grape juice, you would want to be on the top of this list so that people searching for a place to buy grape juice would be most likely to buy it from one of the first few on the list. Interestingly enough, web businesses do not have to pay for high natural search engine rankings. Instead, it has to do with how the site is constructed, the format of its content and how many other sites it is linked to in a reciprocal fashion. Many web retailers struggle to gain high level search rankings, because mastering those three site characteristics is very difficult and the competition for those top spots is very intense.
b. Instead many web retailers “buy” their traffic by registering their site with Overture, Google or Yahoo. In other words the owners of the web business for sale may pay per click in a bidding fashion. If the web business sells ceiling fans they will register key words” with Overture of “ceiling fan.” The cost per click to get the search engines to present you maybe as low as 5 cents per click or as high as two dollars or more. In a category as popular as ceiling fans, a small web store selling ceiling fans may be competing with Target and Walmart for traffic interested in ceiling fans. Thus, the cost per click maybe $1.40. If the web store wants Overture to route people to their site when the search, they will have to be willing to bid more than $1.40 to capture that traffic and direct it way from Walmart to their site. A word of caution here. This can be a very expensive way to get people to come to the web store. When someone clicks on the search result for the key words “ceiling fans” and comes to the web business’ site, the web business pays $1.45, regardless of whether that consumer purchases anything or not. If one thousand people browse your site in a single day and no one purchases anything, which is very likely, then the web store will have paid out over $1,400 for nothing. Overture and other related services allow the web store to “cap” their total amount spent in a day, by allowing the web store to set a budget. All of these services provide a web site where the web store owner can review their key words, bids, competitors bids and traffic statistics. When evaluating this web business for sale, be sure to get the username and password for their bid placement engine and review it. You will find historical information, monthly costs, etc.
c. The third major way that web businesses increase their traffic is through normal marketing efforts, including paying other sites and/or other media types, including newspaper, magazines, television, etc. You will need to understand the current owner’s marketing plan and the costs associated with it. Understanding and evaluating all marketing efforts is critical in every business, but understand that with a web business, if there is no traffic there is no revenue. For example, if the web business for sale invests in magazine advertising and spends $100 per day with Overture, and they stop both during the sales process, then no one will ever find the site again. There are so many sites in the Internet and unless previous customers happen to remember the site’s name, no one will find the site without those investments. Unlike a brick and mortar retailer that may located on a well trafficked road, a web based business without these investments may be likened to a small store without a sign on a road closed for traffic in the middle of the desert.
3. Any software development customization or maintenance costs. The web business for sale that you are evaluating is most likely built on some sort of “shopping cart” technology. As the name implies, the shopping cart is used to collect the web consumer’s purchases and summarize the cost for “checkout.” Potentially, the look, feel, and operation of the site has been altered in the software code underlying it. If you, as the potential purchaser of this web business for sale are not capable of managing this software, you must calculate in the cost of making changes and/or maintaining the site.
4. Transaction processing costs. As a web retailer, you will forfeit between 2 and 3 percent of every transaction to the payment processors that allow you to accept Mastercard, Visa and other credit cards. In addition, the processors will charge a per transaction cost for each and every transaction, ranging from 20 to 50 cents per transaction, regardless of transaction type.
5. Other normal business expenses, including but not limited to, insurance, communication costs, payroll, etc. In many smaller web businesses for sale, you may find that not all of these categories are in use, however it is important to see their phone bills, payroll reports, etc.
Determining a Valuation and All the Things you Should Ignore
At this point in your due diligence on the web business for sale, you will have validated revenue, gross margin, and net income from operations. Now you are ready to assign value as a multiple of net income.
As a multiple of net income, I believe that web businesses for sale are not worth more than 2 times their net income. In most cases, I don’t think that they are worth more than one times their most recent year’s net income. This is a pretty radical departure from my normal to approach to valuation as 4 times the multiple of net income. Here is why. The web is a hyper competitive market with ultra low barriers to entry. Unless the web business for sale that you are evaluating has something particularly unique to its business model, it simply cannot guarantee 4 years of continued results. In fact, the web business for sale may not be able to guarantee more than a year’s worth of continued results.
So what is unique? Examples of unique behavior include:
1. Special and/or exclusive relationships with suppliers. Drop shipping manufacturers or wholesalers by their very nature are not exclusive, since their business model is predicated on serving many web retailers. However, if a site imports products from Indonesia and as the result of a childhood friendship, the web retailer is getting exceptionally good deal, then that would be considered a unique, competitive advantage.
