Online Business Acquisition Costs You Won’t Find In a Broker Prospectus

February 15, 2021 by Michael Frew

Whenever an online broker lists a business for sale, the prospectus will include the ongoing costs for the online business acquisition. These costs are what the current seller and broker believe the new owner will incur moving forward.

These costs typically represent the pure cash flow from the business. Yet, they do not tell the whole story. These numbers are sheltered from routine expenses in the real business world.

That doesn’t mean the broker or seller are trying to deceive you. They trying to remove all the costs that would be variable for different types of buyers. They are presenting a buyer-agnostic set of online business costs. It’s up to the buyer to add-back all the expenses that they would incur to know the true cost of running the business.

For example, business insurance is rarely included as an online business acquisition cost. Yet, most companies over a few thousand ARR a year need some level of business insurance. This is to protect the investment and shield the owner from some personal liability that you should keep in mind.

There is a healthy debate as to what expenses always should be included in an online business acquisition cost prospectus. My goal here isn’t to argue what should or should not be included. My goal is to highlight some types of costs that aren’t typically included.

The Red Flag Online Acquisition Non-Cost – Less than 10% Expenses

Before we go too deep into normal add-backs and costs you should consider, there is one flagrant red flag.

Removing every expense so that a business has almost no ongoing operational costs.

No names will be mentioned, but some very high profile and trusted brokers have started to list businesses that have less than 10% operational costs. 90% profit margins are attainable in some niches (advertising/content). But I doubt so many other niches can suddenly start coming to market with such low operational costs.

It is currently February 9, 2021 at 8:38pm PST. For fun, I’ll look at a few broker sites to see if I can find an example.

I easily found a business listed with revenue of $280,000 that claims their online business cost is $6,000 a year.

That means, for an ongoing expense of $500 a month, they make $22,833 in profit each month.

Of course, the owner claims to do nothing. That’s required, since this business must be ‘completely passive’ at $500/month. Yet, the business grew 50% in the last quarter without a penny in new cost. Does that pass the sniff test? If it does, why would the owner have an interest to sell a business growing 50% a quarter with zero effort?

I doubt both situations can be true at the same time.

I’m not saying the $500 is not true – even though they are omitting a lot of actual time and costs. I’m just saying that those numbers should immediately raise from a red flag warning when related to an online business acquisition cost structure.

Personally, I wouldn’t touch one of these businesses. If you want to purchase one, dig really, really deep into how the business operates. How much of that revenue is coming from legitimate, recurring, and sustainable traffic and customer sources?

Owner Compensation – Pay, Hours, and “Owner Time”

https://twitter.com/ariozick/status/1337035086152282112

I’m the first to admit, I love running my businesses. I work on them all the time. Not because they need me (heck, they would likely do better without me in there mucking things up) but because I love working on them, talking with my customers, and operating in the online business world in general. It took 12 minutes to write this paragraph because I am task switching between business items and writing.

If you asked me how many hours I spend to keep these businesses going, I honestly wouldn’t have an accurate answer. I’d have to think about what I do that’s an essential cost and what I do just because I enjoy it.

Essential costs are creating new marketing goals or filing legal paperwork. Delegated tasks – that some owners do themselves – include customer service, advertising campaigns, and subscription management.

It’s not just that the cost of the extra help would put less money in my pocket. I just love the work. If I get overloaded in the future, I can always pass along my Work the System SOP’s and delegate these tasks.

When a business is ready to sell, brokers do a good job of segregating those activities to determine the time required to run the business.

Despite that, always 2x the number of hours a prospectus claims a business needs from the owner. Just like software projects take 2x longer than expected, you should 2x the amount of time an owner says they work on a business. At a minimum. If they say the business is between 15-20 hours a week, don’t kid yourself, you’re buying a full time job.

Should Brokers Include Owner Compensation?

I appreciate that Owner’s Compensation is usually not included. My owner situation is different than your owner situation. By not including that cost, I can make an accurate judgement based on my own unique circumstances. I may hire someone, add the work to a current team, or do the work myself.

For a seller, if it’s included, it moves the price downward. This conditions the seller to be reluctant to accept any other reasonable price drops. For buyers, I don’t want it included because what I pay myself likely as little to do with the true value I add to the business. For example, the seller may pay themselves very little because they already pay themselves a solid salary in another business.

Personally, I want owner compensation removed. How the current owner pays himself has no bearing on how I will pay myself in the future.

The real issue is when brokers remove the salary of an employee based on the same reasoning. If you’re paying someone $250k a year to run the business, that’s a real expense. Changing it to $150k because you can likely run it with someone less expensive is not acceptable.

Overhead – Routine Online Business Acquisition Costs Not Included

There are a few routine online business acquisition costs that are not included on any financial prospectus. The reasoning is the same as the one for Owner Compensation. Mainly these costs are external to the business itself and completely dependent on the new owner.

An example list of these types of expenses, typically referred to as “overhead”:

Business Insurance (multiple policies likely for online businesses)
Office Expense (home or commercial location)
Internet Access
Computer and Technical Equipment for Owner and Employees
Office Supply Expenses (pens, paper, phone chargers, etc)
Payroll Tax
Payroll Expense
Preferred Software (for example, I use Baremetrics to easily monitor my SaaS metrics, but I wouldn’t consider it essential software to run the business.)

These expenses run into thousands of dollars a year. However, they can also be split up among multiple businesses. Your fixed costs per business decrease as your portfolio grows.

