8 steps to consider before investing in a web-based startup

Web-based startups can offer phenomenal returns on investment without the need for a large staff or expansive physical infrastructures to make them happen.

A few years ago, a friend told me he’d found a website that generated US$50 000 in annual revenue. He claimed no more than 10 hours of work a week were needed to operate it; he landed the site for a steal. He was excited for its potential — and excited he’d made a solid investment.

Envious, I followed his acquisition with particular scrutiny. Sure enough, it looked like a great investment — for two months. Google unexpectedly changed its search algorithm, and my friend’s cash cow crashed.

Buying a website is risky. Any investment is risky, but websites have the added risk of being based on intangible assets. You can’t break down a web business and sell it for parts the same way you can sell a brick-and-mortar store.

Read more: Don’t do a startup, build a business

That doesn’t mean you shouldn’t do it, but good investing requires identifying the most intelligent gambles.

Do due diligence

Smart risk-taking begins with information, but gathering information is too broad. Here are some specifics:

1. Make a plan

A good planning stage should give you a feel for the website you’re acquiring to the point that you can begin planning for your ownership of the business. Done right, due diligence will narrow your post-purchase learning curve. It will allow you to jump into revenue growth projects faster to accelerate your return on investment.

2. Look for omissions

The prospective seller can’t do your work and likely won’t know what you need to make a good buying decision. Due diligence finds what well-intentioned sellers might omit, from the big picture to accounting errors. A few mistakes and omissions are forgivable.

That said, be wary if a pattern emerges; it can signal incompetence or worse. There are ill-intentioned sellers who think they can present only the good parts of their businesses while hiding the bad parts.

3. Run from lies

A lie from a seller — even a small one — is inexcusable. If you catch your seller in a lie, don’t bother. The best way to avoid losing money is by simply working with honest sellers.

4. Ensure transferability

Search for evidence that the website you’re buying can come under your control in the same (or similar) condition it did under its previous owner. The business you think you’re buying — and the business you’re actually buying — must be one and the same.

5. Question yellow flags

Just because something seems too good to be true doesn’t necessarily mean it’s false, but it’s a yellow flag worth inspecting. People who want to sell quickly could be hoping that you are greedy and will miss important details.

6. Verify, verify, verify

Before you buy, always obtain third-party verification of documents. Don’t rely on screenshots or conference calls; both can be easily faked. Get actual statements from banks and get access to analytics.

Know where you’re going

Knowing what a website has done in the past is only part of the story. You’re buying it for the future. When smart investors evaluate websites, they consider what they’re poised to do with them down the road. They also consider how the websites could be improved with new leadership.

7. Value growth

Some websites sell for four times their earnings — others struggle to reach 1.5 times their earnings. The missing variable is growth.

Read more: 11 of SA’s biggest (and most exciting) tech startup investments of 2014

Consider two separate websites, each making US$100 000 a year. The first site grows 50 percent annually, while the second shrinks 50 percent annually. The first site sells at US$400 000, while the second sells for just US$150 000. Not only does the first offer a better three-year ROI, but it is also far more valuable to sell after that three-year period.

8. Look for natural points of leverage

Experienced buyers develop strengths they can exploit when acquiring businesses. A buyer with a great technology development team might be interested in websites that need significant facelifts. I knew a buyer who had unused warehouse space. He looked for drop-ship businesses that could achieve better margins and more favorable pricing if he transformed them into inventoried businesses. He immediately improved profits over the previous owners’ efforts.

As humans, we’re vulnerable to our emotions — especially excitement. If we let emotions take control, we won’t give honest risk assessments during planning or give realistic estimates when evaluating growth potential.

Having detailed, focused plans and executing them are important steps across the board, but they’re especially important when identifying opportunities for website investments.

Image by epSos .de via Flickr