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”
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.
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Want to learn more about my journey acquiring and operating online companies, including other failed acquisition lessons learned? Check out Online Business Ride Along, a monthly deep dive into my journey, with actual online investments and monthly P&L’s for each businesses.