Part 4: Due Diligence

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by nhussein · 0 comments

OK, so you’ve decided the sort of website you’re after. You’ve carried out the quick checks to eliminate the obvious dross from your search. Now it’s worth spending more time and effort on finding out whether your potential gold mine has seams worth working or is exhausted, or if you’re being shown fool’s gold. This more rigorous checking process is known as due diligence.

What’s the purpose of due diligence?

By definition, investment entails risk – it’s tying your money up in an enterprise in the hope of future returns. You can’t eliminate all risk, but you’d be wise to do everything you reasonably can to eliminate unnecessary risk. That’s what due diligence is all about. It’s a way of ensuring you don’t get fooled into losing your money – by a seller’s lack of scruples or business naivety, by a change of business environment due to a third party’s actions, or by your own wishful thinking overriding your better judgment.

What is due diligence?

Due diligence (DD) is the name commonly given to the process of conducting independent checks on a potential investment opportunity to ensure that if the investment proceeds, the investor won’t be sprung with any nasty surprises that could have been foreseen.

Many of us will have come into contact with a form of DD when taking out a mortgage to buy a house. The lender naturally wants to be sure as possible that it can recover its money by selling the house if you default on the mortgage repayments, so it will insist that checks are carried out (legal search, survey, structural report) to ensure that there are no legal snags, structural faults or other threats to the house’s future value.

There are all sorts of things you can check in conducting DD; Wikipedia lists nine different areas that the process can look at. The more deeply and widely you check, the more it will cost, in time and money – so the extent and depth of your DD depends on how much you’re likely to gain in buying the website. If a site’s only going to earn you hundreds of dollars a year, there is no point in spending thousands on checking it out, or even hundreds! On the other hand, you’d be a fool to spend just a couple of hundred dollars if you’re seriously contemplating buying a site that’s allegedly worth six figures.

Essentially there are four things that you will need to look at in deciding whether to buy an online business. Here they are, listed roughly in the sequence they’ll need to be approached in:

  • ownership
  • assets
  • profitability
  • traffic

Ownership

This is the first thing you’ll need to get established: if the seller doesn’t have the right to sell the website, you can’t legally buy it from him.

The readily available public data about the people operating a website aren’t necessarily to be relied upon. The WHOIS data about the website domain’s registrar may not be accurate or up to date. Official government registry data about the company or person running a business offers a little more confidence, but people have been known to lie to governments. If you can get a trusted person to make contact with the person selling – or even make the contact yourself – then so much the better.

Even if the person is who they say they are, you still need to check that they’re entitled to sell it. Proof that they have access to the server isn’t enough – they may have hacked their way in, or be a disgruntled ex-employee.

Has the seller sold other websites in the past? If so, it’s worth finding out more about their online reputation. Check out any bad feedback thoroughly, including by getting the seller’s side of the story.

The other thing you’ll need to address with regard to ownership is: do you have the right to own the website? Which brings us on to…assets.

Assets

The next thing you need to look at is the assets held by the business. Is their value what you’d expect for the asking price, or has the seller inflated it?

First look at the domain. A good domain can be a valuable part of a business’s brand, but “where” is it on the Web? Domains ending in .com are highly desirable for almost any purpose anywhere; the .org and .net domains less so. Geographical domains like .co.uk, .de and .jp can be even more valuable than .com locally but have little value elsewhere – and you may find that there are restrictions on who can own them, eg residents or citizens of the country concerned. You can check the rules with the registration authority.

As for the “name” part of the domain name, very short names and single dictionary words can command high prices because they’re memorable. Longer phrases hoping to capitalize on Google search traffic have fallen out of favor. Domains that rely on another company’s brand are highly risky propositions, especially if the company has a big team of corporate lawyers ready to close down such websites.

Check out the history of the domain name. Who’s been using it before, and for what? A domain that’s previously been used for an adult website or that’s been blacklisted for spam may require some effort to rehabilitate and be hard to sell later.

Now look at the website. How much is the content worth? Has it been churned out or “spun” from a basic mother text, in barely literate English, adding nothing to the reader’s understanding of the subject? Or is it well written and genuinely useful and/or entertaining?

Does the site owner hold copyright for all the site’s content, including images and other media – and if so, are the rights transferable? You don’t want to be slapped with a DMCA notice forcing you to remove most of your new acquisition’s content – and pay for the violation.