Investors handle these overhead expenses differently based on their own situations. Some skimp on business insurance or run their company out of their bedroom. Others have company cars and pay themselves very well. It’s entirely up to you, one of the benefits of running your own company.

Annual Plan Obligations

Many businesses offer annual plans to their customers. Those businesses may also operate on a cash-based accounting system. This means that when money is received or spent, it is recognized immediately for accounting purposes.

Many companies also offer a discount if you pay up front for an annual plan. By trading for less money today, companies use the upfront cash to gain more customers tomorrow.

When you sell your business, you’ve received the benefit of the annual plan – the money. But have an invisible liability within your company – the obligation to deliver the service.

Brokers do their best to adjust valuations if a business has a lot of annual plans. Yet, I’ve never seen a business listed at exactly 4x and then showing a subtraction in the purchase price for the ongoing obligation of servicing annual plans. I’ve heard “yes, we factor that into the sale price”, but can’t show where that was factored into the purchase price.

If you are buying a SaaS, it might be worthwhile to look at the number of annual plans. Then, adjust the value based on liabilities where you aren’t receiving the benefit.

Help is on the horizon, however. Stripe (and other payment processors) provide a Revenue Recognition feature. This can help illustrate ongoing pre-paid obligations for potential buyers.

State Business Fees, Taxes, and Other Incorporation Fees

A business does not exist without support from state and federal organizations. Think your local Secretary of State and the IRS.

Every business will require an entity for the assets, whether it’s an LLC, corporation, or partnership. (I don’t recommend a sole proprietor set up. It exposes the individual to 100% of the business risk).

Those entities cost money to set up and operate. You will have to pay state fees, state taxes in most states, and other taxes disguised as convenience fees.

Your state of business incorporation – many times the state you live in, but not always – will dictate the amount of paperwork and the costs involved.

There are also operational activities that each business must perform each month, quarter, and year. They can range from documenting an annual meeting with the managing partners (even if it’s just one person) and keeping track of operational documents. This demonstrates that the business is run “as a business” and not as a personal piggy bank.

If you’ve had an interest in owning a business for a while, you likely know most of the things you need to do to start your business. What most people forget is that you also have to operate the business correctly. I used the book Run Your Own Corporation as a starting point for what I needed to do to stay in compliance. I want to sleep easy at night knowing I can show any legal eagles that I’m operating my company professionally.

Discretionary Training, Certifications, and Conference Costs

I’m surprised at how many businesses leave out significant costs that aren’t operational costs, but are part of the “realm” the business operates in…for lack of a better way to say it.

Some scenarios I’ve seen:

Many companies have “must go to” conferences, events, and trainings each year. If leads come primarily from attending conferences, is that included in the ‘owners hours’ and expenses?
Does the business have ongoing compliance certification costs? For example, does the business need SOC-2 certifications? Those cost a lot of moolah and if an owner lets the certification lapse in the year prior to the sale – to lower costs and boost their sale price – is regaining the certification cost factored into the sale price?
What is the cost to replace an owner with multiple relevant certifications and is well known in the industry?
A company says they have “10,000 emails in their database” in the prospectus. Did the company recontact all email addresses collected prior to May 2018 to re-confirm the recipient accepts GDPR compliance and privacy restrictions? (I’ll save you the time, they did not.) Does the seller have GDPR record of consent for each email? If not, the emails are a liability, not an asset.

Under GDPR, email addresses are considered confidential and must be used and stored within strict privacy and security guidelines. Emails can only be collected through explicit opt-in, with a requirement to keep record of consent.

This section could go on for miles. I wanted to give you a little sample some of the more nuanced online business acquisition costs that don’t show up on the broker prospectus. I hope this helps you think through some of these online business operational costs next time you’re valuing a potential acquisition.

None Are Show Stoppers

None of these items are show stoppers by any means. They are just additional costs that don’t show up on the prospectus. It’s good to know about them before you invest rather than learning about them afterwards. Some companies may not look as exciting when you have to 2x the time it takes to run them, they have GDPR issues, and sell 95% of their subscriptions on annual plans. Maybe it will even keep you from ending up with a failed acquisition.

For more similar insights, please check my companion article 8 Buying SaaS Business Insights I Learned from David Newall’s SaaS Business Valuation Guide.

Affiliate Disclaimer: If you click on the Run Your Own Corporation or Work the System SOP’s Amazon links and purchase a book, I earn something like $0.13 – give or take a dime or two. So be forewarned, that’s an affiliate link and I will be compensated so handsomely that I may be able to retire.

Photo by Stephen Phillips – Hostreviews.co.uk on Unsplash

Failed Acquisition – Lessons Learned from Acquiring the Wrong Business

February 7, 2021 by Michael Frew

In 2016, I purchased an E-commerce business that sold plugin’s for the Magento storefront platform. As a result, a lot of my capital was tied up in a low-margin, resource intense, and challenging business. After a year, I realized the business was my first failed acquisition.

As an investor, my goal is to operate my businesses with high margins and healthy cashflow. I achieved neither of those goals and sold the company after two years.

I knew I had to admit my mistake and prepare to sell when we were spending 70% of our attention on this underperforming business and neglecting the other companies that were growing and thriving.

Focusing on the least rewarding business is the opposite of how I operate today, a lesson learned from this failed acquisition. Today, all my efforts go into nurturing the horse that’s running the fastest with the most wide-open space ahead.

With years of time to reflect – and the pain from this failed acquisition fading into the past – I wanted to capture the lessons I learned so that others can learn from them too.

