Aug 15, 2023
Tanner is the CEO at Order Protection.
Question: what’s better than a profitable, well-managed eCommerce business? Answer: a profitable, well-managed eCommerce business with a solid exit strategy.
Most brand owners don’t go into business thinking they’ll be doing this forever. In fact, isn’t the reason we start our own businesses at all so that we can better control our futures? The point here is that if you’re not running your business in such a way that sets you up for success (and an exit) down the line, you may want to change that now. And in order to build a great exit strategy, you need to know how much your business is worth, and how to find its true valuation.
In eCommerce, several metrics are used to evaluate the financial health and potential value of businesses. These metrics include revenue multiples, gross merchandise value (GMV), customer acquisition cost (CAC), and more. However, when it comes to determining a company's true value, one metric stands out among the rest: EBITDA.
In this comprehensive guide, we'll explore the importance of EBITDA in eCommerce valuation and provide actionable strategies to optimize it for success.
What is EBITDA?
First, let’s take a closer look at the metric. EBITDA stands for earnings before interest, taxes, depreciation, and amortization, and it’s a critical metric used to assess the financial health and profitability of eCommerce businesses. Unlike net income, EBITDA provides a clearer picture of the company's operating performance by excluding non-operational expenses.
EBITDA is highly regarded by investors and buyers as it allows them to compare the financial performance of different eCommerce businesses on an apples-to-apples basis. It provides a holistic view of a company's profitability before considering the impact of financing decisions, tax obligations, and non-cash expenses.
The importance of EBITDA in eCommerce valuation
Like we mentioned above, there are several eCommerce business metrics used to evaluate a brand’s financial health and potential value. But let’s explore why EBITDA stands above the rest.
While revenue multiples, GMV, and CAC provide valuable insights into different aspects of a business's performance, EBITDA offers a comprehensive view of its profitability and operational efficiency. EBITDA allows investors and buyers to assess the cash flow generation capabilities of an eCommerce business without the impact of non-operational factors.
Compared to net income, EBITDA provides a clearer picture of a company's operating performance by excluding non-cash expenses and one-time charges. This makes it a valuable metric for evaluating eCommerce businesses, where expenses like depreciation and amortization may not accurately reflect the company's true financial health.
The investor perspective
Investors and buyers prioritize EBITDA over other metrics for several reasons. Firstly, EBITDA enables them to evaluate the operational efficiency of a business by focusing on its core revenue-generating activities. By excluding interest expenses, taxes, and non-cash items, EBITDA provides a more accurate representation of a company's ability to generate profits solely from its operations.
Secondly, EBITDA allows for easy comparisons across different eCommerce businesses. Since it eliminates the influence of financing decisions and tax obligations, EBITDA enables investors to compare profitability and cash flow generation potential across companies, regardless of their capital structure or tax strategy. This makes it an essential metric for benchmarking and identifying investment opportunities.
The impact of EBITDA on the valuation of an eCommerce business cannot be understated. Businesses with higher EBITDA tend to attract greater investor interest and achieve more favorable valuations. A higher EBITDA implies stronger cash flow generation potential and signals a company's ability to withstand market fluctuations and generate sustainable profits.
For instance, consider two eCommerce businesses with similar revenues but different EBITDA levels. The business with a higher EBITDA is likely to command a higher selling price because it demonstrates greater profitability and financial stability. Investors and buyers recognize the value of a strong EBITDA and are willing to pay a premium for businesses that exhibit robust operational performance.
Real-life examples abound where companies with higher EBITDA achieved remarkable valuations during acquisitions or funding rounds. These success stories highlight how optimizing EBITDA can significantly enhance the value of an eCommerce business and attract potential investors who recognize the importance of sustainable profitability and cash flow generation.
How to optimize EBITDA for your eCommerce business
To optimize EBITDA and enhance the value of your eCommerce business, it's crucial to focus on increasing revenue, reducing expenses, and optimizing margins. Implementing the following actionable tips will help you improve your EBITDA and drive long-term success.
Streamline operations: Identify areas in your operations that can be streamlined to improve efficiency and reduce costs. Automate repetitive tasks, implement effective inventory management systems, and optimize your order fulfillment process to minimize errors and delays.
Invest in marketing: Effective marketing strategies can drive revenue growth and increase profitability. Allocate resources to targeted marketing campaigns that reach your ideal customers, maximize ROI on advertising spend, and leverage data analytics to optimize your marketing efforts.
Optimize pricing strategies: Pricing plays a significant role in profitability. Conduct market research to understand pricing trends and competitive positioning. Adjust your pricing strategy to strike a balance between attracting customers and maximizing profit margins.
Track EBITDA regularly: Regularly monitor and analyze your EBITDA to stay informed about your business's financial performance. Set key performance indicators (KPIs) related to EBITDA and track them consistently. This enables you to make data-driven decisions and take corrective actions when necessary.
Shore up lost money below gross margin: It's essential to identify and address any areas where your business is losing money below the gross margin. Common areas include inventory management, shipping and handling, and returns.
