Accounting & Tax, E-Commerce

Valuing an eCommerce Business

ATanya

Are you considering selling your eCommerce store? Or are you more concerned with the potential value of your store? Whether you’re selling a Shopify store or another type of eCommerce business, this article will demonstrate how to achieve an appropriate eCommerce business valuation.

Earnings Calculation

To arrive at an accurate valuation of an eCommerce business, the first step is to ascertain earnings, or “net revenue.” For businesses with an estimated value of less than $10 million, the Seller’s Discretionary Earnings (SDE) method is almost always used.

SDE Method of Valuation
SDE = Revenue – Cost of Goods Sold – Operating Expenses + Owner Compensation

SDE is a deceptively straightforward formula. Gross revenue is subtracted from cost of goods sold and operating expenses. Then, assuming the business is owner-operated, the owner’s salary is subtracted from earnings. This is a discretionary expense that the new owner may choose to reduce or eliminate.

Reconciling owner compensation with revenue assists in determining the business’s true earning potential. Additional expenses that may be added back include personal travel and any other discretionary personal expenditures that were taxed through the business.

Earnings are almost always calculated using the Earnings Before Interest, Taxation, Depreciation, and Amortization formula for businesses with an estimated value greater than $10 million.

EBITDA Method of Valuation
EBITDA = (Revenue – Expenses) + Depreciation + Amortization

Ecommerce businesses valued at $10 million or more frequently have more complicated ownership structures with multiple stakeholders. Compensation paid to an owner is treated as a legitimate operating expense and is not recouped. EBITDA is used to evaluate a business’s profitability prior to the deduction of certain uncontrollable or non-operational expenses. EBITDA is the industry standard for valuing and comparing businesses valued at more than $10 million.

Valuations Based on Revenue and Growth

SDE or EBITDA will suffice to determine earnings for the vast majority of eCommerce businesses. Neither benchmark, however, will be effective for some rapidly growing, typically well-capitalized businesses that are heavily investing in technology and future growth. In this case, future earnings can be forecast based on revenue and growth, even if current expenses exceed revenue.

Revenue-based earnings forecasts are inherently more volatile than those based on SDE or EBITDA because they are based solely on growth. As a result, they are only used when SDE or EBITDA is ineffective. In some cases, a blended approach may be used, with SDE or EBITDA forecasts combined with revenue forecasts.

Calculating the Earnings Multiple

After determining earnings using one of the methods outlined above, it’s time to calculate the earnings multiple. This is the most time-consuming and complicated stage of the valuation process. At FE International, we employ a proprietary algorithm that takes into account thousands of different data points and has been refined over hundreds of transactions. The objective is to identify the earnings multiple that most accurately predicts the highest price at which a business can be sold successfully.

VALUATION OF BUSINESS = Earnings x Earnings Multiple

Depending on the fundamentals of the e-commerce business, most companies will garner an earnings multiple of between 3.5x to 6.0x. So, an e-commerce business with $4 million in annual earnings and a 5x earnings multiple achieves a valuation of $20 million.

Depending on which of the above valuation drivers is used, an eCommerce business should trade at a multiple of 3.5x to 6.0x of SDE, EBITDA, or Revenue:

The majority of valuation drivers can be classified broadly into three categories: transferability, scalability, and sustainability. We take an in-depth look at the most critical drivers of eCommerce business valuation in this section.

Age of Business

The age of the business is one of the first things a prospective buyer will consider. Buyers will generally disregard an eCommerce business that has been in operation for less than a year. Many buyers will require proof of operation for at least three years, while an eCommerce business that has demonstrated consistent growth for five years or more will typically command a premium multiple.

Financial

It should go without saying that an eCommerce business’s financial health will be a critical factor in determining its value. While no two eCommerce businesses are identical, the following will serve as a checklist for preparing a business for valuation and potential sale.

Financial Records That Are Complete and Verifiable

Maintaining accurate and verifiable financial records is a critical step that owners can take to not only increase the value of their business but also to run it efficiently. Fortunately, much of the traditional bookkeeping grind has been eliminated thanks to accounting software such as QuickBooks and Xero.

Both QuickBooks and Xero seamlessly sync with business bank accounts, credit cards, and payment processors, obviating the need for manual data entry. We strongly advise all of our clients to begin using QuickBooks or a similar product at the very beginning of their eCommerce business. This minimizes the need for backtracking during the process of preparing the business for sale and simplifies tax preparation for a tax professional. They will put financial reporting capabilities for businesses in the hands of business owners.

online businessman on his laptop with money bag

Revenue Concentration

Once revenue has been verified (typically using bank and payment processor statements in conjunction with an up-to-date QuickBooks account file), it is critical for an eCommerce valuation to segment revenue in several ways, the most critical of which are as follows:

  • Revenue breakdown by customer
  • Revenue breakdown by product
  • Revenue breakdown by the supplier

By analyzing each of these, potential strengths and weaknesses in each revenue stream can be identified. For instance, if 15% or more of revenue is generated by a single customer, the business may face significant risk if that customer leaves. Obviously, any customer who accounts for such a sizable portion of revenue must be closely monitored.