How Innocent Can A Failed Acquisition Look?

If an online business broker sent you the below executive summary, would you be able to spot a future failed acquisition in this broker description?

For Sale: A software business selling plugins for the second most popular E-commerce platform with over 250,000 companies actively using the platform worldwide. The platform recently released their newest and most expansive upgrade, thereby guaranteeing a healthy, long-term ecosystem for the business. The global popularity ensures a large developer pool that can help the new owner maintain current levels of growth.

Started by a top tier developer with deep ties to the industry, sales increased 100% in the past 12 months via his unique sales channel. Included in the sale are all of the tools, methods, SOP’s to replicate his success.

With thousands of current customers on annual licenses, a new owner is ensured an ongoing recurring revenue stream. The large user base ensures numerous opportunities for future up-sells and custom migration services.

The challenges are all listed in the executive summary, but I did not recognize them at the time.

Why Write About Failure?

When something goes right, we tend to give ourselves too much credit for our role in the positive result.

When things go wrong, we want to blame others, or the external environment, or anything other than ourselves.

Essentially, we believe that we are the reason for all of our success, yet we are not the cause of our failures.

I know all online company acquisitions aren’t successful. I know future ones that I make will also not be as successful as others. Some may even end up as a future failed acquisition example too.

Across the board, there are likely many more failures than successes. Yet, I don’t see a lot of failed acquisition examples discussed openly. It’s natural in business and in life to only point out the good events that happen to us and bury the bad things under the rug.

My goal here is to acknowledge where I was wrong in this acquisition and assign blame where it is due, with myself. Furthermore, if others can benefit from my experience, I would be selfish to withhold my education and thoughts from the community.

Due Diligence Against Myself

In this essay, I highlight my lack of self-awareness regarding the acquisition. I outline how I failed to educate myself about the company, the marketplace the products sold into, and my place in them both.

The issues below are just the technical reasons the acquisition failed. They are particular to that business and not applicable to many other acquisitions. However, my failed approach to the acquisition is relevant to all other acquisitions.

I was the wrong investor and owner for this company because I displayed hubris, ignorance, and the false belief that I could do anything with software if I put my mind to it. I went forward with an overestimation of my abilities and a blind ignorance of my weaknesses.

The lesson I learned from this acquisition was not “stay away from Magento” or “I’m not cut out for B2C or E-commerce”. I learned I needed to be a much more impartial judge of the strengths I bring to a business acquisition. Additionally, I needed to perform due diligence on myself to determine if the company would benefit from what I brought to the table.

I regret that it cost me so much time, money, and pride to learn these lessons. Yet, it has made me a much more cautious, methodical, and successful investor in the long term.

When all is said and done, this acquisition failure will likely be one of the best things that’s ever happened to me in my online business acquisition and operation career.

Five Lessons Learned from a Failed Acquisition

Framing the Business Incorrectly

I believed I bought a software company that sold products via an E-commerce platform. But in reality, I bought an E-Commerce company that sold software.

When I reviewed the business for purchase, I framed the business in my mind as a software business that made sales online instead of an E-Commerce business that sells software products. Even if you had told me at the time, I likely wouldn’t have realized how framing the business genre incorrectly would impact my long-term success.

E-Commerce was not an online industry I had spent much time studying or working in prior to the purchase. At the time, I was primarily a software investor. That doesn’t mean I can’t learn about E-commerce, or affiliate marketing, or lead-gen services. It’s just that my strengths lie in software first and other online genre’s second.

Therefore, from the start, I didn’t understand the company business model. Nor did I recognize that the B2C market for E-commerce was different than the B2B/B2C market for software.

Failing to frame my acquisition properly wasn’t something I realized until years after I sold the company. It was an unknown unknown because I didn’t know how badly I mischaracterized my own company.

Framing the Market Incorrectly

Magento v2 was released in late 2015, the same time I purchased the company. The platform – from a plug-in developer perspective – was incompatibly different. This was not an unknown issue at the time, it was just unknown to me.

A simple porting of our v1 extensions to v2 wasn’t easy, cheap, or even necessary. Many of the issues with v1 that my new business solved were unnecessary for new installations of Magento v2. Once customers upgraded to v2, many of them no longer needed our best-selling plugins.

I was a complete outsider to Magento. That caused me to overlook the fact that Magento was an overcomplicated and hard to use framework. I assumed, incorrectly, that v1 plugins would still be needed and could easily be upgraded to v2 plugins simply because the seller said so.

On top of that, Magento’s v2 change resulted in significant v1 to v2 migration expenses and beta-type functionality bugs. These changes rankled even their most satisfied and dedicated customers.

The prior switching cost headaches and expenses that kept companies on Magento even when they hated it disappeared when migrating to Magento 2 was just as painful and expensive as starting fresh on Shopify. Online stores started dumping Magento for more business-friendly solutions like Shopify. They could replace it with solutions that had lower complexity, more modern features, and a comprehensible path forward.

Magento vs. Shopify Google Trends for the two years I owned the business

The overall trend for Magento shows that it fell out of favor following 2016’s move to v2. In short, my most profitable customer pool was shrinking every day.

2016 – 2020 Magento v2 vs. Shopify

What’s my point here?

My point is, these trends were foreseeable and known within the Magento community. I was not one of those people. I neglected to either learn for myself or speak with people in the Magento ecosystem.

