Learn the Key Financial Metrics that Increase (or plummet) the Value of your Business

Aug 7, 2018

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Combined, Mark and I have reviewed thousands of profit and loss statements over the years. What we've seen and learned in that time, is that certain key financial metrics can make or break the value of a business.

In today's podcast we cover all of these metrics, including one that could cost a seller hundreds of thousands in value, and give a buyer huge instant equity. If you think the financial metrics and details are boring, wake up!

You work night and day and risk everything to build your business, and it is more than likely that your business is your most valuable asset. Having deep financial details will bring more you more value, peace of mind, and maybe someday help you create a "lifetime event" sale and an exit that will change your life, and the lives of your descendants for generations to come.

Episode Highlights:

[:10] How long does it take to do a valuation?
[2:35] What are "clean financials"?
[4:02] YOY trends tend to be the most important financial factor.
[6:12} We always look at a monthly view of the financials. Not just quarterly or annually.
[9:15} Revenue by Channel show a deeper view of overall revenue trends (and reveal gold, or roadblocks).
[14:40] Any channel that has you "own" the customer brings more value.
{15:20] After total revenues, Mark views gross profit margins next, as do many buyers.
[17:20] COGs should not include 3rd party fees!
[18:41] Gross profit margins below 20% make Mark nervous.
[20:10] Joe loves to see advertising expenses by revenue channel (this does not have to be in the P&L).
[23:14] When you "get" the metrics right a business value can instantly jump by hundreds of thousands of dollars.
[25:31] Trust offsets risk. The lower the risk is the more value your business will bring.
[27:03] Don't hide negative trends…if you've recovered. A recovery shows how resilient the business is.
[28:23] Drilling down to specific expenses and their trends tell a fuller story of the business condition.
[30:19] QLB brokers Advertising, Saas, eCommerce and other business models.
[31:01] Certain metrics are key with SaaS and Subscription based businesses.
[33:49] Discretionary earnings equals net income, plus add backs.
[34:06] Discretionary Earnings as a percent of total revenue "comfort levels" vary depending on the niche.
[38:01] Revenue by SKU can show huge built-in growth if some were launched in the trailing 12 months.
[39:55] Joe & Mark get into the weeds. Go there with them and learn how to increase the value of your business by hundreds of thousands of dollars, or buy one and get instant equity.

Transcription:

Mark: All right Joe you probably know this from your experience here at Quiet Light Brokerage but how long does it take you … when you're talking to a client for the first time or somebody who's requesting a value of the business, how long on average do you think it really takes you to be able to get an estimate of the size of the business and the value of their business?

Joe: Yeah there's really no short answer to that. I feel like you want me to tell you five minutes but the answer is it's at least an initial call you get a ballpark range. And then you got to look at the financials and look at the trends, know your trends and look at the details of the financials. It's so much of that answer and the time frame around it depends upon how good their documentation is and how much they know about their own books.

Mark: Sure and just you know I want you to answer whatever you want to answer. I'm not going to feed you answers; answer the truth. Yeah, well I think that's true. We've been looking at businesses for a while. We've looked at a lot of businesses in the roles that we have. And so I thought it would be good for us to have a discussion today to talk about some of the things that we look at in a business's financials to really be able to determine its value pretty quickly. What are some of the things that you with your expert eye from all the deals that you've done, what do you look at when you look at a company's financials? Now I know every buyer out there listening to this you probably have the reports that you look at. We have the advantage of working with lots of different buyers. We see the different approaches that different buyers have made. And I know that over the last 10 years I've expanded and changed what I look at and probably look at more things and things maybe that wouldn't concern me as much directly but I'm looking at to try and anticipate what buyers would want to see.

Joe: So what is … what's the number one thing you look at first? You're always looking at this one thing what is it?

Mark: By the way, if anyone is wondering no we don't have a guest so you have to live with Joe and I for the rest of this episode. But we'll try to make it entertaining. Okay, so what do I look at first and foremost? I have gotten very addicted to looking at trends. Trends to me to it's one of the most important thing with somebody's financials … outside of whether or not they're clean of course right? They've got to be clean if I'm going to … if we're going to be able to make any real valuation.

Joe: Can we define clean? What do you mean by that?

Mark: That's a good question actually.

Joe: Somebody in the audience was just asking it they just [inaudible 00:03:03.7] through to my head.

