This article is part of our Internet Business Due Diligence series, in which we provide you with information on what makes a particular business model unique when it comes to due diligence. For more in-depth reading on due diligence, see our posts on Due Diligence of an Internet Business and Advanced Due Diligence.
Due diligence of any business purchase is an essential part of the acquisition process. We’ve written before about how best to structure due diligence of an online business, and in this article we will dig deeper into each area as it relates specifically to e-commerce.
It is worth reiterating that some parts of the process may be considered more important by some investors than others. As it relates to e-commerce, there are a number of special areas for focus, for example, customer support, inventory management and supplier relations, which we will explore in greater detail below.
Analyzing the traffic profile of the business is one the first things a buyer should do.
Firstly, buyers should use Google Analytics to observe the trends in the overall traffic and for each channel, on a daily, monthly and annual basis. This should serve as the first stage of the traffic analysis before delving deeper on issues of interest.
Naturally the desired trend is for slow and steady growth across all sources, but it is perfectly acceptable to see some sources grow and diminish in importance over time. It is important to observe spikes in the data set and carefully explore the reasons for these, asking direct questions of the seller if need be.
- Did the traffic spikes correspond to specific action by the owner?
- Did it correlate to increased revenue?
- Can it be repeated?
These are all important considerations to understand. Buyers should use the following screens in GA to probe the trends data:
Penalties are an important consideration too. Use Google Webmaster Tools if you have access or third-party tools, such as our Website Penalty Indicator.
With a better sense on the overall traffic trends it’s time to turn focus to traffic composition. A diverse set of traffic sources in an e-commerce business is the desirable situation, but not all storefronts have this and it is by no means a negative trait, depending on the fundamentals underpinning each traffic source.
Buyers should look to investigate at least the top three channels that cumulatively account for 80+ percent of traffic. For many e-commerce businesses, organic search traffic will make up the bulk of overall visitors. It is therefore important to examine the quality of the search traffic. SEMRush is a great tool for digging deeper on keyword rankings and concentration.
The three characteristics buyers should be looking for are:
- A high number of ranking keywords (preferably on page 1 for the target term);
- Traffic split relatively evenly across the keyword spectrum; and
- Consistency in keyword rankings
The next thing to examine is the website’s backlink profile. Ahrefs is a good tool for analyzing a website’s current profile and link growth over time. We’ve written about backlink profile analysis extensively in our guide on advanced due diligence
Having understood the major traffic channels in greater detail it’s time to focus on the nature of the traffic coming through to the site. The nature of the traffic is somewhat subjective and its desirable qualities vary with the e-commerce business under review.
For the specific business under examination, the key is to understand the traffic profile of the desirable visitor and look for this in the traffic data. Key measures of value are pages per session, average session duration, bounce rate and of course the conversion rate on the products listed.
Graduating on from traffic, next to review should be the financials. These two areas complement each other and the findings from the traffic analysis should be overlaid to the financial analysis. In particular if there is clear traffic and conversion data available, this can be used as an additional sense check on the stated revenues.
Once you’ve established the legitimacy of the revenue, it is time to dig into the composition of those sales.
For e-commerce businesses composition and particularly concentration of revenue should be of great focus. The first things a buyer should analyze are:
- The breakdown of revenue by customer;
- The breakdown of revenue by product; and
- The breakdown of revenue by supplier
Getting detailed splits on revenues by customer, product and supplier will point to concentrations in the business that buyers should be aware of when evaluating the risk profile of the revenue. If 10 percent or more of the revenue is coming from a single customer, this merits further analysis into the history of the relationship and the customer profile.
Likewise, product concentration will demonstrate the dependence of the site on a particular item and the supplier of that item, which helps the buyer understand both inventory and pricing risks within the business.
The analysis should not only be thought of as a risk assessment exercise. Often insights such as which products are top sellers can provide ideas for growth opportunities post-sale (e.g. product bundles, discount sales etc) and so buyers should keep an opportunistic mindset when conducting the work.
Cost Analysis, Refunds and Chargebacks
COGS and expenses should be looked at thoroughly, requisitioning the monthly bank statements, PayPal statements and credit card statements relevant to the business and going through line by line totaling up expenditure in each month.
For an e-commerce business there are a number of costs that merit closer analysis as they can point to greater insights about the business. In particular, refunds and chargebacks are worth close examination.
Both refunds and chargebacks should be looked at carefully. A high rate of refunds can indicate customer support issues, product issues or a low quality customer base. How does one assess what is high though? There are a number of different industry studies out there, which indicate a wide range. More recent research indicates that 3 percent is about average for refunds on the physical goods space. FE International has found over time that 2 percent is about typical for the refund rate and 0.5 percent for chargebacks.
A high refund rate should be examined further to find the cause of the problem. The seller’s transparency on this is crucial to building trust in the sale. Buyers shouldn’t terminate their interest right away if the rate is high as it is often resolvable through a number of approaches. Improved product descriptions, faster delivery with tracking and better quality customer service are all common ways to go about it.
Due diligence on the operations of the business is a vital component of e-commerce due diligence and a key area overlooked by some buyers. The hourly time requirement and owner/employee responsibilities are important elements for the buyer to assess in order to both understand the obligations for taking over the business and validating the pricing of that work in to the valuation.