Inventory management: Optimize your inventory management by reducing overstocking, identifying slow-moving inventory, and negotiating better terms with suppliers. Implement demand forecasting techniques to ensure optimal inventory levels and avoid excess holding costs.
Shipping and handling: Seek opportunities to optimize your shipping and handling processes. Negotiate better rates with carriers, explore options for fulfillment centers or third-party logistics providers, and implement efficient packaging and labeling practices. Partnering with a shipping protection provider can also help you cut operational and customer service costs while adding profit to your bottom line.
Returns management: Effectively manage returns by providing a seamless customer experience and minimizing return rates. Improve product descriptions and images to reduce the likelihood of returns due to miscommunication. Implement quality control measures to minimize returns caused by defective products.
By addressing these areas, you can reduce costs, increase operational efficiency, and ultimately improve your EBITDA.
Remember, optimizing EBITDA requires continuous monitoring, analysis, and adjustment. Stay vigilant in tracking your financial performance, implementing strategies to enhance revenue, and identifying cost-saving opportunities. By consistently improving your EBITDA, you'll greatly strengthen your business's financial position.
Other metrics to consider for eCommerce valuation
While EBITDA is a more comprehensive financial measure, sometimes it can be helpful to get a more straightforward measure of your company’s overall income. Only looking at your company’s EBITDA has limitations, in that it doesn’t account for changes in working capital, capital expenditures, or debt payments, which ultimately impact your cash flow and long-term financial health. On the flip side, revenue can provide insights into sales performance and top-line growth.
Let’s take a closer look at revenue, specifically the difference between top-line and bottom-line revenue, and how both can impact your company’s valuation and potential sale amounts.
1% of top-line revenue: a catalyst for bottom-line growth
When it comes to managing the financials of an eCommerce business, focusing on the bottom line is essential. But to get there, you need to take a look at your top line first.
By allocating just 1% of your top-line revenue towards improving your bottom line, you can unlock substantial profitability gains. This allocation can be achieved through various means such as reducing costs, optimizing operations, or increasing efficiency.
So what’s the potential impact of this 1% allocation on the bottom line?
Impact on bottom-line revenue
While the specific impact on the bottom line may vary depending on the unique characteristics of each business, it's important to consider the potential scenarios. Let's assume that your eCommerce business has an annual top-line revenue of $1,000,000 and a bottom line of $100,000.
If 1% of this top-line revenue—which amounts to $10,000—is dedicated to improving the bottom line, the effect on profitability can be significant. By implementing cost-saving measures, streamlining operations, or exploring new revenue streams (or any of the action items we listed earlier in the section about optimizing your EBITDA), you could potentially increase your bottom line by X%—in this example, let’s say 10%. This means an additional $100,000 would be added to your bottom line revenue, taking it from $100,000 to $200,000.
The power of a 6X multiple in company valuation
Now that we’ve increased our bottom-line revenue to $200,000, it's time to consider the impact on the potential sale value of the company. In mergers and acquisitions, companies are often valued based on a multiple of their bottom-line revenue. A commonly-used multiple is 6X, which means the company's value is estimated at six times its bottom-line revenue.
Considering our increased bottom line revenue of $200,000, the potential company sale amount would be $1,200,000 (6 times $200,000). Not bad, right? But let’s pause here and recall what our bottom line was before that 1% allocation—$100,000. The difference between 100k and 200k is a lot different when you start thinking in multiples. Because even with a 6X multiple, that initial bottom line would only be increased to $600,000. It’s certainly nothing to sneeze at, but it is far less impressive than the $1,200,000 number after that allocation from the top line.
By optimizing your bottom line revenue through a 1% allocation from the top line, you have significantly enhanced the company's value and potential return on investment.
The impact of expenses on valuation
Remember that list of optimization tactics from earlier? Those are going to come back into play again as we look closer at the impact that expenses can have on revenue.
Let's explore a scenario where a company is paying 90% of its revenue in expenses. In this case, if your top-line revenue is $1,000,000, your expenses would amount to $900,000. Obviously, this is not a sustainable business model, and your company would need to look into ways to reduce expenses and improve the bottom line.
By allocating 1% of the top line revenue towards the cost reduction strategies, operational efficiencies, or diversification tactics mentioned above, you can mitigate expenses and potentially increase your bottom line.
Maximize your brand’s value
Selling your eCommerce business may not be in your immediate plans, but it’s never too early to start preparing for an eventual exit. The work you put in now can help you maximize its future valuation, so long as you prioritize the right areas for optimization.
While various metrics are used to evaluate eCommerce businesses, EBITDA plays an important role when it comes to valuation. It offers a comprehensive view of profitability, operational efficiency, and cash flow generation potential. Investors and buyers prioritize EBITDA because it allows for accurate comparisons, reflects a company's true operational performance, and directly impacts the selling price of a business. By understanding the importance of EBITDA and actively working to optimize it, eCommerce CEOs and founders can unlock greater value, attract potential investors, and drive long-term success.