2. Special and/or exclusive arrangements with customers. A web business for sale that has been running for three or more years should have an extensive library of customer information. They should be able to define repeat customers, how those customers find their site and how they behave while in the site. Most well run sites will have technology that allows them to analyze reports that tell the operator of the site everything about their customer interaction, including what search they used to find the site, what categories of products the customer browsed, what products were bought, etc. Web businesses for sale that do not have this information available are not worth buying.
3. The web business for sale consistently ranks at the top of the search engine results. I looked at one site that had ranked at the top of the search engines for a particular keyword for the last 4 years. The owner of the site clearly understood how to configure his site to maintain that ranking and could explain to me how to perpetuate that behavior. The only catch here is that the search engines, like Google, MSN, Yahoo and others are constantly adjusting the algorithm they use to scan the web, and the site configuration used today to gain top search engine ranking may not serve you well after a change. Maintaining top search engine rankings is a moving target and you must keep up. If you are relying on good search engine results for your traffic and one day Google changes their model, as they did about 2 months ago, no one may find you ever again. Revenues will go to zero. Scary stuff, but just another reason why web businesses for sale are not worth more than one to two times net income.
4. Domain names are an interesting point of differentiation. People continue to spend lots of money for coveted domain names. Sad, since you can register and unused name for $8 on Godaddy.com. Nevertheless, people continue to charge unknowing people for easy to remember domain names. Keep in mind that most people do not use domain names to find something on the web. With the exception Google, Travelocity, etc. most people simply use a keyword search to find what they are looking for. Unless they are actively involved in a site as c community or a constant reference, they typically scour the web for what they are looking for by typing in their search key words into Google, MSN or Yahoo. Now, domain names may become important for repeat sales. If I own dogbowls.com and someone purchases a dog bowl from me, than I would hope that my site sticks in their brain, so that the next time they go to buy a dog bowl, they come directly to my dogbowls.com. So, the domain name is important for recall, not the initial discovery of the site itself. So here are some guidelines:
a. Do not place value on a domain name. The most popular domain names you can think of are only valuable because they are heavily marketed in the mainstream media. Google, Yahoo, MSN and Travelocity were not names anyone ever heard of before they were marketed aggressively in the mainstream media. With a little creativity you can register a name with a site like Godaddy.com for $8. What you do with it after that is what makes the name valuable. While you may not be able to afford a multi-million advertising campaign to support name recognition you could instead follow up with emails to your customers, keeping your web business in the front of their minds.
b. Domain names that have been operated as a web business for three or more years are useful. After that amount of time and with careful search engine optimization strategies, it is likely that the site attached to that domain name is being “crawled.” In other words, the search engines are aware of the web site and scan it for its content on a regular basis in an automated fashion. The more content a site has and the more often that content changes increases the interest a search engine takes in a particular site.
c. Unless the web business for sale that you are evaluating is in the business of providing some type of infrastructure service, names ending with .com are far better than names ending with .net. biz, .info, .org, etc. The majority of people think .com, not .net. If you are asking your customers to recall your name, make it easy for them with a .com ending. Most people are not aware of .net endings and will tend to type your domain name with a .com extension. If they do not find you, they will not likely search any harder. They will move on. Save yourself the trouble and stick with .com domains. If this web business for sale operates under a .net name, even for several years, it would be best to pass on the deal.
d. There are various parasites in the world that collect names that have fallen off their registration. For example, if I registered the domain name whitephone.com and I fail to re-register after two years, there are companies that will snap up the site for $8 and then attempt to market the site for thousands. Sometimes, people will pay for theses sites. Don’t waste your money. Instead, be creative and find some terms that are relevant to your subject or industry and register that name for $8 on Godaddy.com or like site. In other words, don’t buy a web business with whitephone.net and then pay additional money for whitephone.com in order to improve recall. The new domain will not be registered with the search engines anyway and you are better off passing on the business.
If you determine that the web business for sale that you are evaluating has some unique point of differentiation and the current owner is willing to accept one to two times validated net income, then you may be on to something. You have two areas of due diligence to pursue before you are ready to purchase the site.