These facts were discoverable and likely the reason the seller wanted out of the company. I failed to do my research, failed to look critically at the business and the market it operated in, and failed to account for the fact that I was ignorant of the larger market forces that would dictate the success of the investment. And that left me with capital tied up in a failed acquisition instead working productively for me and my team.

Framing the Customer’s POV Incorrectly

Getting people to pay for a Magento plugin is difficult.

Magento is a free open source solution. The user is conditioned from the start that using Magento is not going to cost them a lot of money, in many ways like WordPress conditions users today.

The problem is that getting Magento to work can be very expensive in both time and money.

Incidentally, this is the one of the reasons some investors shy away from business offerings centered around WordPress. Most people using WordPress are conditioned to believe they can run their website without paying for anything other than hosting. It’s difficult to create WordPress plugins that do well financially, despite WordPress’ market share and success. (At the end of 2020, there were over 54,000 free WordPress plugins. The number of paying WordPress plugins is likely only a small fraction of that total.)

There is nothing wrong with users not expecting to pay. The problem was with me, not the users. I was not a Magento user, never built a store with the product, nor took the time to interview any Magento customers. Therefore, I didn’t know the resistance Magento customers had for paying for products.

Failing to frame my acquisition customers correctly resulted in our focus being completely wrong for their typical use cases and need for our services.

Framing the Prior Business Success Incorrectly

The original owner was a top tier Magento developer. He also excelled at a unique method of increasing sales via customer service interactions with customers. He shared all the tools, email sequences, SOP’s, and funnels to replicate his success. Sounds great, right?

Unique and Personable Sales and Customer Service =

Expensive Employees to Replace

The prior owner learned how to profitably exploit his customer service queue as his primary sales channel. Customers would write in with an issue and by the end of the ticket they would purchase additional products. This was due to his deep understanding of the technology, knowledge of the routine pain points of Magento, and his willingness to spend time reviewing his customers store-fronts and recommend the right plug-ins for their business.

To replace him, I had to find someone who was not only a top tier expert in Magento development, but also really strong in customer service and add-on B2C sales via email. How many unemployed engineers are out there waiting for me that are experts at those three skills? Very, very few.

What appeared like an obvious benefit (wow, what a unique sales channel!) as a buyer turned out to be a liability as an owner (wow, nobody else can do the same affordably!). The prior owner was not replaceable by one, or even three, people. I failed to understand during my due diligence that he was unique and I would never replace such a charismatic founder at a price that made the investment viable.

Be wary of businesses that do well because of the owner. If the owner is the reason for the success, not the business itself, that person will cost a lot to replace.

Highly Customized Solution =

Highly Priced Experts to Maintain

The prior owner also built a highly customized Magento storefront, which was a strong selling point. Not that I knew when I bought it, because I didn’t know the differences an out-of-the-box storefront and a highly customized version. The customization allowed the store to execute complex up-sells that significantly sold more products. Therefore, breaking any portion of that customization meant lost sales and high costs to fix.

The storefront was expensive to maintain because it required a lot of time invested to understand how to make even the simplest change. Every time we fixed one issue, we broke some other part of the storefront.

It required full-time maintenance and monitoring by an experienced engineer commanding high-level compensation. This was not the type of acquisition where one could hire a few outsourced engineers and be successful.

Paying for a talented engineer to do complex work is not an issue, but purchasing a site not discounting the expense to replace the founder was an issue.

Framing the Technical Support Ecosystem Incorrectly

If you had to guess, which ad would get the stronger and more qualified responses?

Ad #1: PHP developer familiar with Magento needed to design, prototype, build and launch new Magento Plugins.

Ad #2 PHP developer familiar with Magento needed to answer customer support questions, fix bugs, and push new sales with customers.

When developers spend 5-10 years learning how to write complex applications and refine their skills, customer service is not where they want to end up. They want to create, design, and implement. Not answer tickets, appease sometimes overbearing customers, and fix what others have broken.

The Magento ecosystem has a large supply of developers, but the pool is much smaller when you need strong language skills, the temperament to work in customer service, and the soft sales skills to artfully recommend products without sounding like you are reading from a pitch sheet.

There are many developers with these skills, but most of them are like the seller…building out tools, services, and products themselves. They’re not waiting around for someone to hire them. Most likely, they already have a high paying position or are working for themselves over at Indie Hackers.

I wasn’t knowledgeable enough about the Magento talent pool to know how challenging it would be to replace a superior technical founder with the available talent on the market.

In the end, I just didn’t understand the technical support ecosystem for Magento. I assumed a single developer could replace a single founder like many other software projects I worked on previously.

A Failed Acquisition – Was It The Business or Was It Me?

To go back to my earlier question of “Would you be able to spot a failed acquisition in this broker description“, the answer isn’t really with the description of the business at all.

The problem was I didn’t perform the proper due diligence against my own skills, education, and talents. Had I done that honest self-assessment when I read that description, I would have realized that the business was a poor fit for my business background and skills that early in my acquisition career.

It was me that failed the business, not the business that failed me.

Photo by Sarah Kilian on Unsplash

8 Buying SaaS Businesses Insights I Learned from David Newell’s SaaS Business Valuation Guide

October 8, 2020 by Michael Frew

David Newell from Quiet Light Brokerage is one of the most seasoned SaaS-oriented brokers in the online buying and selling community. He recently dropped a 13,000(!) word knowledge-bomb on the topic of How To Build, Value, and Sell A SaaS Business for 6, 7 or 8 Figures.