Mark: You're anticipating what people are going to be asking weeks from now; I love it. What are clean financials? So clean would be separated from other businesses. And that doesn't mean that you have to have completely separate tax IDs. That's ideal … you know separate tax IDs and separate books. I would love it if that's what you had but at least within QuickBooks or Xero or whatever you're using, some way of identifying this is for this business. This expense goes for this business and that expense goes for another business if you have multiple businesses running. Also actually having that tracked clearly and so that you're not just taking estimates on things and finally not mixing in a lot of personal expenses into it. In the episode that I recorded with Brian we talked about some of the warning signs. We saw in financials … and that episode is aired by now so go back and take a listen to that, but one of the warning signs that we often see are round numbers.

Joe: Oh yeah.

Mark: Round numbers are … yeah, these are not clean financials; these are estimates.

Joe: Unless it's payroll but if you've got expenses of advertising of $1500 a month or your phone bills … you know $2300 a month yeah the round numbers are always challenging. But clean financials are so important because it allows us to look at things from an analytical eye and from the buyer's eye. And you yourself you say you look at trends, which trend specifically do you hone in on?

Mark: Well the number one trend I like to look at would be year over year trends. So there's … when we're looking at trends just as in general for a business there's two main approaches that people take. One would be a month over month so are we doing better this month than we did the month before and was that month better than the month before that and how does that look. And maybe you spread that out and do like a quarter over quarter analysis. I like to take a look at businesses more from the year over year analysis. So if I'm taking a look at July of 2018 I want to compare that against July of 2017. Or if I'm going to do it on it like a quarterly basis I might take a look at quarter two of this year and compare it to quarter two of the year before and of the year before that. And the reason that I do this is I think people have seasonal businesses without knowing that they have a seasonal business. Obviously like Halloween … you know I've sold a number of Halloween sites in the past, that's an obvious seasonal business, Christmas obviously a seasonal business. Gardening and supply store a little less obvious but when you think about yeah it's a seasonal business. I think those aren't too far off stretches. But when you take a look at a company like Quiet Light Brokerage we also have seasons. We have our busy seasons, we have our a little bit less busy seasons. Summer, it tends to slow down a little bit. It's not appreciable. It's not like one of those things where you can look at and say it's going to be absolutely dead. And I wouldn't call us having a seasonal business but in the books, it does get reflected that way. So I like the year over year financial analysis because it controls all of those variables and also some of the variables for having a few extra days in a month or a few less days in a month.

Joe: Yeah I think you've got to specifically look at that month over month analysis because of the seasonality. You know some will say well is there the best time to sell my business and it's really the time that's right for that particular individual. But when you're comparing December of 2018 to December of 2017 that is what is most relevant. It's not necessarily all of 2018 against all of 2017 because if you just look at the annual numbers of '17 versus '18 it's only going to paint a partial picture. We're always looking for monthly trends beyond that. We can … we look at that bigger picture and that's what we can talk about, that big picture in the teaser where people are going to see the listing for the first time. You know 60% year over year growth or whatever the number might be. But you've got to drill down into that month over month. How does December … I guess it's year over year December of '18 looked to December of '17. Because you could have had a great first three quarters and then in the fourth quarter of 2018 it could have fallen off a cliff. It still may look like 60% growth year over year but the most recent quarter could be down dramatically. And that dramatically reduces the value of the business because of the risk going forward.

Mark: And the other thing that I found and I wrote a blog post on this a several years ago, we'll link to it in the show notes and if you and I were professional podcasters I would have done like actual show prop and been able to have this example at my fingertips. But I did this blog post years ago on how to perform a year over year financial analysis. And then I put together some dummy data and this actually kind of randomly happened when I put it together. Where at from a month over month standpoint the business looked like it was growing and growing at a good clip. But when you took a look at it at a year over year financial analysis what you're able to see is that the growth was slowing dramatically on the business. And that was extremely valuable in that and again it's a pretend scenario to be able to see the actual trend. What is … where is the direction of this business going? The other thing that I want to point out about this and I don't want to spend [inaudible 00:08:10.9] of time on this specific topic of year over year financial analysis but I think the one thing that we need to kind of pull back on with online businesses is we tend to really take a microscopic view of the financials. We'll often take a look at just the past couple of months and consider that to be a trend. Starting to broaden out our timeframes I think is a good thing to do especially from a buying stand point and understanding what is the context of the earnings of this business. When I started Quiet Light Brokerage in 2006, 2007 well most companies were just a few years old. Now we're seeing businesses that are 20, 25 years old on the long end and so we have more history to work with. And I just think year over year is a better solution for that. So that's my number one thing that I look for.

