This guest post was contributed by Thomas Smale, Founder of FE International, the premiere M&A Advisory firm for online businesses.
In a recent post, we discussed the importance of keeping the sale value of your app in mind when building the business that supports it. Optimizing the operations of the app business will increase the value, and contribute to the larger success, of the business.
Most people know that building and sustaining a commercially viable business is step one in eventually selling the business for a profit, but which specific variables contribute to app valuation? In other words, how does one value an app business?
Understanding the valuation process and the various drivers affecting its price is paramount if you want to base business decisions around creating value.
At FE International, we have sold over 500 businesses with a combined value of hundreds of millions of dollars, ranging from mid-five figures to $20 million in value each. During this time we have perfected what has grown to be the online M&A industry’s most sophisticated and reliable method of establishing how to value an online business.
Our approach leads the market in its use of real data and is fundamentally based on establishing a figure to accurate represent the business’ annual revenue, often EBITA or SDE (depending on the size of the business) and then multiplying it by a number determined by hundreds of variables and comparable businesses sold.
The most complex part of any deal, however is in the expert research and analytical processes involved in establishing these two variables. It is here that our valuation process shows its true worth. WE treat each unique business as a holistic entity when valuing an app.
The best way to understand what goes into determining an app’s sale price is to take an in-depth look at the method FE International uses to perform a valuation on app businesses. Having extensively covered how to value a SaaS Business, the most recent post in our valuation series covers how to value an app in a comprehensive analysis of app valuation.
Establish Earnings as a Baseline
There are several ways to determine a business’ annual earnings. At FE International we have found that the two most reliable methods to find the most accurate valuations for app businesses are Seller’s Discretionary Earnings (SDE) and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA).
Seller’s Discretionary Earnings is used for most apps under $5 million, and can be calculated using the following high level formula:
In other words, SDE is what remains once total operating expenses have been deducted from gross income, and the owner’s salary added back.
The main reason for relying on SDE is that most small businesses are owner-operated and, thus, owner-reliant. Therefore, an owner will often pay themselves a salary and purchase personal items through the business for tax purposes. To uncover the true underlying profit potential of a business, these expenses should be added back to revenue.
Other qualifying add backs include one-time expenses, such as web design for the business’ website. The business’ value should not be compromised by a conditional expense that bears no ongoing relevance to its earnings.
Valuing companies worth more than $5m is more complex, however, so Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is typically used in such cases. In acquisitions of companies with over $5m in value, EBITDA multiples are used almost exclusively, with revenue multiples also used in larger, more strategic sales.
The EBITDA formula below can be used to calculate revenue:
Once the SDE or EBITDA value is calculated, you can move onto establishing the valuation multiple by which the revenue will be multiplied to determine the sale price.
Establish the Valuation Multiple
To calculate the market price the seller should expect for the app, the earnings baseline figure is multiplied by a number derived from the business’ growth potential, possible risks faced by the new owners, and other relevant factors.
This factor is referred to as the valuation multiple and requires expert analysis of every aspect surrounding the app business to be calculated.
An app’s valuation will always be most accurate when based on verifiable data rather than simply speculation or the owner’s word, therefore a quality advisor will always requisition evidence for the data for each step of the valuation process. If you are uncertain about the mechanisms that can be used to create this proof, get in touch with a mergers and acquisitions advisor at FE International for guidance.
To learn more about app valuation, read our comprehensive guide to App Valuation: How to Build, Value and Sell an App.