How to price an internet business
Valuation is arguably the number one concern when selling and buying bits of an internet business. It is subsequently the most frequently asked question by sellers and buyers on BitsForDigits. Naturally both parties seek a good deal which is why accurate price approximation matters to ensure a fair number of digits in exchange for the bits in question. The answer to this problem depends on several things but primarily the asset for sale of course.
Here, we have listed a few guiding principles that can help both sides closer to a fair deal. Agreeing on a price is, in addition to a negotiation of terms between two parties, also a highly personal and emotional matter; oftentimes especially for the owner who likely build the business themselves. That’s why we recommend consulting more than one source before making up your mind on a price point and way before putting down your signature on a term sheet. Speaking with peers who have bought and/or sold businesses is one way of getting wiser on the matter of valuation as well as the due diligence and negotiation processes.
The first step in approximating the price of a business is choosing a method of valuation. Some are more common than others, but we would like to highlight a few here that you might take into consideration. Note that these methodologies can also be combined with each other.
The Discounted Cashflow (DCF) method refers to forecasting the free cash flows of the target company and discounting them with a predetermined discount rate (usually the weighted average cost of capital, or WACC, which is an important number to estimate in this equation as it aims to quantify the uncertainty associated with future cashflows). That’s why this method makes sense to apply for more mature businesses with predictable future cashflows. In case your internet business is more mature than say a newly-founded startup and has more stable, recurring revenue streams from returning customers with little up- or downside risk, give this method a try. If not (which is most likely the case), skip ahead.
Next up is the Benchmarking approach. This is also called the Precedent Transactions method and aims to help you value your business by looking for comparable metrics in other acquisitions. This could for instance be multiples of earnings or revenue. So if a very similar business to yours sold for three times its annual gross revenue or five times its earnings, then your business could also be priced that way.
That brings us to what is possibly the most popular used method, the Earnings Multiple approach. This methodology means that a certain business metric such as the EBIT will be multiplied with an appropriate number to get to the value of the company. Choosing the right multiple number can depend on factors like the growth potential of the company, maturity and industry standards as well as metrics like customer lifetime value, cost overhead and many more.
As referenced, make sure to always take a hard look at your most important KPIs. For internet businesses, metrics such as Monthly Unique Visitors, Customer Conversion Rate, Average Revenue Per User, Customer Acquisition Costs and others can play a big role in approximating its value. A word of advice is to choose those that have the biggest impact on your business.
After having chosen one or several methods of valuation, apply them to your company. When setting a price, try and set a range rather than a single number and use that as your starting point for negotiations. And remember, the asking price is oftentimes more of a starting point for negotiation. At the end of the day, the value of a business is determined by the market, i.e. the price equilibrium between what a buyer is willing to pay for it and a seller is willing to part with it for. As such, valuation methods are more like guides of approximation to get you closer to a fair deal.
For sellers determining the asking price on their business listing, we always recommend putting “Open to offers” unless they have a price floor, i.e. a minimum asking price they would be happy to start the negotiation at. Time is usually an important factor when selling a business so using the high end of the valuation range can come at the cost of a long, and potentially endless wait from discouraged buyers. Instead, using the lower end of the valuation range to get the most offers and to start negotiations with more than one buyer is a common tactic as some talks of acquisition inevitably fall through. On the other hand, if you as a seller have patience, setting an asking price somewhere in the middle can leave a bit of room for negotiation as well as allow for more predictions to be considered in the process. The good news is that you are entirely in control of your asking price so experimenting is also an option as you are under no obligation to sell. Just make sure to prepare yourself for walking prospect buyers through your price reasoning and expect to be challenged on some of your valuation assumptions. Transparency is a very natural and important part of the negotiation process. Finally, remember to keep an open mind when engaging with buyers and stay patient.
For buyers trying to gauge the price of a business, using these models with just the information displayed on the business listings can be challenging as you are at a slight disadvantage when compared to the seller in terms of completeness and richness of data available to you. However, using the information found on the business listing you can start to compare and contrast other businesses in that category, operating within the same sector, generating similar revenues and profits, etc. So if you know the ballpark figure of an analogous deal, then you can attempt to reverse engineer the multiple and apply a similar number to your acquisition target. Unless you have bought or sold companies in the past, uncovering examples can be hard as the majority of private equity acquisitions happen behind closed doors with signed NDAs. Nevertheless, this type of benchmarking is common practice and a great way to get your bearings on a rough price estimation. From there you can set a price range of your maximum willingness to pay and your best case scenario. Next step is to decide whether to approach the seller to make a conditional offer or ask due diligence questions. When making an offer, be serious and remember to keep an open mind if you want to close a deal.
Further resources: How to Value a Website or Internet Business, Valuing Startup Ventures, How does an early-stage investor value a startup?, Startup Valuation Metrics (for internet companies)