Joe: I agree and I'm going to drill down beyond that and the next thing that I would look at but you know not being professional podcasters shows that we're human which is exactly what we are. Okay, that's too much ego there, sorry folks. What I do when you talk about a particular blog and we're not prepared for it, all you're going to do is Google Quiet Light Brokerage and year over year analysis and boom there it is. So for the record, you've done a great job on the last decade. Beyond the year over year comparison, month over month comparison what I drill down into next is revenue by channel. Because a buyer is going to look at it and see what's happening in the most recent three months compared to the same three months last year or year to date things of that nature. And so that shows the trends of the business and which way it's going. Beyond that what I like to drill down to and this goes to documentation is revenue by channel. So is it … let's say it's in a physical products business am I getting 60% of my revenue from Amazon, 25% B2B, and 15% from a new Shopify store. And then beyond that what are the trends within those channels? For instance, I had a listing awhile back where it was it was 100% Amazon and they like most started out on Amazon.com and then expanded to Germany, UK, Canada, Japan, Italy, and those countries took off and were really growing at the same time the US started to trend down. So they put all of their efforts into the new countries and stopped putting efforts into the country that was generating the most revenue. Overall if you look at month over month numbers as a whole we were still up, year over year we were still up, but there was a concerning trend within all of it and that was that the biggest revenue generator was dropping and then it was being replaced with other channels. So overall I guess if you just look at the broad picture it was okay but when you … you want to drill down into those things to get a really clearer picture of it. And that goes for Shopify channels [inaudible 00:11:11.5] or Shopify whatever it might be and then the B2B side too. These are if you're selling physical products. Same goes for content sites or SaaS sites, whatever they might be; advertising sites or SaaS sites. If you've got different methods of advertising and revenues whether it's straight up sales from your website or affiliate revenue you want to break that out in your financials so that you can see them. So you can see what you're doing right and what you're doing wrong but also so that your broker, advisor, exit planner, and your buyer can see it as well. Because you have some great things in there … you know if you started a Shopify store nine months ago and it's already at 15% of your total revenue it's only nine months out of the trailing 12 so you've got built in growth there and that is a really exciting thing for buyers.

Mark: Yeah I dealt with a client recently where we were having a little bit of trouble moving his business because it was not on a decline. And he had a lot of revenue but there was a couple of problems with the business where it was sick in a few ways. And what I found is out of our buyers … and we had lots of inquiries on this business because we put it up at a pretty low multiple, most buyers backed out right away when they saw the trends they just kind of backed out and said "No I'm not really all that interested in this business. I don't want to turn around but I have you." And the buyers that we've grown to know over the years that they're really successful at what they're doing they took a little bit more time and the first thing that they started to do is exactly what you're talking about. They started to take those financials and some of those summation numbers that we see in financials and they started to break them apart. They started to really dig into those numbers and see okay what makes up this revenue. And when we started to break these apart what can we find in here; what's sick and what's healthy? And is what's healthy sustainable and is what's sick is that fixable or is it something that we can just get rid of? And so they started looking at that on a per channel basis but they also started looking at it on a per SKU basis as well in running an analysis. And one of the things that we found with this is that you could actually lighten up the workload of this business and actually increase profitability significantly by removing a large number of the SKUs because they were not all that profitable. But again the front is still the multi-channel analysis that you're talking about. But I think this general principle of when you're looking at revenue especially with an e-commerce business that can have multiple channels of revenue don't just take the summation number, start to break it apart. And from the sell side, if you're selling don't be afraid of reporting those numbers either. There's opportunity in those numbers that you can show potential buyers and I think a little dose of humility for all of this goes a long way. Sometimes somebody is going to come and take a look at your business and be able to have an observation that maybe we've been missing for a while. And from a selling standpoint that's your opportunity if a buyer comes in and notices something that you missed. And so give them that data, give them that opportunity to make that sort of observation. And I think that's a good thing for people to look for. Is there any channel in your opinion that you like better than others or that you look at and you would weight as more valuable than others?

Joe: Oh yeah I mean any channel you own the customer. If it's just your own website where you are owning the customer completely and you can remarket to them and upsell them and reach out to them socially via email, whatever method you can. But absolutely owning the customer brings more value than … you know in Amazon platform for instance. Amazon is growing like crazy so don't discount it if you're selling physical products. You have to be there in my opinion. You're missing out on a tremendous amount of revenue if you're not there. But owning the customer is the most important thing in terms of overall value. One of the things I want to jump to Mark is … it's on our list here to talk about in terms of the year over year analysis and drilling down and getting below that total revenue line to either gross profit as a percentage of total revenue or discretionary earnings as a percentage to total revenue. Which one do you look at first?

