Why verifying financials?
Let's say you want to purchase an online business. You have already set your acquisition budget, chosen a business type, and sifted through potential options.
Finally, you found an interesting online brand, and its owner (the Seller) has provided you with some financials, possibly granted access to their accounts on platforms like Amazon and Shopify, along with various legal documents.
At first glance, everything seems promising. Over LTM (Last 12 Months) the business generated $1 million in sales growing at 30%, and a decent EBITDA (Earnings Before Interest, Tax, Depreciation, and Amortization) of $250,000. You are considering paying $750,000 for this business applying a 3.0x multiple of its EBITDA.
However, it's important to recognize that EBITDA of eCommerce businesses can sometimes be overstated by 10-30%. A lower actual EBITDA means less cash flow, reduced flexibility in changing strategies, and the risk of overpaying for the business.
So, instead of relying solely on the reported $250,000 EBITDA, you can put efforts to verify this figure based on available primary data - transaction reports, invoices, marketplace reports and more. After that you may discover that the actual figure is only $200,000, implying a higher purchase multiple of 3.75x.
Had you known this beforehand, you could have negotiated to purchase the business for $600,000, maintaining the same 3.0x multiple. This would save you $150,000 and allow you to look underneath the hood before proceeding with the acquisition.
Now, the question becomes: how do you confirm the actual EBITDA of the business?
Verification approach by item
Sales
Sales may seem straightforward to verify, but in reality, Sellers might inflate net sales figures by including Value Added Tax (VAT), improperly combining sales from different channels, misaccounting product returns, or making mistakes in currency conversions.
Sales can be verified with transaction or monthly reports from all sales channels. This may include Amazon, eBay, Walmart marketplaces as well as DTC (Direct-to-Consumer) platforms like Shopify. Then this data should be combined across all channels.
The most reliable method to confirm sales is through detailed transaction logs. Compared to aggregated sales reports, you can control methodology of sales and returns accounting as well as gain detailed insights into order economics, product and customer cohorts. These insights are crucial for understanding how to grow the top line post-acquisition.
Cost of sales
The cost of sales typically makes up 20-35% of a brand's total sales, but it's one of the trickiest things to verify. Business owners keep records of their costs in accounting software like Quickbooks or Xero, but there are various ways to calculate these costs.
Companies must purchase products in advance, then handle shipping and storage before making a sale. Expensive logistics and long-term storage can drive up unit costs over time. For instance, if products were procured in multiple batches at different costs and shipped by different freight forwarders at varying rates, determining the exact cost per unit at the time of sale becomes complicated. Additionally, incidental costs like storage or inland logistics might be simply overlooked.
In many cases, the actual cost of sales ends up being underestimated by 10-20% due to irregular accounting practices or the misallocation of certain expenses.
To accurately calculate the cost of sales, you'll need to request invoices from suppliers, freight forwarders, and other logistics providers. These invoices should then be carefully examined and matched with the actual products sold using product catalog and packaging lists.
Reviewing individual invoices rather than relying on aggregated data also helps you understand how unit costs trends and assess product-level profitability, enabling you to identify opportunities for optimizing your product portfolio in advance.
Marketplace fees
Marketplaces charge referral, transaction, subscription and other kinds of fees. These fees typically range between 5% and 20% of sales, depending on the marketplace and the products being sold.
For DTC businesses, marketplace fees are either nonexistent or very low. However, brands invest more in marketing to attract customers to their websites.
You can verify marketplace fees by obtaining reports or transaction logs directly from the marketplaces. Similar to the revenue data, it's best to utilize transaction logs to gain insight into order economics.
Fulfillment costs
Fulfillment costs are essentially the expenses incurred by the seller to get the products to the customer's doorstep. These costs can range from 6% to 30% of sales. Verification of these expenses depends on the type of logistics used by the business. There are two main types - managed by the seller and outsourced.
Under a fully managed logistics model, the seller handles everything from finding warehouses to transportation and last-mile delivery, possibly even utilising their own resources. To confirm these costs, the buyer should request invoices for each step in logistics and then match them with products sold during the period.
In the case of outsourced fulfillment, such as the Fulfilled by Amazon (FBA) model, fulfillment costs are typically detailed in transaction logs and reports provided by the marketplace. Consequently, the buyer can rely on these records to confirm fulfillment costs.
Advertising
Advertising plays a vital role in driving revenue for eCommerce businesses. Typically online brands have Total Advertising Cost of Sales (TACOS) of around 15-20%. In some cases brands receive a lot of organic sales with TACOS being as low as 1-5%.
Verification of advertising costs requires a comprehensive understanding of all advertising channels and methods used. Nowadays, most online brands utilize a combination of sponsored advertising on marketplaces, social media marketing, and email marketing, each with its own costs.
For PPC (Pay Per Click) or brand advertising on platforms like Amazon, reviewing monthly cost reports from the platforms is usually sufficient. However, for other marketing channels, a combination of bank statements and access to advertising accounts is required.
Payroll
Payroll usually amounts to 5-10% of the sales. Team payroll includes the salaries of freelancers, part-time, and full-time employees who handle various aspects of the brand's operations, such as managing listings, developing marketing campaigns and content, providing customer support, managing the supply chain, and launching new products. Smaller brands often depend on remote and distributed teams of freelancers.
Verifying these costs requires more than just examining existing employment agreements. The buyer needs to review bank statements for payments made to freelance platforms like Upwork and Fiverr, as well as payments to individual freelancers.
If no confirmation of payroll payments is available, you may use current market salaries and freelance rates to estimate the payroll cost.
Other
Other operating expenses usually comprise less than 5% of sales. These expenses include IT costs, subscriptions, content creation costs, legal and tax consultation fees, and more.
The most reliable way to verify these expenses is through bank statements. However, it often depends on the materiality of these costs. Reconciling bank statements with the P&L demands considerable input and explanations from the brand owner, as well as a lot of manual data processing from the buyer.
EBITDA, Cash Flow and SDE
Verifying the P&L should give you a solid understanding of the business performance and potential to generate profits going forward.
Additionally, some Sellers pay themselves a salary or use business credit cards for personal expenses. These cash outflows aren't considered business expenses, but they contribute to Seller’s Discretionary Earnings (SDE) from the business.
Keep in mind that EBITDA does not fully capture the cash flow dynamics of the business. To better estimate the cash flow profile, you need to subtract working capital, taxes, investments in new product development, and then add back owner salaries and personal expenses.
Conclusion
When purchasing an eCommerce business, relying solely on the accounts provided by the Seller may lead to significant overpayment. These accounts may overlook expenses, allocate costs inaccurately to products sold, or lack the detail needed to explain unit economics, trends and one-time expenses.
Re-building the P&L requires access to primary sources - transaction logs, invoices, bank statements (see Exhibit 1). While this process takes time, the payoff is significant. It provides a fair, data-driven estimate of the actual business results and saves your money because you pay only for verified EBITDA.
We at Quantacap are building a solution to automate investment analysis and verification of eCommerce financials, enabling business buyers and sellers to swiftly obtain a transparent and detailed snapshot of a business from an independent party.