Buying an Internet Business – Advanced Offer Structuring

If you have evaluated a website or internet business for sale and decided you want to make an offer to the seller, there are a number of considerations to structuring the best one for the business.

Perhaps due to a lack of experience or information readily available, some buyers can find themselves leaving value on the table by not structuring their offer with all the important factors in mind.

When devising the best structure it’s important to get information on at least these three things:

1. Structuring options – be sure to understand the funding options available for buying a business. Get to know the different financing tools and how they can be used to mitigate risks in the transaction as well as how they increase the value to you. Equally, knowing when they are appropriate to use and to suggest to the seller is also very important for getting acceptance on the terms you want.
2. Risk factors – through your research and preliminary due diligence to this point you should have conducted enough of an examination to understand any risks in the business. This will prove vital in how you think about structuring the consideration so that you protect against potential downside scenarios and mitigate the risk of other undesirable outcomes.
3. Seller characteristics – a successful deal is a win-win for both parties. A good buyer knows to take the measure of the seller, understand their priorities and structure a deal that works out for both. Larger deals could involve longer transition periods so it’s good to keep the seller motivated. Equally, an offer that hits the specific needs to the seller is more likely to get accepted, even one that is potentially lower than another offer elsewhere that doesn’t meet those requirements.

Naturally there may be more variables in play (the buyer’s finances is of course a major one) but for the purposes of this article we will explain how a core understanding of the deal-specific risk factors (2) and the seller’s characteristics (3) will lead the buyer to a better decision on the implementation of the financing tools available (1) and ultimately a better deal all round.

Understanding The Risk Factors

Businesses come in all shapes and sizes and every deal is different. As a buyer you want to strike a deal that at a minimum ensures similar financial performance in the business (as is currently being achieved) with strong scope for upside. Some of the common risk factors to identify and think about are:

Consistency

The consistency of traffic, customers and ultimately revenue is of paramount importance when assessing the risk profile of the business. Buyers should be cognizant of the age of the business but closer examination should be on the revenue trends since inception and the driving factors underlying this (i.e. traffic and customer churn).

The desirable trend is clearly a slow and steady increase. Fast is okay if it looks sustainable or the valuation multiple reflects normalised income both historically and going forward. You will want to carefully analyse the drivers underlying the trends and think about how replicable this is in your hands. The growth could be from anything as wide as search engine rankings to outbound sales calls by the current owner.

Knowing what moves the business’ bottom line is fundamental to deciding if the buyer can run the business but also to structuring a good offer. Spikes in revenue, traffic and customers will tell you a lot about a business so examine them very carefully and ask questions of the seller to explain it.

Seasonality

Continuing the idea of volatility, many businesses have natural peaks and troughs (i.e. seasonality) and it is generally okay to acquire a seasonal business as long as due consideration has been taken. Take care to note when seasonal spikes occur and to observe what percentage of total revenue and profit this accounts for.

In general, buyers should think carefully about a business with more than 25% of annual revenue from seasonal spikes, if it is higher and the investment case is still strong then it’s worth thinking about what can be done to structure out some risk. In either event, it’s also essential for the buyer to confirm to replicability of the event. Compare the year-on-year seasonal revenues to see how the proportions change and observe what other factors played a role (e.g. seasonal discounting, special events) and whether these can be duplicated in the future.

Concentration

Concentration is another major component of assessing the risk factors in a business. There are many different types of concentration depending on the business model, one example is affiliate concentration where one affiliate makes up 50%+ of the revenue of the business.

Another can be channel concentration where one monetisation method dominates revenue or one partner (e.g. advertising or affiliate network) accounts for all the revenue. Customer concentration is also another similar one, for example SaaS businesses where one enterprise client accounts for >20% of revenue. Lastly, traffic concentration is a very common type, though not necessarily a bad one depending on the sustainability. Many buyers are concerned with search engine risk and it is a valid risk, but it depends entirely on the rankings of the business, history, backlink profile and quality of the site in general.

