What is E-commerce?
E-commerce is buying and selling goods and services over an electronic network. Some examples of e-commerce platforms are eBay, Woolworths, BigW, etc. Transmitting data or funds over the internet also lies within the scope of e-commerce. Furthermore, e-commerce includes business transactions like B2B (Business to business), B2C (Business to consumer), or vice-versa.
Like any other business, even e-commerce businesses are sold and bought following certain procedures, one of which is valuation. This blog will look into all factors related to e-commerce business valuation.
The Current State of E-commerce
The e-commerce industry is finally starting to make significant breakthroughs after providing the same e-commerce experience for over 20 years. These developments have enhanced the online purchasing experience and seamlessly merged the physical and online worlds to provide customers with some original and brand-driven experiences. Moreover, because of the democratization of e-commerce, small businesses now have just as much opportunity as big brands to capture a large market.
Third-party e-commerce sellers
Third-party e-commerce sellers bring in the majority of sales in the e-commerce sphere. In fact, there are currently 2 million third-party sellers who are selling more than some well-known online marketplaces. Moreover, in recent years it has been observed that the sales for independent businesses selling on Amazon grew over 50% more compared to previous years.
Amazon’s competitors
Even though Amazon, Walmart, Apple, eBay, and The Home Depot account for more than 60% of all e-commerce sales, there is still a sizable market share available for smaller online businesses.
However, it has been difficult to ascertain the exact revenue of independent e-commerce businesses. Nevertheless, data from Shopify reveals the strength of the independent e-commerce sector.
FE international and e-commerce businesses
For more than ten years, the FE International team has provided advice on e-commerce business valuation and overseen sales of hundreds of successful online shops. A common query received by FE International has been about how to evaluate a business.
Therefore, FE International has created a resource to assist merchants in determining the rough value of their e-commerce business. Additionally, they have guided e-commerce business owners on how to increase the value of their enterprise.
Benefits of valuing an e-commerce business
Some of the major benefits of e-commerce business valuation include getting information about expense operations, cash flow, net worth, gross margins, etc.
Furthermore, the accurate valuation of your company will affect future exit strategies as well as your current financial well-being.
Additionally, e-commerce business valuation can also spot operational inefficiencies and improve overall performance, both of which increase the worth of your company.
There are several ways by which the e-commerce business valuation is calculated, which are given later in the article below.
Factors to Consider when Evaluating an E-commerce Business
Several parameters are to be considered during the valuation of an e-commerce business. Some of the parameters are discussed here:
Traffic quality and quantity
While generating traffic quantity, businesses often lose sight of traffic quality. However, this is a key measure of a business’s well-being. Therefore, while evaluating a business, looking for the perfect balance between quality and quantity is essential. This is because, while higher traffic quantity means a brand is reaching a wider audience, better traffic quality implies a brand has better chances of converting its audience to actual buyers.
Operating expenses
Operating expenses are what a brand spends on carrying out the daily tasks necessary for business. In every business, the primary expenses are the cost of goods sold (COGS). Beyond that, other expenditures include inventory, shipping, utilities, labor, marketing, and so on.
While evaluating a business, it is essential to consider its operating costs to understand the company’s financial health further. This also helps evaluate a company’s profit margins.
Annual revenue and return on investment (ROI)
Annual revenue is the amount which is earned by any e-commerce business in a financial year without any deductions like returns, COGS, and expenses. ROI can be calculated using the following formula:
ROI = Net worth / Cost of investment x 100%
Net return is calculated by subtracting the initial invested value from the final invested value.
Owner compensation and discretionary earnings
Owner compensation and discretionary earnings are major factors in an e-commerce business. Owner compensation depends on the level of involvement of owners in the business. This means that owners are compensated based on the time and energy they put into the company.
On the other hand, discretionary earning, also known as adjusted cash flow, reveals how much money the company makes that can either be paid to the owner or invested back into the company. Discretionary earning is a more significant metric than net profit.
Customer base and customer retention rate
A reliable method for assessing a company’s performance is to keep track of its customer base and the rate at which customers are retained. If a business provides reliable products or services, they are bound to have a bigger customer base and a higher retention rate. Such a business will definitely continue to be profitable in the long run.
Customer service and satisfaction levels
In continuation with the previous point, customer services and satisfaction are the key elements for maintaining a healthy customer base. Many companies offer several measures to ensure customer satisfaction, such as:
- Automated chatbots
- Ticketing software
- Services over social media platforms
- Live chats and detailed FAQs
These factors help elevate customer experience and increase the value of a business.
How can you Evaluate an E-commerce Business to Understand What it’s Worth?
The valuation of an e-commerce business is often determined by evaluating a company’s existing and projected profitability and its potential for expansion. This is accomplished by using some variables, including the volume of revenue earned, the present financial situation of the company, and the efficacy of its competitive edge.
The abovementioned criteria can accurately determine an e-commerce business’s worth. Most e-commerce businesses combine various valuation techniques to produce a thorough analysis. Some techniques are the comparable transaction method, discounted cash flow (DCF) method, market capitalization method, discounted earnings method, etc.