I’m fortunate enough to have bought a SaaS business from him in the past and he is truly one of the marquee brokers professionalizing our industry. His 60-page article is a must-read for anyone that is building, operating, or transacting in the sub $5M SaaS world.

Much of the article provides a solid background on buying SaaS businesses, but it does also have some intriguing nuggets even for more experienced SaaS operators and buyers that go beyond the beginner basics.

In this essay, I pull out what I thought were the eight most interesting takeaways that I learned from his article and sprinkle in some of my own opinions about our acquisition space.

1) Developers Can Unlock Tons of Additional Income

Let’s look at how brokers set up a business for sale:

“The key-man risk associated with the business is very high, presenting buyers with a major transferability issue (a key valuation pillar). This translates into a discounted multiple, an earnout offer structure (to de-risk the deal), or a very extended transition and training period. None of which is particularly ideal for the owner.”

“A smart, de-risked way to bring in a third-party developer (contractor or employee) is to have them learn the codebase and document it at the same time (code architecture map, annotations, etc).”

“In a best-case scenario, you want to demonstrate to a buyer that the developer has worked for you for a long period of time and had experience shipping major developments with the software.”

What does this all mean to developers and technically experienced professionals on the buy-side?

Brokers require sellers to set up their SaaS businesses to be sold to passive investors, not technically oriented operators like developers, engineers, and IT professionals.

Passive Investors vs. Developers / IT Investors

For a SaaS business seller that was founder run, brokers usually will want the selling founder to set up either a team before selling or have one ready to step in on day one.

This lowers the purchase price because that developer cost lowers the eventual SDE and sale price.

This can be a huge opportunity for developers, or people who have technical experience, or anyone who has managed technical teams before.

As a developer or technical oriented operator, you can purchase the business and either replace the team yourself or bring in a more competent, focused, and less expensive team that you already work with on other businesses.

Since technical help often is the most expensive part of your P&L (after the cost of taxes), this can immediately juice the returns of your business.

Unlocking Value with a SaaS Business Buying Example

When I bought the founder-run business Appointment Reminder, the broker made the seller spend six months training up a team of remote developers to be ready to go to assist me with the business.

Once I had bought the business, I dropped that contract and had my own team just absorb those tasks as another responsibility in their daily functions. (It really helps to always buy businesses in the same tech stack. I’m going to write an article on this concept soon.)

I earned back the equivalent of one year of expenses immediately from that move alone. Instead of taking four years to earn my money back, it would theoretically only take three.

2) The Differences Between Value and What You Get

“Your business’s worth is based on who is out there to buy it in the first place.”

“How much is my SaaS business worth?” is best answered as, “It depends on who you sell it to.”

The difference between value and what you get is:

Value is how much the business is worth using common valuation methods.
What You Get is what it can be sold for in the market.

And rarely the two shall meet.

Your business’ worth is based on who is out there to buy it in the first place and what they say it’s worth.

I run some esoteric businesses where there aren’t a lot of buyers that would pay what I believe is the true value for the business. My value and what I would earn on a sale may not match up.

I can live with that, but only because I don’t go to market assuming I can achieve a sale price that will match what I believe the business is truly worth.

3) Sellers: Understanding the Buying SaaS Business Landscape

Sub $3M Threshold

“…you can see that in the $100K to $3M exit landscape, the vast majority of exits (by volume and value) are made to individual, portfolio, or syndicated buyer types.”

Microfunds/Syndicates: They differ from private equity in that they do not have institutional financing and acquire 100% of the company at closing.

Under $3M, you’re likely only interested in a few types of buyers, and very likely not private equity and strategic parties.

“Private equity investors aim to incentivize the owner to stay on for at least 18 to 24 months post-sale to work towards pre-agreed revenue and/or development targets.”

At a certain revenue point and complexity of the business, it’s almost unavoidable that there’s going to be some post-sale work unless you’re willing to give up a lot of cash at closing.

But under that purchase price level, my recommendation is to get as much cash upfront as possible, with as little post-sale work as possible, and don’t settle for ‘holdbacks’. Holdbacks, which I cover below, are dependent on hitting revenue or development targets where the acquirer determines your “success” in the future. You never know when a pandemic of global proportions might show up and evaporate that hold back payoff.

Above $3M threshold

“Above the $3M threshold, the landscape shifts towards PE and strategic buyers. They focus on revenue-multiple and are willing to pay more, but often want the owner as a part of the deal, working for 18 to 24 months post-sale.”

Above $3M, your choices about selling, taking the cash and walking away get more limited.

There are many cases where getting money off the table is a good idea, even if you end up with a job from the old business you just sold for a year or two. Just be aware that if you’re a serial entrepreneur, you may want to conder selling before you reach that level and move on to buy your next business.

**4) Holdbacks (Sub $3M Range)**

If there is a substantial performance component to the deal, then there should be an emphasis on the skill and experience of the acquirer to ensure they can achieve those goals and future payments.

My opinion on holdbacks?

Pandemics…enough said.

Try and stay away from holdbacks as much as possible.

Remember, the acquirer is the entity that determines if the goals are reached in the future.

And let’s face it, business accounting can reclassify a lot of expenses, assets, revenues, and marketing efforts into other categories that can change key metrics in any direction an accountant would desire.

Holdbacks are standard for larger deals, but don’t let smaller sellers try and “pull-down” holdback standards from the upper echelons of PE firms and act like that’s acceptable under $3M.