When analysing concentration it pays to understand the back story behind each. For example, customer concentration might not be a bad thing if the customer has been using the software for 5 years and they are renewing for another year. Where the story gives pause for concern (e.g. 90% search traffic and no quality backlinks), then it pays to think about how to structure an offer to protect against this.

Survivability

Any concentration naturally leads to a contemplation of the survivability of that concentration. Will the affiliate partner stay around on the same terms? Will the customer cancel? Are the current backlinks going to stay in place? What reassurances do you have the status quo will remain post sale and in 12+ months’ time? To what extent is the business reliant on a significant time investment by the seller?

It’s useful to evaluate points (a) – (d) at the same time and plot them on a matrix if need be. This will significantly improve your decision-making around the initial “go, no-go” as well as around the price you’re willing to pay and the structure to lay it out with.

Understanding The Seller

With a concrete assessment of the risk factors of the business, the buyer should turn to understanding the seller as part of the overall equation. Surprisingly, only a minority of buyers do this habitually and it can make the difference between offer acceptance or not, sometimes even against competitive bids with a higher total consideration. These are some of the things that buyers should seek to understand.

Consideration

Naturally the tangible value of the deal is of high importance to most sellers but preferences over the structure and timing can vary considerably. Most sellers know their businesses intimately, are reasonable individuals and are cognizant of all the risk factors that buyers tend to highlight before offering. As a result, many can be amenable to creatively structured deals where it makes sense for both parties.

Certainty

Execution certainty is of great importance in any deal. The world of online business brokerage is fraught with execution perils and partnering the right buyer and seller is half the art in a successful deal. Don’t underestimate the value of offering the seller a quicker execution timetable and a deposit, if you’re confident you can complete due diligence and close in that timeframe.

Future

Think about what the seller wants to do in the future and what role they want in the business? What role do you want them to have? If they are important to the business then you’re going to want to consider a structure that keeps them engaged and motivated post sale. It’s worth thinking about what potential revenue upside could you offer them to incentivise the seller taking the deal and motivate them to help grow the business post sale.

Benefits

An extension of the thinking about the seller’s future, benefits relates to non-monetary deal terms and/or synergies that the buyer can offer to sweeten the deal. This can include making introductions to other business partners/contacts that might be useful for the seller’s new business ventures, share platforms, systems or special relationships together and any other number of synergies that might have made themselves apparent in pre offer due diligence. This is another reason why having a call with the seller or at the least the broker is a good idea for putting the best offer together.

Picking The Tools For The Job

With a firm sense on the risk factors and the seller’s position, it’s time to formulate an offer structure using the funding options available.

Before diving in, it’s very important to note that buyers should consider the use of these tools in the context of the wider bidding environment and marketplace dynamics. A seller is unlikely to accept 70% upfront with an earn out if other bidders are offering similar overall consideration and 100% cash, after all, cash is king. Equally, on smaller cap listings (i.e. <$75K), most sellers are expecting (and achieve) all cash offers and most buyers are willing to provide that so creatively structured deals are less feasible. Above that, things become more interesting.

Earn-out

Useful for:

1. Buyers who can add value and want to share growth with seller
2. Businesses reliant on seller’s personal relationships
3. Incentivizing the seller to consult or advise during the earn out period
4. Incentivizing the seller to grow the business post sale

If there are risk factors that suggest a higher degree of uncertainty in the next 12-18 months then an earn-out can be a useful way tool to collectively share the risk and performance. It can also be used as a carrot to incentivise collaboration to grow the business higher than its historic performance.

Considerations:

The efficacy of an earn-out in this regard is largely reliant on two things 1) the % of total consideration that the earn-out accounts for and 2) the seller’s willingness to invest time and effort in the business post sale. It is worth noting also that earn-outs have limited flexibility in that they only correspond to a percentage of revenue or profit, which is somewhat inflexible in the event of significant changes in revenue/profitability.

In general, earn outs are superior at incentivising growth post sale vs ensuring consistent performance or protecting downside where in fact ‘performance based’ consideration plays a better role.

