How to Perform Due Diligence for eCommerce and Shopify Websites
When it comes to online business and websites, launching an eCommerce store is the most popular side-hustle for earning income online. With the explosion of the internet and online purchases by consumers, there is a ton of opportunity.
But there is also a ton to watch out for.
eCommerce websites can be started for next to nothing nowadays with dropshipping and Alibaba, which means there is a ton of competition, and frankly, a ton of terrible businesses out there.
There are a ton of fraudulent people out there trying to sell bad eCommerce stores to beginner buyers who don’t know what they are doing.
Table of Contents:
This article is near 5,000 words and I’m not ignorant enough to think anyone reads more than just the headlines. So here is a table of contents so that you can scroll to whatever section is most important to you. There are two types of diligence we are going to run here:
Smell Test Diligence: does this smell right?
- The Golden Rule of Buying an eCommerce Store
- The Worst Buyer Excuse
- eCommerce Business Models to Watch Out For (MUST READ)
Analytical/Financial Diligence: are the numbers and SEO good?
- Domain Name Due Diligence
- Auditing Website Traffic
- SEO Audit
- Analyzing the Financials
- eCommerce Specific Metrics to Pay Attention to
- Email Marketing Tactics to Watch out for
- Suppliers and the Age of Dropshipping
- eCommerce Website Valuation
The Golden Rule of Buying an eCommerce Store
If the deal sounds to good to be true, it’s 100% too good to be true.
If someone says their store is making $10k of profit per month and that they will sell it to you for $20k, run away! Even if they said they would sell it to you for $100k, you need to always be very skeptical.
Ask yourself this one question: “If I were making $x of profit per month, how much money would I need to give up that steady income?”
We will dig into valuation further, but we analyzed over 800 transactions and learned that eCommerce businesses on average trade around 24x average monthly profits, or 2x annual profits. BUT this rule does not apply to all eCommerce businesses, especially the ones to watch out for below.
The “I don’t have time to run it” Excuse
This is the worst excuse ever. Especially when they try to tell you it only takes them 5 hours per week to manage.
If something takes you 5 hours a week to manage and makes you $5k+ don’t you think you would make time to manage it?
Always dig in hard on the buyers reason for selling it. With eCommerce businesses it is usually because the advertising is no longer profitable, competitors popped up and started selling the same product, or they don’t think the business can continue its success for much longer.
I was looking at a business that made $350k in 2018 and the owner told me his bottom dollar was $50k. He needed to sell it cause he was more excited about this new business he was launching and that was taking up all his time. LOL. The Golden Rule applies here.
eCommerce Business Models to Watch Out For
1. Advertising Arbitrage Aliexpress Sites
These eCommerce sites are are called “advertising arbitrage” sites because their business model is simply taking advantage of cheap Facebook advertising.
They will find a $5 product, offer it for $25 on their site and send thousands of dollars of paid traffic to the site per month. They know they can acquire a new customer for $10. So their total cost of a sale is $15 and they sold the product for $25.
This sounds smart, but the issue is the cost of acquiring a new customer will increase eventually and become unprofitable. It is not evergreen!
Lets walk through an example of one of these businesses I found on Flippa:
Here is a site that is profiting $6k per month, and it can be yours for just $39k, what a steal!
If we take a look at the website, it is selling the most random assortment of products. A kids snorkel mask, bird fountain, acupuncture pen, what???
And then we take a look at the P&L:
Notice the massive ad spend in October, November, and February, and the big ad spend dropoff in December and January. Advertising likely wasn’t profitable in these months due to holiday shopping, so the owner had to pause the spending until it was profitable again.
Another big issue with these sites is you not only have the purchase the business for $39k, you then need to have another $7-15k to pump into your first month of ads.
Characteristics of Advertising Arbitrage eCommerce Sites:
- Huge and variable ad spend from month to month
- Random assortment of products (or sometimes a single product)
- Dropshipping from Aliexpress – zero value add!