Determining your E-commerce Business Valuation
To determine the valuation of an e-commerce business, several methods can be used, some of which are mentioned here:
Determination of earnings
Calculating earnings or net revenue is the first and most essential step to get an accurate valuation of an e-commerce business.
It is observed that for businesses that own an estimated value of $10 million or less, the seller’s discretionary earnings (SDE) approach is nearly always used for evaluations.
SDE method of valuation
It can be formulated as follows:
SDE = Total Revenue – COGS – Operating expenses + Owner Compensation
Here,
(COGS = Cost of Goods sold)
However, for businesses that make more than $10 million, the EBITDA method is considered the industry standard for assessing the valuation.
EBITDA method of valuation
EBITDA is an acronym that represents the earnings a company generates before accounting for interest, taxes, depreciation, and amortization expenses. It is an alternate method used to calculate profitability on net revenue. It can be formulated as follows:
EBITDA = (Total Income – Total Expenses) + Depreciation + Amortization
Revenue and growth-based valuations
SDE or EBITDA works well for many e-commerce businesses when calculating earnings. Nevertheless, neither comparison will be useful for some rapidly expanding, often well-funded businesses that are substantially investing in technological advancement. Even though expenses currently surpass income in this case, earnings in the future can still be predicted based on revenues and growth.
Since revenue estimates are purely centered around growth, they are naturally more unpredictable than those based on SDE or EBITDA. Hence, they are only implemented if SDE and EBITDA are unsuccessful.
Finding your E-commerce Valuation
This is the most crucial step after calculating the valuation of an e-commerce business, and the formula for it is as follows:
Valuation of an e-commerce Business = Total Earnings X Earning Multiples
The valuation of an e-commerce business is influenced by several factors, such as:
Age of the business
The company’s age is one of the initial considerations that an interested buyer will consider. Buyers often refuse to invest in e-commerce businesses that have been in operation for a short period of time, for instance, less than one year or so.
A lot of investors may demand proof that a business has been running smoothly with a marginal profit for at least three years. However, an e-commerce business that has grown steadily for at least five years is likely to be purchased for a greater price tag.
Financial
One of the most important aspects in establishing the worth of any e-commerce business is its financial stability. Although no two e-commerce enterprises are perfectly the same, the following are requirements for getting a business ready for valuation:
Thorough and verifiable financial records
Owners should be proactive about keeping accurate and reliable financial documentation. Nowadays, a few accounting software like QuickBooks and Xero help carry out the tedious work associated with financial documentation by syncing with financial banking accounts, credit cards, and payment processors. Hence, these tools help simplify financial records management.
Concentration of revenue
As the net revenue is verified, it is critical to segment revenue in a number of ways. Some of the most important aspects of that are as follows:
- Breakdown of revenue by product or goods
- Breakdown by the suppliers
- Breakdown by the consumers
In general, an e-commerce business can be protected from a sudden decline in demand for certain products, the loss of a key customer, or the end of a supplier relationship by spreading sales among a large number of consumers, products, and suppliers appropriately.
Seasonality
Many e-commerce businesses may find themselves more vulnerable to changing seasons than the majority of other online businesses. To avoid this, e-commerce businesses should focus on the previous statistical sales data during specific seasons to sustain themselves throughout the year.
Chargebacks, returns, and refunds
These factors are major challenges for an e-commerce business. The majority of customers demand free-of-cost returns for any product or a full refund in some cases. Hence, it considerably influences the financial status of the company.
Site traffic metrics
Site traffic metrics are important elements for any e-commerce business. A number of critical elements are taken into consideration while looking for site traffic, and they are as follows:
Trends
Trends refer to the products which are present on a website for days, months, and years and are regularly monitored by Google Analytics. An accurate statistical analysis is a necessity for an emerging e-commerce business. It will help by providing the level of steadiness and growth of the business.
Concentration
Some e-commerce businesses may acquire most of their traffic from a limited number of keywords. At the same time, some have to use a diverse range of sources in addition to keywords. Hence, it is important to understand the concentration of search engine optimization required to get noticed.
Backlinks
This is another factor that affects website traffic, and SEO ranks. The caliber of a website’s backlink profile can reveal a lot about how successful the operator’s content marketing efforts have been.
Some tools like Ahrefs help look inside any website’s backlink profile. It is very important to go for a high-rating domain website instead of believing in a low domain one. Referrals from another website also highly impact the rating of any domain and make them trustable.
Quality
After analyzing the traffic trends on the website, it is important to analyze the quality of traffic rather than the quantity of traffic. This is because the former is a more reliable indicator of a brand’s success.
Operations
Any e-commerce company that is up for sale will have prospective buyers closely monitoring its activities. The following operational factors usually influence the valuation of a company:
Level of owner involvement
The majority of clients of e-commerce businesses do not want full-time employment. However, businesses that demand an owner’s involvement for a maximum of twenty hours weekly will typically fetch a greater multiple. Less than ten hours of owner engagement are often required for businesses to achieve a premium multiple.