Similarly, examining the percentage of revenue generated by each product may reveal areas of opportunity and risk. If a significant portion of revenue is generated by a single product, how vulnerable is the business to a competitor entering the market and selling it at a lower price? Is it a trendy item with a short shelf life?
Finally, if the business is heavily reliant on a single supplier, what type of relationship does the business have with that vendor? Is it contingent on existing ownership or is it a handshake deal? Is there a transferable written agreement or contract to supply, perhaps even exclusively?

In general, spreading sales across a large number of customers, products, and suppliers can help protect an e-commerce business from a sudden decline in demand for a specific product, the loss of a significant customer, or the dissolution of a supplier relationship.

Seasonality

Ecommerce businesses, more than most other online business models, may be highly susceptible to seasonality. Sales may fluctuate significantly by season depending on the niche and type of products sold by the e-commerce store—for example, a golf specialty store that does the majority of its business during the summer months. The longer a business has been in operation, the easier it is to identify and plan for seasonal trends.

Apart from seasonality, many eCommerce businesses rely heavily on sales “holidays” such as Black Friday and Cyber Monday, as well as the holiday shopping season as a whole.

It may be prudent for eCommerce merchants to consider adding less seasonal merchandise to help smooth out the peaks and valleys associated with a highly seasonal product.

Returns, Chargebacks, and Refunds

Customer returns, refunds, and chargebacks are an unavoidable part of doing business for almost all eCommerce businesses. They can also be quite costly. In 2020, it is estimated that the cost of returning merchandise in the United States will be approximately $550 billion. Shopify discovered that brick-and-mortar stores see an average return rate of 8-10%, while e-commerce merchants see an average return rate of 20%.

Additionally, Shopify discovered that 80% of consumers now expect free returns. This, combined with the fact that 71% of customers say restocking fees deter them from making a purchase, puts eCommerce merchants under significant pressure to make the return and refund process as simple and painless as possible for consumers.

While this is great news for consumers, the cost of offering free returns can quickly erode an eCommerce merchant’s profit margins. Buyers of eCommerce businesses will almost certainly scrutinize the rate of refunds, returns, and chargebacks. If they are significantly higher than the vertical average, there could be a variety of operational reasons for this. Improved product descriptions, expedited shipping with tracking information, and enhanced customer service can all contribute to lower return rates.

If chargebacks are excessively high, this could indicate that insufficient fraud prevention measures are in place, such as billing address verification for credit card purchases.

Returns, refunds, and chargebacks, in general, are an area where many eCommerce businesses can improve. Taking steps to reduce them can have a positive impact on both the bottom line and customer satisfaction.

Good eCommerce accounting hygiene

Before entering a sale scenario, it is important that the eCommerce founder has organised for the financials to be up-to-date and ready for presentation. A purchaser will most likely request for some due diligence to be conducted on the accounts to ensure these are accurate and reliable. A check would also be done to ensure that there are no lingering tax debts or lodgements for the business.

A good eCommerce accountant firm like Fullstack can help you ensure that you pass a stringent due diligence by the business purchaser with flying colours.

Traffic

The majority, if not all, eCommerce businesses rely heavily on organic and paid traffic to grow their customer base. Similar to how we advise our clients to implement QuickBooks from the start, we also recommend Google Analytics.
Google Analytics should be considered a bare minimum requirement for virtually any online business in order to maintain historical data on the source of the site’s web traffic.

When evaluating an eCommerce business’s traffic, four critical factors must be considered:

  • Trends – Tracking daily, monthly, and annual traffic trends with Google Analytics should be considered a prerequisite for any successful eCommerce business.
  • Concentration – Once a picture of broad traffic trends emerges, the time has come to delve deeper. Many eCommerce businesses receive traffic from a variety of sources, while others may rely heavily on a small number of keywords.
  • Backlinks – Another critical factor in Google rankings and organic traffic are backlinks. The quality of an eCommerce site’s backlink profile can reveal a great deal about the owner’s content marketing efforts.
  • Ahrefs is an excellent tool for delving into a website’s backlink profile. It is recommended that at least the top twenty backlinks to an eCommerce site are analyzed. If these have a low “domain rating,” they have a deficient backlink profile. This could erode Google’s ranking in the future. Along with the domain rating, it can be beneficial to visit the linking domains and determine if they appear to be legitimate sources of high-quality content.

