December 31, 2011, 12:00 AM

Cashing Out

What's a web-only retail company worth? A lot more if it's growing rapidly and sells unique merchandise.

Over the past 15 years many entrepreneurs have built successful businesses selling on the Internet. Eventually, many want to cash out. And they face the question: What's my e-retail business worth?

Just because Amazon.com Inc. is valued by the stock market at 50 times its free cash flow doesn't mean a smaller, privately held e-retailer with $2 million in annual profits is worth $100 million. In fact, a company of that size would need a very strong story to command that kind of multiple.

Over the last three years we've been involved as investment bankers in several deals involving web-only retail businesses. Based on these negotiations we've developed a method for calculating the value of privately held e-retailers. We hope it will prove useful to buyers and sellers as they try to reach deals that reward both sides.

Without revealing the punch line, we'll say there are some things web retailers can do to increase the value of an e-retail business. They include making it larger, building a moat around your niche, and demonstrating fast growth. We'll explain more below.

But first we'll describe our method, which any e-retailer can use to estimate the value of its business.

It's a two-step approach. First, we analyze how investors currently value publicly traded online retailers; second, we translate that valuation into a formula that estimates the value of privately held online merchants.

Key metrics

To arrive at the current value of publicly traded companies we created the Focus Web-only Retail Index of 14 Internet-only retailers. It compares the revenue and profitability of each company to its value. Profitability is measured by EBITDA, or earnings before interest, taxes, depreciation and amortization. Enterprise Value is our measure of what a company is worth, that is, what it would cost to buy the company: the cash outlay plus any debt assumed minus the cash the company has in the bank. The retailers included, in order of revenue, are: Amazon.com Inc., eBay Inc., Overstock.com Inc., United Online Inc., Vistaprint Ltd., 1-800-Flowers.com Inc., NutriSystem Inc., Blue Nile Inc., U.S. Auto Parts Network, Vitacost.com Inc., PetMed Express Inc., Coastal Contacts Inc., Bluefly Inc. and Stamps.com Inc.

The key values we derive are the ratios of Enterprise Value to revenue and EBITDA. We look at the median figures on the list and take out any values outside the normal range. Sometimes a company's value fluctuates because of specific events—consider the recent drop in the price of Netflix Inc. shares after it alienated customers with a new pricing plan. We remove those outlying figures and come up with an adjusted median.

For November, the adjusted median Enterprise Value of these 14 e-retailers was $285.7 million. The median value of these publicly traded companies was 0.66 times annual revenue and 8.12 times annual EBITDA.

Public vs. private

Smaller privately held companies in all industries tend to sell for lower multiples than those assigned to larger, public companies. There are two reasons for this. One is liquidity. You can easily sell your shares in Amazon and get cash; but you cannot as easily sell your share of a private company. The second is size. The effort and cost associated with buying two $50 million companies is twice that of acquiring one $100 million company.

Many studies have attempted to quantify these discounts. We believe that together they lower the price of a private company by 35% to 50% of the value of a comparable public company.

Because value increases with a company's size, we developed the Public Company Comparable model to estimate how much privately held e-retailers are worth based on their size.

As the chart shows, a privately held retailer in the top 100 of the Top 500 Guide will command multiples fairly close to those of publicly traded e-retailers as a whole. A company with $500 million in sales could expect to be valued at $300 million, or 0.6 times revenue. If the same company had $50 million in EBITDA, the valuation based on that ratio would be about $350 million. The likely value of an actual sale would take both ratios into account, perhaps arriving at a figure in the middle.

For smaller companies the valuation ratios go down steadily. Investors have more confidence in the staying power of a retailer with $50 million in annual sales than a $10 million retailer. And an e-retailer with less than $2 million in annual EBITDA is going to have a hard time sparking much interest.

How can I get a better price?

There are many factors that drive the price of a particular e-retailer.

One is the product it sells. A retailer selling a product that many others sell, such as cell phones, will be valued at a lower multiple than a retailer of mixed martial arts equipment who may sell merchandise hard to get elsewhere and have established exclusive relationships with key suppliers.

Another factor is the source of sales. If most of your sales are on Amazon, investors are likely to view that as a risky business model. Amazon could decide to compete with you and cut into your sales. Diversification in revenue sources is less risky from an investor's point of view.

Any patents a retailer holds can drive up the value of the business. And investors get more excited about companies growing rapidly.

Finally, investors will pay more for a controlling interest in a firm. That gives them the power to decide what investments to make, and to sell the firm if they want to cash out. Minority stakes sell at an additional discount.

We're hearing from a steady stream of online retailers interested in learning what they could get for their businesses. Some of this is driven by natural causes—a desire to diversify a personal wealth portfolio, fatigue from keeping up with the constant pressure of online competition.

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