Making changes to owner involvement
Some new business owners want to maintain control over the company’s operations. However, new start-ups should outsource to freelancers and skilled agencies. Not only does this help improve the owner’s work-life balance. but it also scales up the business.
Customer service
Efficient customer service usually means better company valuation. To retain customers, the following additions could be made:
- Introducing chatbots on the websites
- Providing ticketing software on the help desk
- Introducing customer service links over social media
- Giving detailed explanations of FAQs
- Providing live chat for customers
- Providing billing and the payment details
Streamlined logistics and fulfillment
Logistics play an important role in scaling up businesses. Customers always expect their orders to be fulfilled on time. This can be done through:
Logistics and fulfillment solutions
Some e-commerce businesses make the logistics process very smooth by hiring third-party logistics companies. Overall, third-party logistics providers are much more reliable regarding order fulfillment, as they have an entire dedicated system for executing deliveries.
Inventory management
Inventory management can be quite a big problem for new businesses due to a lack of resources. However, some companies that outsource inventory management or participate in drop-shipping might find inventory management less of a burden.
Formalize supplier relationships
Suppliers play an important role in maintaining the overall supply chain in any e-commerce business. Therefore, formalizing such relations and ensuring as much price certainty as possible is always a good idea. Preparing contracts with suppliers makes them easily transferable and helps avoid the sudden loss of key suppliers.
Technology
Currently, technology should be at the core of any e-commerce development. The following two factors can be used to amplify the benefits of technology:
Reduce the technical burden
Overall, while every business wants to launch a website with the most advanced tech stacks, using user-friendly software on both ends is best. This means that an e-commerce website should not pose a barrier to buyers or owners due to its complicated technicalities. Hence, the technical burden is reduced for both business owners and buyers.
Employ coding best practices
Whether a website is built using proprietary software or on major platforms like Shopify, it is advisable to follow the latest and most reliable coding practices. This ensures changes can be made to the code whenever required.
Legal and Escrow Considerations
Owners considering selling their businesses should get legal counsel from early on, as they can provide guidance from the very first step of the process. Some other legal steps worth taking are:
Secure intellectual property
Proper intellectual property registration is necessary for businesses to protect their trademarks, USPs, domain names, and so on. Furthermore, this also ensures easy transfer from one owner to the other. Hence, intellectual properties should be secured early with the correct legal guidance.
Work-for-hire agreements
Contrary to the belief that businesses automatically own the content they produce through their employees or freelancers, businesses need to have work-for-hire agreements to establish ownership of the copyright of their content. This helps businesses prove their ownership of their material and minimizes legal issues related to content ownership later.
Non-compete
A non-compete is established to prevent a seller from opening a business that resembles the business they just sold. While non-compete agreements are very commonly established between buyers and sellers, both parties should be well aware of the clauses in the agreement.
Assets to transfer
It is essential to make a list of all the essential assets that should be transferred from the seller to the owner. Some of the key assets are:
- Website source, related files, content
- Domain
- Graphics
- Customer database
- Social media accounts
- Payment processor
Transition assistance
In most cases, the seller is required to assist the buyer for a fixed period after the business has been sold. The terms of this assistance are mentioned in the sale contract and must be respected by both parties. Usually, the support period lasts for a month. However, the duration could be longer in the case of bigger businesses.
Escrow
Lastly, hiring an experienced escrow agent to take care of the transfer of assets and funds is important. The steps in this process are:
- Both buyer and seller agree on the escrow transaction conditions.
- Next, the buyer transfers the pre-decided funds to the escrow.
- Subsequently, the seller transfers the assets to the buyer.
- After acknowledging the receipt of the asset, the buyer inspects the asset during the inspection period.
- Finally, once the buyer is satisfied with the assets, the escrow releases the funds to the seller.
Conclusion
In conclusion, e-commerce business valuation is a critical step that has several factors associated with it. For instance, operating expenses, customer retention rate, profit margins, and so on are all used to evaluate a company. Furthermore, several conditions related to daily operations, financials, and site metrics all influence the long-term profitability of a business.
Overall, there are two methods using which a company can be evaluated. Valuation of e-commerce business helps assess long-term risks, profitability, and a company’s overall health. Hence, for individuals looking to sell their business or buy one, it is essential to understand the value of the business first.
FAQs
What are the top methods for valuing an e-commerce company?
The top methods for the valuation of an e-commerce business include the SDE method and the EBITDA method.
What is a rule of thumb for valuing a business?
The rule of thumb for an e-commerce business valuation is to multiply the revenue of that business by a factor of 3 to 6.
How is e-commerce valuation calculated?
The valuation of an e-commerce business can be calculated by determining current and future profits along with potential growth. Some of the factors which must be included for calculations are the strength of a business, competitors, and current financial conditions.
How many times revenue is a business worth?
This entirely depends on a company’s strength and the profit the business makes throughout the year. Generally, to value a business, its revenue is multiplied by a factor of 3-6 based on the given factors.
Why is a business’s future growth potential important to buyers?
A business’s future growth potential helps buyers understand the profitability of the business. Hence, it becomes an important deciding factor for buyers.