Concerns About Operations and Site Design for the Web Business for Sale
The first is order management and the second is site construction. Order management refers to how the orders collected on this web business get fulfilled. If the web retailer relies on a drop shipper, then they will likely copy the order information out of their site and into an email to the drop shipper. If they carry inventory, they will likely fulfill the order themselves. Examine this process closely. You may find that the amount of work necessary to keep up with the orders may not warrant the margins produced. If the site is producing $20,000 per year in annual net income and you have to work 60 hours a week to fulfill and/or coordinate the order fulfillment, then it may not be worth it if you can earn more doing something else. I have seen several businesses where the effort to fulfill orders simply exceeds the returns. This is especially true with sites that take orders that require customizing an item. If the web business itself does not manage the coordination, then it may become difficult to coordinate the customer and the supplier to complete the requirements of the order. One must evaluate whether the effort justifies the return. In other words, how efficient is this effort and is it worth the returns.
For those of you who are not technical, site construction may very well be the biggest due diligence hurdle. You need to assess whether all the features of the site are functional. In addition, you need to understand what customization was done and whether those changes were documented. This can be terribly difficult to do and represents the biggest risk factor for non-technical people. I believe that it makes sense to find an independent developer that understands what technologies the web business is using, including database, site look, shipping cart, hosting platform, etc. In a recent investigation, I contacted the developer of the shopping cart software to make inquiries into the functionality of certain features. I discovered that person selling the site did not actually own a valid license for the software. I also discovered that the customization had destroyed 2 critical functions within the shopping cart itself and that it would cost an undetermined amount of money to correct these problems. I passed on the deal.
Some Good and Bad Examples of Web Businesses for Sale
So here are a few examples, one of a promising site and one tragic site that I evaluated. The first site sold home accessories. The current owner of this web business for sale was completely forthcoming with his paperwork and validating revenue, gross margins and ongoing expenses was no issue. The owner also agreed that a range of one to tow times net income was reasonable in pricing. The domain name is memorable and his relationships with the drop shipping manufacturers was strong and in some cases exclusive. However, the site had issues in two areas. First, the site derived its entire traffic from Overture related bidding. The second issue was that the site’s navigation and general look and feel was terrible. However, every web business for sale will have its issues and I still feel that this site is a solid candidate for acquisition. For me personally, I am not convinced that the product selection is appropriate for the markets I think that I want to serve. More importantly, I feel that the current owner must handle extensively every order that comes in. What I need to think through is what is the appropriate selection of products to offer and how much of my time will be spent getting those orders handled. Would I be better off in another project?
At the same time, I evaluated another web business for sale. Things began well in that the site was priced below its reported pervious year’s income. The site’s shopping cart technology was featured rich and the site’s look and feel are appealing. The site reportedly was in operation for more than three years and was actively crawled by Google. The site used a drop shipper but carefully maintained lower prices than its competitors.
Sadly, none of these things turned out to be true. This web business for sale had several problems. There was no evidence of the sales for more than one month. When I looked into the domain name with a “Whois” I discovered that the domain name had only been in operation for three months, not three years. The customer database contained no more than a month’s worth of data. There was no traffic on the site because the owner had cancelled their Overture account. The owner did not actually have a license for the shopping cart software, instead it was licensed to a competitor that sold the exact same products. More importantly, many key capabilities of the site were broken due to rampant, undocumented customization. They used the same drop shipper that every other simple related site on the web used and had no repeat customers at all. Needless to say, I spent more than 40 hours evaluating this business and ultimately concluded that it was worth nothing.
Your Checklist for Evaluating a Web Based Business for Sale
In some cases, the results of your due diligence may force you to conclude one of two directions. Maybe you ought to build your own site from scratch, since the site you are evaluating does not offer enough upside to warrant paying a premium. Your second conclusion may be that this web business for sale is simply not worth purchasing, but others like it may offer more value for less money. The steps to reaching these conclusions should include:
1. Validating the revenue stream over several years
2. Validating the cost of goods sold associated with that revenue stream
3. Validating the costs of care and feeding of the site, including the ongoing costs of acquiring customers.
4. Determining the efficiency of the operations of the order management and related efforts and deciding if the time spent is worth the return.
5. Recognizing that the web is a very competitive space and identifying something unique about the business that would allow it survive and attract customers.
6. Ferreting out the value of the domain name and related issues.
7. Assigning a value to the site, if any, that ranges between one and two times its net income.
Remember, as always, to include in your analysis and macro factors, legislation, competition, etc. that could impact the viability of this web business for sale.
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