Mark: I look at gross profit first if it's an e-commerce business and just because it's a simpler number to digest. Now there's only really one thing that's getting thrown into that gross profit number you've got your revenue, you've got your landed cost of goods sold and that's pretty much it that's going into the gross profit number. So it's an easier thing to really understand and really at the core of an e-commerce business is that you know what is the cost of your product, and what are people willing to pay for it right now, and how is that trending. And I think with e-commerce businesses specifically because price competition is a real thing with e-commerce businesses and most niches you have to really pay attention to how is the profitability of this industry holding up over time. Is it becoming more competitive? Is the competition happening on a price front? Or are suppliers becoming more aggressive in their pricing as well? So that's one of the first things that I look at when I start to really dig into those financials. I want to see how is that gross profit margin holding up over time, is it getting more expensive to do this business or is it holding up?

Joe: You know it's funny I think I agree with you that what you should have in your expenses above the gross profit line are your cost of goods sold, your landed cost of goods sold. But I often see them in from bookkeepers and they include in some cases fees associated with third party platforms. I don't know if there's a right way or a wrong way but you got to dissect to that a little bit when doing the analysis. Is there a particular percentage of profit that you look at and you're like no, your cost of goods sold are just simply too high, the margins are too tight, this is going to be really hard one to sell. Do you ever run across any of those?

Mark: I do and I'll get to that in just a second I'm going to chide all the book keepers out there that are including fees in there as cost of goods sold. The technical definition for a cost of goods sold has to be … be involved in the actual production and sourcing of the product itself; the transactional cost. So if you're keeping your books that way it's a minor issue and a crawling issue that I won't fight too hard but it's supposed to go on the regular operational expenses instead.

Joe: I fell asleep in accounting class. I just focus on what I focus on. I told you this story before. We work with Scott of Catching Clouds, Matt of CapForge, Fully Accountable is a recent one that's come across my desk and all three seem to do a really solid job. And having a great bookkeeper brings a windfall of cash when you go to list your business for sale.

Mark: Absolutely and one of those guys might disagree with me and then we can whip out our pocket protectors and have a pen fight over that.

Joe: All right yeah … let's keep the people awake. We don't want to talk about that.

Mark: All right, move on. So percentages absolutely, you want to see a healthy gross profit percentage. I talked to one buyer and I won't say her name because I don't know if she wants me saying this but she told me that she wouldn't look at a business that had less than 50% gross profit margins. I wouldn't go that far. In my opinion, when I'm looking at the business from a broker standpoint I start to get nervous when gross profit margins dip below 20% is when I get nervous, 25% and lower I'm a little uncomfortable with that but you know I think that's doable. I think the average that I'd see would be right around 35%; 30-35% would be the average. Obviously the higher you can have it the better. There are certain industries, electronics being one of them that tend to just have really low gross profit margins and you know the problem with that and just thinking about it I have basic basis if you're … say you have a 10% gross margin which for a lot of electronics that's where you're at, you're looking at having a million dollars in revenue to be able to generate $100,000 in just gross profit. That's a lot of money that you have to generate in order to get some gross profit. So my rule is about 20%.

Joe: It doesn't count your advertising; it doesn't count your payroll or anything like that so.

Mark: Or your transactional fees [inaudible 00:19:26.7] marketplace.

Joe: Exactly as it should be down below that gross profit line. So that's going down that P&L you know you've got total revenue you've got gross profit and then you've got all these expenses in there. One of the things that I always look pretty closely at if I have the detail up above is the advertising channel. Do you ever get to see advertising expenses by channel in a P&L?

Mark: By channel … I'm trying to think if I've seen it. With Amazon, you'll see it. Sometimes you'll see Amazon advertising expenses broken out separate from-

Joe: Wouldn't it be amazing to see it there? Just for those bookkeepers out there and those people that are doing it themselves.

Mark: Oh my gosh.