Another critical factor to consider when assessing an eCommerce site’s traffic is the amount of traffic generated through referrals—for example, as part of an affiliate program. If this generates a substantial amount of traffic, it’s worth considering how secure these referral sources will be in the future.

After analyzing the broad trends in traffic, it is prudent to examine the “quality” of the traffic. Traffic quality can be quantified in a variety of ways and is highly dependent on the target customer profile. Several critical metrics include the following: pages per session, the average duration of a session, rate of reversal, and rate of conversion (Conversion can mean making a sale or enticing a visitor to perform the desired action, such as signing up for a newsletter).

Operations

Prospective buyers will closely examine the operations of any eCommerce business they consider acquiring. Operations is frequently an area in which a new owner can immediately begin cutting costs, increasing efficiency and productivity, and increasing margins.

Additionally, even if they are not considering an exit, eCommerce business owners should be constantly looking for ways to improve their operations. Not only can this increase the value of their business, but it is frequently more profitable as well. Knowing which aspects of operations are of particular interest to buyers can direct eCommerce business owners to areas they should objectively evaluate and improve, if possible.

Owner Involvement Level

The majority of purchasers of eCommerce businesses are not looking for full-time work. Businesses that require less than 20 hours of an owner’s time per week typically command a higher multiple. Businesses that require less than ten hours per week of owner involvement typically command a higher multiple.

Changing Owner Involvement

Many entrepreneurs, particularly bootstrapped solopreneurs, are accustomed to wearing multiple hats and working long hours. While this is understandable and even admirable during the initial stages of business development, excessive owner involvement can actually detract from the business’s value.

While some founders may find it difficult to relinquish control of any aspect of their business, it is highly recommended to conduct a thorough inventory of tasks and processes. Frequently, processes can be automated or outsourced. Upwork and Toptal are two freelance marketplaces that make it simple to connect with experienced and talented freelancers. If hiring someone in-house appears to be a better fit, AngelList is an excellent resource for locating employees interested in working for a startup.

Automating and outsourcing business processes wherever possible improves not only the value of an eCommerce business but also the owner’s work/life balance significantly. Additionally, it simplifies scaling the business—after all, even the most determined entrepreneur can only accomplish so much on their own.

Customer Support

Logistics and fulfillment processes are streamlined

One area where eCommerce businesses frequently have significant room for improvement is in the realm of logistics and fulfillment. Order fulfillment is critical to any eCommerce business’s survival. According to studies, 38% of consumers who had a negative delivery experience with an eCommerce merchant indicated that they are unlikely to shop with that retailer again. Consumers now expect to receive their orders faster than ever before, thanks to the success of programs like Amazon Prime.
While many eCommerce merchants, particularly in the early stages of their business, choose to handle their own shipping and fulfillment, as their business grows, many outsource logistics and fulfillment to a third party.

Solutions for Logistics and Fulfillment

Numerous merchants leverage Amazon’s Multi-Channel Fulfillment (MCF) program. MCF is available on its own or as part of Amazon’s popular Fulfillment By Amazon (FBA) program. MCF allows merchants to ship their products to Amazon’s warehouses, and Amazon handles the picking, packing, and shipping of the product, as well as any returns. This storage and fulfillment service is charged on a per-unit basis by Amazon.

Inventory Control

Inventory management is significantly simplified for drop-shipping eCommerce businesses or those that outsource warehousing and fulfillment. For merchants who manage their own warehousing and fulfillment, a robust inventory management solution is critical to the business’s smooth operation.

While there are numerous dedicated inventory management tools available, such as Zoho Inventory or Oracle Netsuite, there is a lot to be said for having financial reporting and inventory management “all under one roof” if QuickBooks is already installed.

Establish Formal Supplier Relationships

Relationships with critical suppliers should be formalized to the extent possible and easily transferable to a new owner. Wherever possible, steps should be taken to ensure price certainty. Too frequently, supplier relationships are based solely on goodwill and a handshake.

For eCommerce merchants who rely on unique or branded products that are difficult to replicate in the market, the loss of a key supplier can be devastating.

Technology

Any online business relies on technology. Even eCommerce stores built on well-known platforms such as Shopify, Magento, WooCommerce, and Big Commerce are likely to have customized templates and plugins. For those eCommerce stores that are built using custom software, the complexity of the technology involved is almost certainly much greater.

To maximize the earnings multiple on their eCommerce business, owners must take critical steps to make the business more appealing to potential buyers.

Reduce Technical Difficulties

ECommerce businesses are frequently extremely appealing to non-technical buyers, who account for a sizable portion of the market.

In comparison to established platforms such as Shopify, Magento, WooCommerce, and BigCommerce, eCommerce stores built on custom software are likely to have a higher technical barrier to entry. One reason for this is that the market for developers for popular eCommerce platforms such as Shopify is competitive and easily accessible.