Performance Based

Useful for:

1. Protecting against uncertain financial performance ahead
2. Incentivizing the seller to consult or advise during the earn out period
3. Incentivizing the seller to grow the business post sale

Similar to an earn-out scenario, performance based consideration makes sense to mitigate the risk of downside and keep the seller motivated post sale. There is a much greater degree of flexibility in the terms for performance based consideration. For example, buyers can structure goal-based targets (e.g. hit a certain revenue/target level to unlock consideration) and choose their specific payments in certain eventualities (e.g. pay a certain % of consideration if a certain % of target is hit). Depending on how the buyer structures it, the seller can feel more of a carrot or stick, which can be a useful tool when motivating going forward.

Considerations:

Similar to earn outs, the efficacy relies on the proportion of total consideration that the performance based component reflects as well as the seller’s willingness to participate post sale. It’s important to carefully balance the stick and carrot incentives offered through the structure, as some sellers will be less amenable than others to these solutions.

Hold Back

Useful for:

1. Securing against a known outcome
2. Enforcing a particular objective deal condition

Hold backs are excellent tools for protecting against a specific known risk or outcome in the business and also for enforcing a particular deal condition. In the latter case they are sometimes used by buyers to ensure training obligations are fulfilled in the first 30 days post-closing. In the former case they have been used in a variety of ways, for example to ensure particular backlinks stayed in place (under the seller’s control) or to ensure a transferable merchant processing account stayed open (see below case study).

Considerations:

Holdbacks are only useful when the seller can actually warrant the upholding or delivery of the performance condition. For example if there is a concentration issue with a customer and the buyer is looking to protect against them churning away, the seller cannot guarantee they will not. That is a structural risk in the business and the buyer should look to protect themselves against that through the overall consideration and proportion of upfront vs. deferred.

Case Studies

Case Study 1 – Holdback For a SaaS Business

On this particular deal FE International identified that a significant percentage of revenues were coming from subscriptions within a PayPal account located in the UK whilst the buyer was located in the US. PayPal don’t allow accounts to be transferred internationally and so to solve the issue, the buyer swapped in their US payment details and the seller guaranteed to keep their UK corporate entity in good standing for at least 12 months in order to keep the PayPal account running normally.

The hold back amount was calculated as the forecast subscription revenue for the 12 months, adjusted for the estimated churn of customers (based on historic numbers). This is a good example of how a holdback can be used to guarantee a risk factor is completely protected against.

Case Study 2 – Performance Based Consideration For a SaaS Business

In this transaction the buyer wanted to include performance based consideration to a) guarantee stable performance because the business was relatively young and b) incentivise growth because it was trending upwards.

The buyer struck a deal to pay out up to $100K in additional consideration on the upfront, paid at 3 and 6 month intervals depending on the revenue achieved by the business in those periods. There was a scaling ladder of revenue goals and consideration that effectively ranged from 75% – 125% of the LTM average revenue of the business. The payout at the 6 month interval was cumulative so if the business missed in the first 3 months (due to transition), the seller was still incentivised to push for growth in months 4-6 to get the final payout.

This was a great example of inventive thinking by the buyer as they effectively ensured they paid for stable performance and growth in exactly the fashion they wanted to. Keeping the goal cumulative through the periods meant the seller stayed motivated throughout.

Making It Work In Practice

Earn-outs, holdbacks and performance based consideration are good in concept but a prudent buyer should also understand enforceability. To bring these structuring options to life a buyer needs a well-worded asset purchase agreement and a strong escrow partner to work with.

The launch of domain name holding by Escrow.com significantly opens up the scope for these arrangements, providing great comfort to the buyer and seller that there is an independent third party there to ensure the terms are honoured by all.

Final Thoughts

Naturally there are a wealth of factors involved in structuring the best offer for a business, not least the financial situation of the buyer in question. This article serves to highlight some of the deal-specific considerations that successful buyers have contemplated in the past and structured offers for success.

Many of these buyers have consulted with the broker on their viability and collaborated to secure a win-win, which is ultimately what a business transaction should aim to conclude with.