Joe: If you've got revenue by channel up above the total revenue line why not have advertising by channel down below? It … you can do it in QuickBooks and Xero you just got to have a subset of it. In the exported P&L it may say just total advertising but you can show that separately. And the reason I love to look at that is because it can show too heavy of a weight in one particular channel again in the advertising dollars. This is airing in August of 2018, as many people listening know there was an algorithm update in Facebook in April. And a lot of people got hurt by that and if they were overspending on Facebook advertising and they might have found themselves too heavily weighted on one channel and that advertising didn't work as well anymore and their revenues might have dropped. Or they had to pick up the ball somewhere else and it took a while. So it goes to that detail. The more detail we can see the more we'll understand those trends and a buyer can make a more informed decision. If somebody's stroking a check for 100,000, 500,000, a million whatever the number is, they worked hard for that money, they saved it, they're smart, they're intelligent, they're going to get through those numbers eventually and it's better to do it upfront in advance so that once you're under a lot of intent you get all the way through the closing. So I'm always trying to drill down into those details. I would love advertising by channel. I don't always get it but it's a question that I'm always asking and is that spending by channel going up or down. I think if you can again diversify by channel and if it's Facebook, if it's Instagram, if it's AdWords, if it's inside your sponsored account or whatever it might be, if you're selling SaaS products, affiliate whatever you might be doing; having that level of detail is truly ideal and I'm always looking for it if I can get it. I can often get it out of just a P&L but generally, there's enough detail in the back end for the client … the person owning the business to be able to share that.

Mark: Yeah I've used an analogy some time … and by the way, real quick just kind of a public service announcement here if anybody is listening to this in your car it's late at night you've been driving for a while put this on pause go put on like a really exciting song for a little bit and then come back and finish it.

Joe: Come on.

Mark: No just … all right so I-

Joe: This is huge. This is all huge that just-

Mark: It should be exciting.

Joe: You and I do this all the time and it's exciting for a client when we go through these numbers and we find something and all of a sudden they realize that if we do this right their business … they don't have to generate any more revenue but their business when properly presented is worth a quarter of a million dollars more. So that's pretty exciting you don't have to generate more revenue.

Mark: Well absolutely. So I'm actually going to bring this to Botany of all things. I think its Botany or probably not but the study of trees and tree rings … you're looking at me like I'm crazy.

Joe: I am. Well, you are. Okay.

Mark: Yeah well I am a little bit crazy but one of the cool things that I learned years ago about the tree rings, you know when you slice a tree and you can see all the rings and stuff like that. Scientists are able to tell all sorts of information from those rings. They're able to tell if there is a fire a certain time in that area, or if it was a drought year or if it was heavy rains that year, and the average temperature as well. You can find all sorts of information like and the reason I bring this up … there is a point here besides me just talking about the fun things I learned on the side outside of work, is that financially I'd look at financials in sort of the same way. It's the record of the business and its quantified what's happening to your business in other ways. Facebook's algorithm change is an actual change in your customer acquisition strategy and it shows up on those books. There's very little that happens in your business that's not going to show up somewhere in your financial records. And so when you keep detailed financial records what you're doing is you're keeping a story of your business in a quantified way. And for buyers who are trying to evaluate a business, you know buyers look at this from all sorts of different ways; especially experienced buyers. They're going to look at your business from an ROI standpoint. They want to understand can I make money from this? But they're also going to look at it from the story of the business and try and get in the head you as a business owner and what it's been like to run it for the past number of X years. And so your point about keeping more beautiful records and breaking advertising down into channels AdWords or Facebook, we've messed around with Pinterest for a while if you've done some Quora advertising or have you. That's part of the story of your business that you can tell when you really start to break down financials historically.

Joe: Yeah and I think it's important to understand that all of those details are important to be able to share. Somebody listening that's planning on selling their business they may want to say I don't want to share those negative trends, I don't want to talk about that fire that I had back in June of 2017. It's going to come out so you might as well get those details out there and ready and available for your buyers because trust … when you lay it all out there it builds trust. And trust is important because it offsets risk a little bit. And again when you offset that risk a buyer is willing to pay more for your business. And it's all important … it goes into your social media accounts too you know. I've had … and I'm going to tangent but … and I won't name names but I had clients that are selling their business and I pop into their social media account and their profile picture is them on the beach topless with a beer on their hand and chugging whatever. Those are men topless by the way. And I'm like it's great but just put a shirt on for a little while, just change your profile picture because we're trying to build trust and respect in who you are. Buyers want to buy from client sellers that they like and that they trust more than anything else. So that's why you want to share all those rings of the tree and tell the full story because they'll look at the mistakes that you've made and the expertise that they have that you don't and go opportunity. I have capital to not run out of inventory and you did, I'm smarter than you are, or I have more money than you are. That's really really critical stuff to have. Anyway-

Mark: With the negative trends in the past by the way I just want to say one quick thing. It's not a bad thing if you have a negative trend in the past. In fact, I like it when I see a business that has had a decline and recovered. I can go to a buyer and say look how resilient this business is.