5) SBA Eligibility for Buyers

“SBA eligibility significantly increases buyer demand. That’s because they only need a 10% to 20% down payment on an SBA loan to buy a business. If you’re selling for $3M, for example, there are a lot more buyers with $300K in cash than there are with $3M in cash. Because there’s more demand, you can qualify for a higher multiple.”

“SBA loan deals do not come with any earnouts or holdbacks either. As the seller, that means you’ll receive between 90% to 100% of the deal value in cash at closing. That’s definitely a strong incentive!”

As a SaaS business buyer, get pre-qualified before you start looking for deals. If you need help with this SBA qualification process, write to me.

As a SaaS business seller, go through the seller SBA process, it’s painful and annoying, but do it. You can get really qualified buyers that have less cash, but more experience, that can really take your business and run with it.

6) SBA and SDE Add-Backs

“The banks and SBA don’t participate in the adding back of expenses that we discussed in the SDE valuation section of this guide. Instead, they rely largely on the bottom-line net profit.”

This oddity of SBA sales changes how I look at my business in the 12-18 months prior to a potential sale.

If expenses like salary, health insurance, training, R&D, etc. aren’t added back in, then I’m not going to run those necessary expenses in the years prior to a sale. (This is why it’s helpful to have multiple businesses where one that you don’t care about selling can be your “overhead business”. Another article I have coming out soon, stay tuned.)

As a buyer, realize an SBA-backed business likely has some costs and expenses neglected that should have been in the business previously. Tasks that good businesses should be doing, like R&D, new customer acquisition, advertising, etc. may have been ignored for 12-18 months. This SBA rule encourages sellers to leave a well-running business on auto-pilot for a year or so and not invest in the business because it would lower the price of the eventual sale.

Just something to keep in mind when looking at SBA-approved businesses.

7) Buyer Beware of Broker Choice on What Is Really SDE

There are not many direct quotes from the article on this tactic…but between the lines there are hints of how brokers use a “massaging” of valuation periods to improve their asking price.

Here are a few things I always look out for:

Non-Standardized SDE Time Periods

Certain brokers use no standardization of SDE models, they just choose “Whatever trailing model looks best in the last 36 months“.

Sometimes it’s the last 3 months, sometimes it’s the last 18 months excepting the last 3 months.

Make sure you are comparing apples to apples when looking at buying SaaS businesses and using the previous performances of similar businesses for comparisons. Some brokers are more notorious for this practice, others don’t do it at all.

Annualizing Current MRR (“Run-Rate”):

However, in some cases, it makes more sense to use either the last six months (L6M), the last three months (L3M), or even the last month (L1M) and annualize that number instead. If you’re in a scenario where your SaaS is growing very quickly, it’s not appropriate to use the last 12 months. Growth over the last 12 months justifies the re-rating. Customer metrics (like churn and LTV) are stable or improving.

This is the most common method of inflating sales prices. It involves annualizing the most recent months of revenue instead of calculating the last 12-24 months. Those months are guaranteed to be juiced for maximum gains. The business likely had a drop in expenses and a mysterious increase in revenue.

Remember, to bring a business to market, a broker will spend months getting it prepared and looking good to potential buyers. They are basically “staging” the business, just like you stage a house for sale.

Then suddenly at the end of this process, the business has an incredible month or two and they decide to base the price on that purely happenstance great time period? Hmmmm….

High Paying Customers That Aren’t Real Customers

Possibly in conjunction with #2, verify in your due diligence that all high paying customers have been with the business a long time, are legitimate businesses, and not just the seller’s friends juicing up the bottom line that will slowly disappear after the sale.

Every single one of my businesses could easily add one or two fake accounts a month for half a year that would really increase my sale price.

Does that high-value subscription have usage? Is it a real business that’s verifiable? Those types of metrics are harder to fake. Could there exist a seller PBN-style of business that’s not spoken about that provides this type of service?

OK, now I’m getting a bit too paranoid…

One Time Gains Added into Sale Price Calculation

A fairly common way a sale price is inflated is a company that has a one-time product offering (software upgrade, etc.) that is factored into the sale price as if it’s a repeatable, normal revenue driver of the business.

One-time product offerings that required 12 months of work for that one month launch are not repeatable for a new buyer. A new buyer would have to spend all of that R&D money again on the next version but would never get the benefit of the one quoted in the prospectus.

Let’s take an example, a business that makes a net profit of $3k per month has a new product upgrade version come out in July that nets $30k that month. The valuation will take into account that $30k month, even though the buyer gets zero of that income, it is not repeatable, and does nothing but increase the sale price.

The seller gets the $30k and gets to bump up the sale price for what is really a one-time product sale.

Just pretend that this bump in revenue was actually a one-time expense? A broker would call that an “add-back” and subtract that one-time event from the expenses line. But since its profit, it’s left in there to boost the sale price.

Keep an eye out for those…

8) Brokers Protections

Enough bashing brokers! I actually do love brokers and they do a tremendous amount of great work under the hood so you don’t even have to realize how complex this business really is on a day to day basis.

Hiring an advisor means you get access to their list of vetted, pre-qualified buyers. These buyers trust that broker to bring good deals.

There is a discount on the sale price if I have to teach you how to sell your business.

Don’t bother looking for that last quote in the article, that one is mine. Brokers provide a ton of value for their cut of the sale.

If a seller doesn’t want to use a broker to sell the business, then I want a discount (roughly equal to what they would have paid the broker) because now I have to do all that work and it’s a real pain.

Many buyers will gladly do that grunt work for a possible sale, but that’s something I believe should be done by an expert and experts should always be paid well for their services.

