In the second chapter of the How to Buy a Digital Business, we talk about how to analyze and value a prospective business acquisition. In particular, we look at what financial and customer data to consider and the general process of how to analyze a business. If you want a more professional looking and complete e-book with images and graphs, you can download the PDF.
2. Pre-Offer Analysis and Business Valuation
Before sharing details on a business, most brokers and sellers will ask that you sign a non-disclosure agreement (NDA). You should not need to put money in escrow in order to get basic information on the business. As part of your pre-offer analysis, some initial high-level topics to explore with the seller or broker include the following:
- A general overview including the business’ products or services, competition, industry, and the state of the business
- The underlying technology, traffic, and platform
- Revenue, profitability, and employee count
- Any concentration risk with customers or suppliers
- Specifics on ownership, motivation to sell, and the goals of a sale
- Thoughts on valuation and deal structure
Remember, when you are talking with sellers and brokers, it should be a two-way conversation. While you’re assessing the business's value, the owner or broker is likely assessing your ability to buy and run it. Come prepared to answer questions about your background, goals and sources of financing. Once you have gained a high-level understanding of the opportunity, it is reasonable to request some basic financial information and detail on the assets that will transfer with the sale.
An initial information request usually includes 3 to 5 years of financial statements. Take the time to develop a spreadsheet that lays out income statements, balance sheets, and cash flow figures so that they can be compared across the years provided. How have the sources of revenue changed from year to year? Are the expense categories consistent over time or do they change? Are there noteworthy balance sheet items? Use your analysis to develop a set of questions for the seller's team that can help provide you with a more accurate picture of the business’s history and any challenges that might lie ahead.
Gain a clear understanding of the physical assets and intellectual property that will be included as part of the sale. Also, understand the assets that are not part of the sale. If there are items contributing to business operations that will not transfer with a sale, your valuation should take this into account. Similarly, items above and beyond what is needed to run the business, such as excess inventory, will also have an impact on valuation.
The next step after your pre-offer analysis work is complete is to place a valuation on the company. There are many different ways to valuing a business, 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 organization, 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, web-based 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 companies 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 focus is owner-operated, web-based 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 by people to maintain and increase them. Greater predictability and less effort lowers risk and improves the multiple.
- What is the business category (e.g. lead generation, content, membership/subscription, eCommerce, or software/SaaS)? 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.
- 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 business be transferred to a new owner?
TIP: Keep enough cash on hand to run your business.
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 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 business value. CPAs, appraisers, and business brokers are all good candidates to help with valuing a company.
In addition to the Multiple of Earnings and Market Value method, a valuation might employ other approaches including discounted cash flow, asset based, or capitalization of earnings. Make sure you understand the assumptions behind each approach before presenting the result to the seller.
Takeaways: How to Analyze a Business to Buy
How much cash do I want to put down on a business?
How do I want to present myself to a seller?
What information do I need from a seller to decide if I want to move forward with an offer?
What valuation method do I intend to use to make a price assessment?
Am I comfortable with comps or do I want to speak with a professional third party to confirm the value of the business?
For NDAs and other legal forms, visit our affiliate LawDepot.com.
Read the next chapter, How to Structure a Deal and Present an Offer or download the complete e-book: How to Buy a Digital Business.
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