If an eCommerce store is built on proprietary software, having a trusted developer on staff or on contract will alleviate any concerns a non-technical founder may have about the technical requirements of running the business.

Utilize Best Coding Practices

If the eCommerce business is built on custom software, it is critical to adhere to current coding standards. Additionally, the code should be thoroughly annotated. The objective is to make it as simple as possible to bring in a new developer to handle the inevitable changes and upgrades that any online business will require.

Legal and Escrow Services

It is critical for owners of eCommerce businesses considering selling to retain legal counsel early in the process. If a reputable eCommerce business broker is used to advise on the sale, they can help advise on any necessary legal steps. Without a doubt, non-disclosure agreements will need to be in place prior to the disclosure of any proprietary information. Additionally, if a business sale is agreed upon, a commercial lawyer should be sought to help finalise the terms and conditions of the transaction.

It is prudent to consult an legal advisor who has extensive experience dealing with the unique intricacies of online businesses in these instances. A seasoned M&A advisor can assist with this.

Additional legal procedures should be completed well in advance of a sale.

Secure Intellectual Property

Branding is a critical component of the marketing strategy for the majority of eCommerce businesses. It assists them in distinguishing themselves from competitors in the public eye. It is critical to register and defend any trademarks, copyrights, and–in the improbable event that they are applicable­–patents. Additional branded assets, such as domain names, should be long-term registered.

Proper intellectual property registration, conducted by a qualified legal professional, will not only assist in defending it, but should also facilitate the transfer of ownership to a new owner.

Agreements for Work-for-Hire

If an eCommerce business relies heavily on graphic or written materials—for example, content for a blog or graphics for a t-shirt—it is best to have “work-for-hire” agreements in place that explicitly state that the company owns the copyright for the content. Contrary to popular belief, copyrightable work created by an employee or commissioned freelancer does not automatically transfer to the business.

Non-Compete

It is common practice for the buyer and seller of an eCommerce business to enter into a non-compete agreement. A non-compete agreement is intended to safeguard the buyer against the seller starting a new business that is too similar to the one being sold. A good advisor will strike a balance between protecting the buyer from excessive competition and not restricting the seller’s future ability to start a non-competing business.

Sellers must pay close attention to the precise wording of the “Restricted Business” definition, which details the post-sale activities that are prohibited. A non-compete agreement should be highly specific to the business being sold in order to avoid unduly restricting the seller’s future ability to start and operate a business.

Transferable Assets

It is critical to be precise about all assets that will be transferred as part of the transaction. Larger eCommerce sites typically require the transfer of significant amounts of content and other assets. The Asset Purchase Agreement should include a detailed description of such assets (APA).

The following is a list of typical assets transferred at the time of sale:

  • Domain(s)
  • The source code, the content, and any other files associated with the website
  • Graphics, images, and logos, among other things.
  • Accounts on social media
  • Clientele database (email lists, etc.)
  • Processor of payments (s)

Assistance with Transition

Generally, a seller is expected to provide support to the buyer for a specified period of time following the business’s sale. The sale contract should specify the duration of post-sale support, anticipated response times, and the number of hours per week/month during which the seller must be available to assist.

Escrow

Once the APA is complete, the time has come to arrange for the transaction’s escrow. A reputable M&A advisor will typically refer both buyer and seller to a third-party service such as Escrow.com to protect both parties during the funds and ownership transfer.

Escrow.com is a privately held company that has processed over $3.5 billion in transactions for over one million customers. Escrow.com collects, holds, and releases funds online once the seller and buyer have agreed on the transaction terms. The procedure is typically as follows:

  • The buyer and seller agree on the terms of the escrow transaction.
  • The buyer securely deposits the funds in escrow. Escrow.com secures the funds but does not release them to the seller.
  • The seller transfers the buyer’s assets.
  • The purchaser confirms receipt of the assets and initiates the inspection period. The buyer and seller agree in advance on the duration of the inspection period.
  • The buyer utilizes the inspection period to ensure that the assets are accurately represented.
  • Escrow.com releases funds to the seller upon the buyer’s confirmation of satisfaction with the assets.

Escrow.com (and similar services) protects both the buyer and seller. Before funds are released, the seller ensures that the buyer has thoroughly inspected and reviewed the assets. All assets must be approved during the inspection period agreed upon. If anything goes wrong, either party may file a complaint with Escrow’s arbitration service.

If you are considering selling or wondering about the value of your eCommerce business, please contact the eCommerce Accountants at Fullstack.

Was this article helpful?
Yes
No
Share this ArticleShare on Facebook
Facebook
Tweet about this on Twitter
Twitter
Share on LinkedIn
Linkedin