How about the site’s software? Is the code well written, well documented, and standards-compliant? Or is it a can of worms, where fixing one problem causes ten more to spring up elsewhere? Are there any bespoke customizations? And has the seller inserted any sneaky snippets of code which will siphon off a cut of your earnings even after you’ve replaced his affiliate codes with your own?

Perhaps the website has other associated promotional assets, like social media. Although it’s nice to have plenty of friends and followers, are you sure they’re genuine? It’s quite easy to buy large numbers of both. Check some, and see how many are fans of literally hundreds of pages – these are likely to have been paid a pittance to visit and “like” those pages by the hundred. Mailing lists should be checked too, to ensure that they’re compliant with laws against spamming.

You’ll also need to check on external factors too. This includes market analysis – how big is the market? Is it growing, stable or declining? Who are the competitors, and what’s stopping new ones from entering the market?

Has the seller identified the site’s unique selling proposition (USP)? If so, is it unique and likely to remain so? And does it genuinely help sales?

If your website relies on sales of physical products, then you may need to check on stock – you don’t want to suddenly be saddled with a big warehouse bill for a bunch of stuff that only sells slowly.

Profitability

This is the crunch question. Profitability is the single most important aspect of a website that’s also a business.

  • It’s more important than traffic – as long as a site consistently makes more profit than your minimum monthly target, it doesn’t matter too much whether the website’s getting a hundred unique visitors each month or a hundred thousand!
  • It’s more important than revenue – a site that’s generated sales worth $4,000 in a month may sound pretty cool, but if the site ran up costs of $5,000 at the same time, then that site just lost its owner $1,000.

There are three aspects of a website business’s operation that you’ll need to focus on.

Net profit: this is the revenue minus all the business’s costs – the “bottom line” of the business. Unfortunately a figure’s often not readily available for online businesses, which tend to be run informally, especially if the business is small. Even if it is, it may not be an accurate figure – it may understate performance to minimize tax. But it’s still useful to try to establish the financials behind the business as best you can.

Income: all the money taken by the business through whatever revenue streams it has. Here are the more usual ways of monetizing a website:

  • Advertising income. This includes large schemes like Google AdSense as well as smaller pay-per-click (PPC) programs. You’ll want to have access to the revenue figures for the last three months or so – though you should be aware of the possibility that totals may include revenue from other sites as well as the one you’re buying. Direct deals with advertisers are another way of generating revenue – potentially more lucrative, but more time-consuming – and you should ask for sight of the relevant agreements (and check them out with the advertiser).
  • Commission. Several programs exist that act as middlemen between merchants (retail websites) and publishers (content-based websites), whereby the publisher promotes the merchant’s website and the merchant pays a commission for any sales generated by the publisher. It’s usually possible to gain limited-rights access to the publisher’s account to check on sales figures.
  • Sale of goods and services. This may be done through a third-party marketplace such as Amazon or ClickBank; figures are usually easy to verify, but beware of sellers paying friends to buy from them to inflate sales. (Look out for refunds too, and products sold by just a few affiliate sellers – are they related to the website owner?) Or the site may have its own shopping cart, in which case the owner should be willing to grant you access to the figures.
    Sites selling services are a bit harder to evaluate. You’ll need to assess how easy it will be for you to continue to provide them – if you can’t do it, how much will it cost to hire someone? And how do you know that sales are genuine, and not simply payments made by the seller’s buddies as favors to be returned later?

You should carry out some sanity checks, too, on figures like signup rates, revenue generated per unique visitor or revenue per thousand page impressions. Beware of any extraordinarily good performance – it may not stand up under closer investigation.

Expenses: these can be surprisingly diverse, but here are the main ones you’re likely to encounter:

  • Site maintenance: Hosting and domain costs are normally trivial. Software licenses may be one-off fixed-price payments, or recurring costs that may even vary depending on use (eg third-party mailing lists). Content creation may be complex – did the seller pay for content, or write his own (and fail to charge for the time spent)?
  • Advertising: this is important to check as large recent expenditure may have affected recent traffic and income figures (and therefore profitability). Check for paid traffic, including PPC campaigns, link building, paid directory entries, and direct advertising.
  • Sales activities: Transaction processing (eg bank/PayPal charges) is relatively straightforward. Customer support can vary hugely, from FAQ and a contact form at the simplest to a whole team of staff working shifts to help perplexed customers worldwide; you may be able to test it for yourself as a mystery shopper. Storage and shipping can be significant costs for websites selling physical products. Affiliate programs may be in-house (incurring significant maintenance costs) or third-party (meaning one more party to split the revenue with).