Joe: Exactly.

Mark: They ran out of product for two months and they're still chugging along great; it didn't kill them.

Joe: That's right. I actually had a situation where a client had a patent infringement claim filed against them. And not just against that particular client but against everybody that was selling a similar product. And it turns out that everyone else stopped selling that product period. My client hired an attorney, fought the infringement, won, and ended up being one of the only sellers of that particular product anymore and that just … the revenues shot up, gained more market share. And it's an ugly thing … a patent infringement; you don't want to talk about that right? No, you absolutely do because odds of it happening again incredibly low and in this situation, it turned out to be very positive as well. So I say expose all the rings of the tree in your analogy in botany. Let us know if botany is not … I think it is the right phrase but-

Mark: I think it's like the big family. I think there is probably a more narrow specialty. Somebody-

Joe: We are sitting in front of computers; you want to drill down a little further? We've talked about advertising by channel what would you look at next in a let's say a financial presentation or a profit and loss statement?

Mark: Well you know I'm going to start getting into these specific expenses and I want to take a look at what the individual average … or what not advertising, the individual expenses are to see are any trending higher. Basically, is this business getting more difficult to run, is it getting more expensive to run? And the other thing that you can see from just kind of an expense profile would be attempts at growth. You often see expenses ramp up when people expect growth so you can get the sense for where the business is arcing from taking a look at individual expenses. So I would look at staffing costs, they really ramped up. Are you seeing a lot of professional legal fees ramp up? That will be something that you wanted to begin to and try and get a little bit of explanation into. But really trying to get in … again some of those individual expenses and see spikes and anomalies. You know things that kind of stand out because those again are going to be the big stories that you want to get into later on. So we move a little bit away from trend analysis when we start looking at that … when we start getting into just kind of that anomaly analysis of a financial statement to see what questions do we need to be asking on this particular business.

Joe: Yeah and it's not just anomalies where there's spikes in revenue but sometimes expenses disappear. And when they disappear for the last two or three months of the trailing 12 and now they want to sell their business they're just … either they made a mistake or just forgot to put it in. But they're just cutting costs to increase their discretionary earnings. So we always … we drill down into all of that, every buyer will and we do it for them, ask those questions and get it exposed so that it's a good investment for a buyer and the selling achieves their goals as well.

Mark: Something I want to ask you about Joe, you know we get talked a lot … Quiet Light, in general, is pegged a lot as kind of like the e-commerce broker like that's what we do but we actually sell a lot of SaaS businesses.

Joe: And content or advertising business. If you look at the revenue on close transactions here to date it's an awful lot of SaaS an awful lot of content in there as well.

Mark: Right and I explain to people it's actually not a majority of e-commerce it's a plurality for us as we're less than 50% of our deals are e-commerce it's more around 40, 45% percent. I want to get into subscription based revenue and how do you look at that when you're evaluating business. What are you … you've done a number of SaaS businesses or a certain number of SaaS businesses, how do you evaluate subscription based revenue?

Joe: Yeah anytime someone's looking at the subscription based businesses to buy you know the eye that I look at it with is what does it cost to acquire that customer and what is the lifetime value of that customer? Could they have different terminologies for it churn rate and so on and so forth … you know how [inaudible 00:30:20.7] if you get 100 new customers how many are churning every month, meaning how many go away? You want to keep that very low. Well I was looking at that churn rate but the simple way to look at it is … from a buyer's perspective is if you've … you know I just closed a transaction it was a software as a service business, it's been around for 14 years and it was created originally as a solution to a developer's problem. The developer created it and then it just sort of grew organically. And 14 years later he had a very successful business but he didn't have any data. He was only spending about literally like $300 a month on advertising. I'm like okay well what is the cost to acquire that customer with your advertising and then how long does that customer stick around? What is their lifetime value? So that a buyer wants to look at it and go okay it costs you $100 to acquire a customer but the lifetime value of that customer is $400. My margins are really strong that means okay I can spend more money on advertising dollars and I can double the revenue of this company. They're always looking at that aspect of it from a subscription based business. And that could be physical products or software as a service. That churn rate is really really important, lifetime value, and repeat customer. Once you've gained a customer and if you've got the ability to offer them additional products and upsells that's something that I'm always looking for if you've got that model where you can add to it. The percentage of repeat customers that monthly recurring revenue; always looking at those numbers. I mean just saying that there's a monthly recurring revenue of $60,000 right away you just do the math on that that's $360,000 of revenue that you're not putting advertising dollars to because it's already recurring and there's a fixed margin there. That stuff is really exciting and if you're an owner of software as a service business or a subscription based model box business you've got to have those numbers because that's what buyers are going to look for. They're going to want to know how much does it cost because I'm bringing a whole lot of working capital I'm going to blow this thing up and they want to know the cost to acquire that customer and lifetime value; two most important things in my opinion.