Bonus, there are nine items!

9) Why Annual Plans Stink for Buying SaaS Businesses

Monthly to Annual Plan Ratio: As a rule of thumb, monthly recurring revenue is more valuable than annual recurring revenue (i.e., monthly plans vs. annual plans) because MRR is more predictable.

Thank you David for someone finally saying this about annual plans!

I’ve always believed annual plans were a terrible idea for many businesses. If I buy a business that has annual plans, I halt the sale of any new annual subscriptions moving forward.

Why are Annual Plans a Bad Idea?

Annual plans are a pain for accounting, a pain for getting the credit card to work the next year, and why do I need to give a 10-20% discount just because a customer wants to pay upfront now? If you want to pay upfront, that’s great, but it’s still going to be full price.

In many cases, businesses want the cash upfront at a 20% discount because they want to invest that cash immediately in finding new customers. Ok…that’s great if you’re running a business with no cash in the bank, but if that’s the case in our sub $5M world, you have other issues. You’re basically paying 20% interest on a one-year loan. That’s predatory loan interest levels.

Would you take out a one-year loan at 20% interest to buy Google Ads for your business? I sure hope not.

Enough of my opinion about the worthlessness of Google Ads and my opinions on selling annual plans, let’s dig into this a bit.

Free Labor for the Seller, Liability for the Buyer

For any business sale, each annual plan is a liability to the buyer. Each annual plan your buyer has to serve…but was never was paid to do the work. It’s free work for the SaaS business seller and a liability for the SaaS business buyer.

Bad Customers Might Only Be On Annual Plans

Many times I have seen customers are on annual plans because they are bad customers, not because they are good customers.

I primarily do annual plans for customers that I decide either need to be fired or can stay if they agree to pay in full a year in advance.

These are the type of customers that are such problems that only earning one or two months of revenue is not enough to keep them around, they must pay one year upfront for me to let them stay as a customer. I’m sure I’ll do an article about firing bad customers soon.

You may find that the annual plans you are counting on as revenue in eight months never pay again because they were all bad customers in the first place.

Factored into the Sale Price?

I know brokers say they factor annual plans into the sale price, but I’ve never seen any broker break it down and say “This business is worth $1,230,000 at 4x but we’ve lowered the price to $967,500 because of the annual plans.”

They list it at $1,230,000 and claim it was lowered to compensate for annual plans.

Sure…sure it was.

Summary

Hopefully, my thoughts above highlighted some of the things I’ve learned from David about buying SaaS businesses in the past.

Dave did an awesome job of really pulling out the details of many complex moving pieces both for sellers, operators, and buyers alike. Many thanks to him and I’m sure I’ll be coming back to his essay many times over the next few months.

Unknown Unknowns of Buying Online Businesses

June 5, 2020 by Michael Frew

“Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tends to be the difficult ones.”

We’ve all heard the Donald Rumsfeld quote about the “Unknown Unknowns” by now. It’s easy to laugh at until you find yourself faced with a situation where an unknown unknown from a business you bought, or a project you inherited, creeps up and surprises you. Hence, that is why they “tend to be the difficult ones”.

One of the biggest unknown unknowns in taking over and running someone else’s project – whether it be their code base, their old business, or even a school project – is where the former user failed to point out – either on purpose, or malice, or through sheer neglect – a few details about their project that are essential for your long term success and viability.

I would wager that it’s not even possible to remember every single detail one would need to share with a potential new business owner, no matter how small or insignificant the business project may be to the seller or buyer.

Even the simple sale of a basic, low 5 figure Amazon Associates website will have a few particular unique qualities about it that might not be properly conveyed to a new owner.

Amazon Affiliate Unknown Unknowns

Many years ago, I purchased my first Amazon Associates affiliate website to get my feet wet and see if acquiring websites as assets for a portfolio of cash-producing investments was something I would enjoy. (The answer turned out to be a resounding Yes!)

What the seller forgot to mention was that all of the tracking ID’s that were passed to Amazon when a user clicked on an Amazon product link weren’t really set in the Associates WordPress plugin where it appeared they were set. Those settings were actually overridden from a different location, leaving the sellers associate ID’s intact and mine “accidentally” overwritten.

Basically, the seller was hijacking my affiliate tags and substituting his despite it looking like mine would be used, and I would get credit for the sale.

(Incidentally, this is how Honey works; they hijack the transaction when you click “Apply Coupon” and slip their own associate ID into the mix, removing the ID of the originator that sent the buyer to Amazon in the first place. For some reason, nobody other than affiliates relying on Amazon Associates for income feels this is unethical, which I believe it is.)

Keep in mind, a broker specializing in transferring Amazon Affiliate websites swapped my associate’s ID for the sellers before transferring the site to me and didn’t even notice that the seller was still going to get credit for future sales. Trust, but verify.

At the time, I don’t even know such a problem was even possible; it was unknown to me that such risk even existed. One could argue it’s known that sellers might try to cheat you, and it’s just unknown how they will do it. Yet, as green as I was, it was unknown to me that someone would try to sell me their site and still keep their IDs in the process, and it was certainly unknown to me how to detect such trickery.

That’s the danger of being new, naive, and not researching as much as humanly possible when starting on a new venture.

Everything I read was public. Anyone could buy the same books and magazines. The same information was available to anyone who wanted it. It turns out most people didn’t want it.