- Low return customer rates
- All traffic and sales are from paid ads, virtually zero organic or natural traffic
- Usually less than a year old with a huge ramp up in revenues in the first few months followed by declining revenues
How to Create an eCommerce Store Yourself Instead of Buying One of These
These sites have virtually zero value-add and are all selling products from Aliexpress. Go find the products on Aliexpress, sign-up for Shopify for $30/month and spend 10 hours building a decent looking website.
Now put $10k into Facebook ads and drive traffic to the site. Voila, you just replicated this business and its success for $10k instead of buying it for $39k and putting the same $10k into advertising.
Analytical, Financial, and Quantitative Diligence:
1. Domain Name and Website Age
Older websites are trusted more by Google, which helps with SEO. And an older business are typically more stable and have more history which gives us more comfort in investing in it.
I don’t touch sites that aren’t at least 18 months old unless I have an existing site I can combine it with or the traffic profile and trends are extremely positive.
Use Godaddy’s WHOIS database to check domain age:
Also use Archive.org to see how long the domain name has been used as an active website. You could have a domain that is 10 years old, but it has only been a real website for 1 year. This is a cool tool that lets you see what websites used to look like, all the way back into the 90’s.
Nothing here is a huge red flag for buying an ecommerce site, its just good to know how old they are to fact check the owner. I prefer sites with 2-3 years of traffic and revenue history.
Takeaway: Older websites have more history and are more likely to continue their success into the long-term.
2. Auditing Website Traffic
Always get access to Google Analytics! If they don’t have them installed, ask why. Every website owner should. If they don’t, ask for Shopify or WooCommerce access so you can look at the traffic stats on there. Don’t ever buy a website without understand where the visitors come from.
Things to watch for:
-Heavy paid traffic: if more than 50% of the traffic comes from paid advertising, I’d be concerned. This means they spend a lot on advertising and if you stop paid ads, half off your business will dissapear.
-Heavy social media traffic: Social media traffic can also mean paid social advertising. But other social media traffic is usually one time. Your pinterest post goes viral and drives a bunch of traffic to the site, but once it gets old and dies down, the traffic is gone and won’t come back until the next viral pin.
-Traffic from India, China, Africa, random countries, etc.: Unless your business is international, you want the majority of the traffic coming from the United States or whichever country you are targeting. Tons of traffic from foreign countries is usually a sign that the owner bought fake traffic!
Check the “What pages do your users visit?” section of Google Analytics:
Make sure all of the traffic is spread out across products (sorry the snip is of my blog, not an ecomm store) and different pages of the site. All the traffic going to one single page means the customers or visitors are only looking at one product and then leaving the site.
Also, be careful about tons of blog traffic if its an ecommerce site. Blogs are a great way to drive traffic to your site, but a site that gets 10,000 uniques per month probably doesn’t convert well or generate much revenue if 9,000 of those visitors are to the blog pages only.
Takeaways: 1) Organic traffic is king! 2) Always get Google Analytics access.
3. Checking for bad SEO
Bad SEO can absolutely kill a business. If you get a penalty from Google and are un-indexed, you will feel the pain.
Use Moz’s Link Explorer and check the “Spam Score” tool:
This is for the site I mentioned from Flippa earlier. Yikes! It has virtually no SEO value.
Sites with very few links and low domain authority typically generate zero organic traffic.
You can click the “Inbound Links” and “Linking Domains” section to see the actual backlinks.
Here is what a bad site looks like:
That’s a dangerously high spam score. If you look at the “Inbound Links” you’ll notice how bad and spammy they look:
Takeaways: Look for sites high with DA/PA, lots of inbound links from relevant sites, and stay away from sites with bad links and high spam scores.
4. Analyzing the Financials
If the site has been operating for 24 months, it should have 24 months of financials you can look at. If the owner says “I don’t have any” or “I only have them for the last 6 months” then just walk away.
We want to buy professional sites that have been run properly and any good business owner keeps financial stats.
Here is what you should look for in the financials:
- How have the revenues been trending?
