We continue to post chapters from our upcoming ebook guide, How to Sell an Online Business, to help business owners prepare for a sale. In this second chapter, we look at different approaches to valuing a company and which one is right for your web-based business in approximating its worth.
2. Business Valuation
The first step for many digital business sellers is to understand the value of their business. There are many different ways to value a company, from asset-based and market-based approaches, to an assessment of historic and future earnings. Different approaches are favored based on the size of the business, its growth trajectory, the profile of the buyer, and the state of the business. For buyers of smaller, closely-held companies, a few useful methods are: (1) the multiple of earnings method, and (2) the market value method.
Multiple of Earnings Method
For an owner-operated, digital business, the metric often used as the number being multiplied is “Seller’s Discretionary Earnings” (SDE). SDE is typically calculated by subtracting the cost of goods sold and operating expenses from annual gross income, and adding back non-recurring, non-cash and discretionary expenses. Operating expenses are the necessary costs to running the business and are non-discretionary. Examples of expenses that are often added back to the businesses’ earnings include owner’s compensation, depreciation, charitable contributions and personal vehicle expenses. For larger businesses where the value is less tied to owner benefits, the metric often used as the number being multiplied is “Earnings Before Interest, Taxes, Depreciation, and Amortization” (EBITDA).
For businesses that are rapidly growing, have recurring revenue models or have high value to the buyer, “Revenue” is often used as the number multiplied. Since our industry focus is owner-operated, digital businesses, we will use SDE as our example metric, however many of the same principles apply for other metrics. Multiples for smaller, website, and similar businesses usually range from 1.5x to 4.5x SDE. Determining where a business falls within the range is tied to the predictability of future earnings and the effort required to maintain and increase them. Businesses that require more advertising to gain traffic or have a less reliable customer base will typically have a lower multiple. More predictable revenue businesses will command a higher multiple. Some thoughts for further consideration:
- What is the digital business category (e.g. lead generation, content, membership/subscription, e-commerce, or software/SaaS)?
- Where does the business’ traffic come from? Organic vs. Paid?
- What is the customer retention rate?
- How stable are the earnings?
- How vulnerable is the company to new entrants in the field? Is the business easy to replicate?
- How quickly is the business growing?
- How easily can the assets be transferred to a new owner?
Market Value Method
Reviewing “comps’’ can be a great way to check whether your valuation assessment is on target. Comps can be obtained through brokerages and marketplaces online. The Hatchit Marketplace is a good place to start. As a first step, conduct a thorough search for business listings similar to that which you’re assessing. Next, narrow down the group, identifying the 5-10 digital businesses closest in type and size to yours. Add these businesses to a spreadsheet, calculating a multiple of SDE or Net Profit for each (be careful to ensure that the figures being multiplied are “apples to apples”). You may want to include notes for each on your spreadsheet, as their unique attributes may help to further refine your range (e.g. “does not include inventory valued at $10k”, or “includes 5 patents”). Lastly, remember, the purchase prices you source online are “asking” vs. “selling” prices – you may need to take this into account when negotiating with a seller.
Choose Someone to Value the Business
To further support your offer, you might consider engaging a professional for a third-party opinion on the value of the business. CPAs, appraisers, and business brokers are all good candidates to help with a valuation.
In addition to the Multiple of Earnings and Market Value method, a business valuation might employ other approaches including discounted cash flow, asset based, or capitalization in earnings. Make sure you understand the assumptions behind each approach before presenting the result to the seller.
Once the valuation is complete and you have decided to move forward with a sale, the next step is to organize your financials. Most buyer’s will want to see 2-5 years of financial statements that document your cash flow, balance sheet and profit and loss statements. In addition, buyers will want to understand the detail around any adjustments you have made to your financials when calculating the business’ SDE or adjusted EBITDA, since these inform the valuation and provide information about the cash available post-transaction.
Take the time to develop a spreadsheet that lays out your financials so that they can be easily compared across the years provided, and clearly spell out any adjustments. Make sure you understand any inconsistencies or noteworthy occurrences in the figures, so you can explain them adequately. Be prepared, also, to show how your reported figures tie to your tax returns. Numbers tell a story and you want to control that narrative as much as possible. If you are selling for-sale-by-owner, it is advisable to engage a professional to help.
Additionally, it is advisable to speak with your CPA or financial advisor to understand what terms are acceptable for your personal and financial situation. Deal structures can vary widely, with implications on your income post-transaction. Also, selling your online business can result in a substantial tax liability:
- Do you require all cash or are you open to the buyer financing part of the purchase?
- What is the minimum amount of cash that you require a buyer to put down?
- Are you open to seller financing if the buyer can’t secure a third-party loan?
- Is your business set up as an LLC, S-Corp, or C-Corp, and what are the tax implications of selling the business’ stock vs. its assets?
- Are you open to staying on during a transition period?
It's best to get these questions answered as early as possible so you don't waste time with an unqualified buyer.
Regardless of whether you decide to sell through a broker or on your own, the process remains essentially the same. We hope you took away a few insights that will help you determine your business's value and yield the most money for it. Email us with any comments, suggestions, or insights of your own.
Quick Answer takeaways:
- Most web-based businesses use SDE for calculating a valuation.
- Comps are a useful way to reality check your number.
- Fast growing SaaS companies often use a multiple of revenue.
- Predictability of future earnings can increase your valuation multiple.
- Prepare 2-5 years of financials that include a balance sheet, cash flow and profit and loss statements.
- Be prepared to tell the story behind your numbers.
Read the next chapter in the Seller's Guide on Marketing Materials.
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