– Mark Cuban on the secret to his success in the computer business

Only after days of digging into the WordPress source code (to solve a completely different problem) did I realize that this developer had set the ID’s in the child theme’s javascript, not via the plugin normally used to set these types of ID’s.

It was a bit of a magic trick – obviously on purpose – where I would change the IDs in the Amazon plugin he claimed he was using to set the affiliate IDs. However, unknowingly, those values were overridden by the javascript affiliate ID’s of his own that were still left in the theme settings. But only a certain percentage of the time, there was a rand() function that only caused this substitution to happen occasionally.

I wonder how that type of seller would trick many non-technical people? They would see a drop in sales immediately after the sale and think traffic was down 20-30% due to the seller removing a PBN or one of the many other usual downticks in income after a sale. There’s little risk to the seller, as the seller is still getting some perpetual income and a purchase price on top of it to boot.

That’s an unknown unknown that I never, ever would have thought of…until I found it. Now I know, but how many more unknown unknowns are still out there that I don’t know about?

Github Code Repo Unknown Unknowns

Could there possibly be unknown unknowns still lurking in a business you’ve been running for 5 years?

Obviously, yes, there could be…

Alerted by Dead Man’s Snitch to some issues with one of our proxies, we slowly discovered that a library we depended upon had been deleted in Github.

How could that happen? What library did we depend on – that we didn’t control – was lurking in our code?

After considerable digging, reviewing backups, and head-scratching, we realized that a prior developer that worked for us was cleaning out his Github repos that he didn’t use any more. He was interviewing for a new position and wanted to clean up his Github profile…a completely logical and sensible move.

Yet, one of those repos he was cleaning up was inserted at some point in the past into our codebase when he worked for us, but it still was called by one of our processes. Obviously, deleting it caused the problem.

The solution wasn’t too hard. We could pull back an old copy of the code and bring it into our private repo. However, what a shock to find that someone who was no longer with our project still had his hands deep within our business!

I’ve been at the helm for over five years, and a developer was able to slip in his own code into the project, leave, and still be able to bring my business to a screeching halt.

That’s pretty much the worst of the unknown unknowns.

Should I have caught it beforehand? Well, I guess so, I’m the owner, and all responsibility falls on my shoulders, the good and the bad.

However, our product is fairly distributed, and I’m not sure, even if I knew that there was code in our files that we didn’t fully control, that I could have found this particular situation.

There still may be some remote library reference that could go offline in the future and catch us completely flat-footed.

The only known thing about that situation is that it will cause a problem at the worst possible time because that’s how it always happens. That I do know.

Challenges for Non-Technical Buyers

I believe that one of the hardest parts for non-technical buyers of technical/online businesses is that by not knowing the nuts and bolts of the underbelly of the business, their blind spots increase, and the number of unknown unknowns that can devastate your cash flow increases exponentially.

I’m not saying that non-technical people shouldn’t buy an online business, far from it, but what I do want to point out with this essay is that not knowing how to build what you are running carries an unquantifiable risk.

In many ways, I think of online business buyers, like myself, like general contractors. General contractors (GC) manage a large project from the top, overseeing resources allocation, scheduling time management for personnel and little bits of code, and taking responsibility for the results.

What I don’t see very often is a construction project with a lead general contractor who has never worked in construction on his or her way to reaching that top-level status. In fact, I would expect that all GC’s know the fundamentals of electrical wiring, bricklaying, fabricating a structure, and framing a house. When you’re going to operate a business solely based on the Internet, technology, and code, and you don’t know your DNS from your DMZ, there’s a considerable amount of risk introduced by that lack of knowledge.

If you aren’t knowledgable in the area of business you prepare to invest in, you owe it to yourself to spend some time learning about the fundamentals of technology and online companies before you risk your time, money, and reputation on a business that’s completely virtual, rarely understood by outsiders, and difficult to protect if you don’t know the risks.

I’ll do my best to help educate via sharing my experiences, but make sure you utilize every resource possible. Read books, take classes, even do a small website design project yourself.

That’s the type of focus and engagement with your future that can help eliminate those types of unknown unknown risks…

The Future – Customize Solutions Trojan Horse

I still have an unknown unknown that I have yet to solve to this day.

I purchased a business from a very skilled technical owner who had customized a considerable amount of an open-source shopping cart platform. It created really wonderful solutions for customer problems, but I always had a nagging feeling that something in the platform was there waiting for me, watching my every sale.

The whole business was too specialized, too personal, and too difficult to figure out where every piece fit without intricate knowledge of how each piece fit together and why it was done that way in the first place.

With this particular project, the seller-financed a majority of the purchase price (so he was still invested in the success of the business), and I was always concerned that if he were disappointed in how I was operating the business, he would reassert his control over the entire platform and shut me out of it. Certainly, he had left some Trojan horse or backdoor in there somewhere, right?

What would be my recourse? You can shut someone out of a software business very easily by changing a few permissions, records, or ownership details. Even if you can’t gain full control back, you can certainly keep someone from operating their business at 100% capacity for long enough that you could prevail in a hostile takeover (would that be a “takeback”?).

Was this something worthwhile to be concerned with on this project? Should I have someone looking for backdoors or a name record not properly listed for my business somewhere? Or would that be a paranoid waste of time?

Fortunately, nothing ever came of it, as the business was never harmed (as far as I know).

Yet, that’s the flip side of unknown unknowns…what if you try and know something by assuming it must exist, but it doesn’t?

One could wrap themselves in a pretty tight knot over these types of concerns, fabricated or not.

So what unknown unknowns are there lurking in your business right now?