Mark: [inaudible 00:08:10.9] things?

Joe: We got a couple more.

Mark: We have a couple more?

Joe: Yeah drill down to the bottom discretionary earnings we know … hopefully, everybody knows discretionary earnings is your net income plus your add backs. Net income of the bottom of a profit and loss [inaudible 00:32:44.9] statement add back to the personal expenses you run through the business that are your own benefits and one-time expenses. So you get net income plus add backs equals seller's discretionary earnings. Where do you feel most comfortable, where do you see buyers feel most comfortable in terms of that discretionary earnings as a percentage of your total revenue?

Mark: Boy that's a great question and I think it depends a little bit on the business itself. So SaaS companies tend to have higher SDE to revenue percentages. Content sites can have … depending on how they're set up can also have a higher percentage. E-commerce tends to have a little bit lower percentages relative to revenue. So I'm not sure if I've looked at this in terms of percentages as far as SDE to a percentage … I would assume since you asked the question that you have.

Joe: I have and you know 10% percent you could have at least I think. I can tell you what I don't want and I've turned away businesses I just simply won't list them because they're not going to sell are those that have 1 or 2%. You know look I'm not talking they're doing three million in discretionary earnings off of 30 million in revenue. That's a sellable business no question about it. But when you're doing 1 or 2% of your total margins you're spending a lot of money on advertising dollars, you're carrying a lot of working capital and inventory, you make a mistake a half a percent one way or the other and your profit drops dramatically. And any time I've looked at those, anytime we've listed things that have a smaller percentage margin there in discretionary earnings buyers get really nervous and they look at it from that point of view. So you've really got to do that math and not go oh yeah it's 200,000 in discretionary earnings. You've got to go okay it's 200,000 and what percentage is that of my total revenue, and how do I improve that? And then you drill down into those expenses. Dave Bryant who's part of the e-commerce podcast … EcomCrew Michael Jackness, he was our client and a year before we sold his business he did that. He looked at that bottom line sellers discretionary earning as a percentage of the total revenue and then drilled down into certain SKUs and looked at the profit margin of those and either renegotiated the ones that were not profitable enough or got rid of a few and added about 40,000 of discretionary earnings to his business and about $120,000 to the list price of the business. So I … you want to get at I'd say shoot for 10%, 5% gets a little you know depending upon the business and how large total revenues are but it's always a case by case basis. [inaudible 00:35:18.2] get down to that 2, 3% range I get really really nervous as do buyers.

Mark: I do think that part of it is revenue dependent. I've found with businesses that have kind of eye popping revenue numbers that even if the discretionary earnings is a very small percentage as you point out … if the business is doing 30 million dollars in revenue per year and it has really low percentage of discretionary earnings it's still a sellable business because you got 30 million dollars of revenue per year to be able to play with. It's when you get in those territories of say you have $500,000 of revenue and your discretionary earnings is just 10% of that so it's $50,000 that's not a lot of room for error before you're at negative territory and you don't have a lot of extra room in capital to be able to really pull into the growth of that business. So I think that's a good thing to be able to look at. I think a lot of it depends on the size of the business.

Joe: Yeah I completely agree. Look we didn't start … we didn't time this podcast, we have no idea how long we've been chatting for but I want to touch on one more thing that is really important I think for buyers to look at in terms of opportunity and for sellers to track in terms of again opportunity to get more value for your business. Buyers in terms of if they're not detailing it and you can figure that out you'll see built in growth and that is revenue by SKU. And that is whether it's a physical products business or a subscription business; again, box or software as a service. Because sometimes software as a service they offer different packages and what not. If you've launched a SKU, a new product in the last 12 months and I've seen this before and let's say you've got a dozen SKUs and six of them are only … they're under nine months old and staggered within there, you've got built in growth. And so what I like to drill down to if I can get it is revenue by SKU for the trailing 12 months. Because if a SKU was launched six months ago but it's already up to 18% of the total revenue that's huge because you've got six more months and it's growing. It's absolute built in growth and it brings more value for a buyer. You can push the value of the business a little bit higher and if you can share that detail with the buyers they're going to get it. They're going to look at it and go yes I get it I understand it. Classic example of that is Kent Renner. We had him on here on the podcast early on back in December right? 300% year over year growth and he only owned the business for six months. The business had a total of 16 SKUs when he bought it. Nine of them had been launched within the trailing 12 months and represented about 40% of the total revenues. So it's absolute built in growth and Kent's took that business and it was doing a million in revenue when he bought it to three million in total revenue inside of it … a total of 12 months. And that was because that revenue by SKU detail that Evan the seller was able to provide and sort of built in past to growth for it for Kent to take over.