The most efficient way to audit the business’ time requirements and responsibilities is to conduct a ‘task audit’ for the owner and the employees of the business.
For an e-commerce business there are a few key workstreams that require close examination, these are customer support, inventory and supplier management and content.
Depending on the size and nature of the e-commerce business in question, the customer support burden associated with the business can vary significantly. Buyers should look to requisition as much information as possible from the seller to understand this.
The volume and nature of customer queries is the primary focus. For volume, buyers should go through 30/60/90 days of support logs to get a sense on the ticket load. The nature of the inquiries can be assessed through the responses but also in other areas such as social media, live chat logs and on the website itself.
Buyers should also look at how customers are being responded to (response times) which gives an idea of the type of questions and the support infrastructure available. The ideal situation is that 80 percent are simple inquiries that can be responded to with a script or wiki, as this is a highly transferable and scalable customer support operation. Hundreds of tickets for difficult to answer questions is obviously not an ideal situation for the buyer to inherit.
Inventory and Supplier Management
Similar to the above, the size and nature of the e-commerce business in question will dictate the level of work associated ordering stock and interacting with suppliers. With a dropshipping operation this is almost entirely mitigated, in an outsourced fulfillment or wholesale model, these are very important areas to understand.
Assuming the business operates a wholesale model, buyers should look to understand a number of things. Principally:
- The total SKUs on offer and the breakdown of these between suppliers;
- The standard operating procedures for reordering inventory from suppliers;
- The pricing and delivery terms for each supplier; and
- The standard procedure for order fulfilment and delivery
Understanding the above is key to seeing into the heart of the business and the time requirements attached to each step. When auditing these aspects, buyers should look to understand how standardized and automated the processes are.
Linked to the number of SKUs and inventory turnover, e-commerce businesses will also have a varying ‘website update’ burden. This means the work done to keep product descriptions up-to-date on site and current with the inventory available. It may seem like a minute detail of the business, but for e-commerce operations with several hundred SKUs, it can be a material piece of the operating puzzle.
Content can be an important component for an e-commerce business. Actively writing on the website’s blog is a useful way of building an audience as well as slowly improving the site’s SEO. If the business under evaluation has an active content strategy, it’s important to understand who is writing for the business, how often and what (if any) outreach is being done. All of this needs to be factored into the time and replacement cost assessments made by the buyer.
Once the buyer has a firm sense on the day-to-day operations of the e-commerce business, its time to turn focus to the technical aspects of those operations.
Technical DD relates to establishing that the e-commerce platform that the business is based on has a solid foundation. Typically this involves assessing technical elements including the shopping cart, plugins, hosting/server data and any email solutions being used.
For e-commerce businesses where the email list is an important element of customer acquisition and monetisation, buyers should take care to verify the key email metrics advertised with the business.
The majority of business owners use 3rd party tools such as Aweber, MailChimp and GetResponse, all of which provide sufficiently detailed analytics to help in this regard. Buyers should look to requisition information on:
- Subscriber growth (recently and over time)
- Open and click-through rates
- Bounce rates
- Broadcast frequency
- Email sequence configuration
Consistency in open and click-through rates is important across broadcasts as is the frequency. Be wary of businesses with declining readership and a high frequency of emails, both of which signal reader fatigue.
Owner risk is an essential part of the due diligence process and quite often overlooked by buyers either because it seems intangible compared to traffic and financial verification or because it’s a relatively unknown area of due diligence.
Broadly speaking, buyers should look to assess 2 things: 1) key man risk and 2) character.
Key Man Risk
Key man risk is essentially how reliant the business is on the owner or its employees. Buyers should examine carefully the role that the owner plays in the business (see next area, operations) and discern what kind of proprietary knowledge is required to maintain those responsibilities. To what extent can that knowledge be taught and in what timeframe?
A character assessment of the owner is vital and should be drawn from all aspects of dealings with them. Buyers can learn a lot from the seller’s readiness to supply answers and information, honesty in response and attitude throughout the sale.
There are various levels of owner due diligence buyers can do, from a spot check to a full private investigation. Much depends on the size of the deal, the parties involved, budget and if the business owner is staying on in some capacity.
Legal due diligence completes the set of key tenets for the due diligence process. In general the depth of legal DD is proportionate to the size of the business being acquired, but there’s certainly no reason not to follow through on some basic checks for any sized business under offer.
There are a number of relatively straightforward checks that buyers should look to take including corporate entity checks, trademark searches, content uniqueness and image source accreditation.
Lastly, any major advertising, affiliate or third-party contract that the business relies up for significant revenue generation or cost should be very closely examined by buyers. Before the business is acquired, buyers should seek reasonable assurances from the seller (and warrant in the APA) that the contracts will survive a change of control on the same terms.
Putting It All Together
With a comprehensive due diligence process completed, it makes sense to step back and assess the findings in the context of the wider business sale. In truth, no e-commerce business is perfect and there are likely to be minor infractions here and there so it is important that buyers approach it with a mindset of materiality and assess any issues in light of the overall purchase and size.
The other important factor to think about is the seller’s responsiveness to issues as they have arisen. Did they act with surprise? Did they response quickly with a detailed and credible explanation? These are important considerations for taking a wider view on the seller’s character which is fundamental to deciding to proceed forward with trust.
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