Traffic

Verifying and analyzing website traffic is more an art than a science – not least because there’s no consistently reliable way of ensuring that every visit to a website gets logged correctly. Besides, experts’ views on how to interpret the same statistics vary widely too. The best answer is to obtain stats from as many different sources as you can – including the stats from the site’s own server as well as third-party stats like Google Analytics (GA).

You’ll need to check out how much traffic comes from each of the main sources:

  • Direct traffic by typing in the URL or using a bookmark, implying a high degree of loyalty;
  • “Organic” search engine traffic, ie from the search results, not from sponsored listings – hailed as “free” traffic, but getting good positioning in the search results may actually entail quite a lot of work;
  • Referred traffic from links on other sites (including the social media) or emails. Check these carefully; links from high quality sites are worth having, links from sites with little or no worthwhile content may be signs of attempts to game the search engines, and “your” site may be penalized by them in future.
  • There’s also paid traffic, whether through PPC advertising, paid links or banner advertising, or even deals for raw traffic. This is OK if done to raise awareness of the site, but beware covert deals to give a misleading impression of the site’s popularity.

You’ll also want to assess the quality of the traffic:

  • Is it genuine? Beware of: large numbers of very short visits (may be bots/paid traffic); visits from a small number of locations (“IP” numbers) (may be bots/accomplices); GA stats including visits to the seller’s other sites.
  • Is it natural? Beware of: PPC campaigns without any apparent commercial reason; large amounts of traffic from surprising countries (or from proxies).
  • Is it diverse? Beware of: sites that depend on a single source of traffic; sites that rank highly in search engines for a very small range of keywords. (An algorithm change could wipe out traffic overnight.)
  • Is it enduring? Beware of: seasonal variations (great traffic for the most recent three months, but what happens for the rest of the year?); links from stablemates (the seller may break those links); high numbers of unique visitors (implying no repeat visitors).

How does DD get done?

Now that you have an idea of what due diligence involves, it’s time to plan the process.

You’ll need to decide the scope. A site worth just a few hundred dollars may not merit anything more than a perfunctory check, especially if the seller’s already known to you online. A site worth hundreds of thousands will need a lot more investigation.

Timing is important too. Start too early before you and the seller have established any kind of meeting of minds, and you might waste your DD fees; but you may be better able to negotiate a good price, and showing the seller that you’re serious may put you ahead of other potential buyers.

Your due diligence budget depends on the value and complexity of the website. At the top end, you should be prepared to bring in professional help, and pay for it. At the lower end, a cloned “turnkey” site may not require anything more than you checking that the seller really does own the domain and isn’t infringing any intellectual property rights.

Who’s going to do it?

This is a question of time and expertise. If you’re making a major investment, you’d be best advised to leave it entirely to the professionals unless you have a lot of experience behind you already. You should be aware that the DD investigator almost never guarantees the completeness of their work, and the final decision whether or not to buy rests solely with you. Nevertheless, a good DD investigator is still worth the outlay.

On the other hand, if you’re starting small, you have the time, and you’re willing to learn, then it can be fun to do at least some of the preliminary work yourself.

Just remember that there are six elements that go into what we can call the SPHERE of good due diligence:

  • S – Information provided by the Seller
    This is your starting point – does it raise any red flags? If not, then you can proceed with caution.
  • P – Information from Public tools
    Use this to cross-check the information the seller’s provided. The more information you have, the better you’ll be able to assess the site’s true value.
  • HHealthy scepticism
    Not too little, not too much. Too little, and you’ll be sold a dud; too much, and you’ll miss out on good opportunities.
  • E – Your own background Experience of business
    You may have to seek advice from trusted, more experienced people at first, and that’s fine. But try to think things out for yourself too, and develop your own expertise. Common sense will help!
  • R – Ask the Right questions
    If something doesn’t seem to add up, then be prepared to ask for an explanation from the seller. The response may be revealing. So may the lack of one!
  • EExtract the correct conclusions
    You may have a lot of information to sift through, and it may support several different interpretations. Your job is to assess which is the most likely. That in turn may lead you to walk away from the deal, move to close the deal, or ask more questions.

What’s next?

You’ve nearly made it through to the deal, and soon it’ll be time to hand over the money. In Part 5 we’ll examine the final steps in closing the deal and how to avoid potential last-minute deal-breakers, review the process, and look briefly at what happens after you’ve taken ownership of your new site!

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nhussein

Managing Partner at VRETycoons

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