Mark: Yes so I'm going to make a point here in this but beginning way to into the weeds on this topic here but I'm going to just venture in there anyways and just as an advanced tactic for buyers to look at I think what you're saying there is absolute gold. And again I've seen some of our top buyers do just that. They really get into the SKUs and these are particular get it. So let's get into a situational analysis here and say you have an e-commerce business that recently launched some SKUs within the past year or two years and … now I'm saying this because I have this case with a client, they're keeping their books on a cash basis. From a buying opportunity, in my opinion, this is like absolute gold because their costs relative to the revenue is going to be very very high. They're building up inventory in a product that is growing in sales but it isn't really there yet and so you have super depressed or understated gross profit which is going to pop very soon. This is like one of those signals that you're like buy. Like if you know what you're looking at buy this thing because it's going to pop in the next year and you're going to see that massive growth. You get maybe too much of the weeds there.

Joe: Yeah getting into cash versus accrual accounting with cost of goods sold way into the weeds but I'm telling you right now as a buying opportunity if you're looking at other brokerage firms … which hopefully you're looking at everybody. Any experienced broker is going to take a listing and go yeah okay there's the discretionary we'll do a few add backs and here's the multiple on that discretionary earnings. An experienced broker is going to take that same profit and loss statement, a physical products business and make sure that the cost of goods sold is presented on accrual basis. That discretionary earnings number … most often with the business, it's growing rapidly where you're taking excess working capital and putting it back in the inventory that discretionary earnings is going to pop. And I've seen a quarter of a million dollar increase in the value of the business because of it. Let's see if I can do some simple math. Imagine you have in the trailing twelve months a cost of goods sold of a million dollars on a cash basis. It's a big number but I'm trying to do round numbers. And let's say that on a cash basis you're over inflated by 5%. If you flipped it to accrual instead of having 35% cost of goods sold your real cost of goods sold is only 30% but because your cash your 5% higher. 5% times that million dollars that you've got there on the books is $50,000. If your business is worth three times that's $150,000 added onto the list price of the business. Or if you're a buyer and it's not presented that way it's $150,000 of instant equity when you're buying that business.

Mark: Right so for those of you listening you know need to fact check out some of the not … botany is the right field of science and also if Joe's math is correct on that because I don't know if it is. But we'll go with it and the point is there. I think the general rule of thumb that we follow here is a growing business that's kept on a cash basis is going to understate their discretionary earnings and their gross profit generally speaking. And a business in decline that is on cash basis generally overstates their discretionary earnings if they're not putting money back in the inventory at that point. So those are the basic rules of thumb. Keep in your mind there's exceptions; there are always. I think this is been a long podcast right now. We have not been timing it. We're probably around the 45 minute mark.

Joe: Hopefully you guys are still awake. If there's any questions that came up during the podcast shoot us an email inquiries@quietlightbrokerage, mark@quietlightbrokerage, joe@quietlightbrokerage, anybody's first name for the most part @quietlightbrokerage.com.

Mark: That's right and this format of an episode … normally, of course, we'd like to bring on guests and the friends of Quiet Light Brokerage onto the show and we have more of those coming up here in the near future. We've got some pretty good guests coming up. But we wanted to start spring cleaning some of these episodes where it's just Joe and I talking or maybe we'll talk with somebody else within the company not to really give a background on them but to give insights or some of the ways that we attack some of the issues that come up when buying or selling an online business. Give us feedback on this, please. We'd love to hear it. You can send an email like Joe said to mark@quietlightbrokerage or joe@quietlightbrokerage or if you don't want us to know and you just want to complain about us send it over to jason@quietlightbrokerage.com and he's god at keeping secrets so you can complain to him.

Joe: Sounds good. Thanks, Mark I appreciate your time.

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