- Are there any large spikes or drops in revenue? If so, what caused them?
- Advertising Spend: watch out for high spend and variability. Ask why they spend $14k on ads one month and then $1k on ads the next month.
- Check gross profit margins, they should be consistent over time.
- Are there large and recurring web development costs?
- IMPORTANT: What expenses are recurring on a monthly basis?
It is common for brokers or individuals to include “add-backs” on their financials. Add-backs are expenses that are one-time in nature and will not reoccur once you take over the business. Adding these expenses back gives you a better understanding of what the true profits will be for you once you take over.
List of acceptable and common add-backs:
- Owners salary (but no employee salaries)
- Website re-designs/development, so long as it is truly one-time in nature
- Licenses/subscriptions purchased that are good for life
Legal fees or consulting fees
PayPal Screenshots can be faked! Always get access to Shopify/WooCommerce/etc. to verify the revenues are coming from real customers!
Verify that there aren’t any expenses that the owner is telling you about by getting access to the backend of the site and seeing what plugins/apps the website is using.
5. eCommerce Metrics to Look For
A. Returning Customer Rates
High levels of returning customers is great! It means you have a brand, not just an eCommerce store. It also means that the business is less reliant on paid ads or acquiring new customers since you have a strong list of existing customers who you can target and sell to.
B. Product Return Rates
The average eCommerce store has a return rate of 20%. Returns suck to deal with and usually result in losing money.
If a store has a >20% return rate it probably means that their products aren’t very good. Stay away! I like <5% return rates.
C. Average Order Value
Target business with high AOV. If your AOV is $10, that means you need to fulfill 100 orders per month to do just $1,000 in revenues. That’s a lot of orders to fulfill every day and month.
I look for sites with average order volumes over $100 so that I can ensure I’m making at least $20 of profit for the amount of time it takes me to fulfill the order. (I don’t mess with stuff with less than 20% net profit margins since they aren’t worth the time)
D. eCommerce Conversion Rates
This is the holy-grail of eCommerce metrics. If a store has a 1% conversion rate, it will receive 10 orders per 1,000 visitors. If it has a 2% conversion rate, it will generate 2x the orders, revenues, and profits without having find ways to get more traffic!
You can also look at conversion rates by traffic source and compare them to these averages above.
I don’t mess with stores that have lower than 2% conversion rates.
6. Email Marketing No-No’s
Email lists are great and can drive a significant amount of revenue. But be careful about relying on an email list.
If the owner is sending out more than 1 email per day to his list, he is ruining its value. Too many emails results in more spam reports which makes all emails eventually end up in your lists spam box. You can also only squeeze so much revenue out of your list.
Things to watch for:
- Check the amount of new sign-ups to the list on a daily or monthly basis. Check whether these are people who purchased a product or just who signed up for the list but didn’t buy. If you are selling a one-time product or something with a really long useful life, then the email list can be almost worthless if it’s only filled with customers who have bought a product.
- High spam report rate
- Low open rates and low click rates
- Too many emails being sent
- Purchased email lists – purchasing lists is illegal and will likely result in your email getting blacklisted
Don’t every let someone tell you you need to buy the email list separate from the business. If the email list is used to generate revenues, it is part of the business. Send them my way if they try to argue otherwise.
I always ask for snips of open rates, click rates, and spam report rates before buying a business, especially if email generates a lot of revenue! A big email list that doesn’t get used frequently can be a huge bonus, but too many eCommerce owners abuse their list which deteriorates their brand.
7. Who are the Suppliers?
Too many eCommerce stores nowadays are using Alibaba to bulk buy products or Aliexpress to dropship them. I wouldn’t touch any of these. If a website doesn’t have unique suppliers or some sort of exclusivity on the product it is selling, I stay away.
If other people can find the products you are selling and buy them too, you will have competitors knocking on your door in 2 weeks.
People are a lot less likely to copy you or steal your idea if you have:
- Custom designed and manufactured products
- Suppliers who require a legal US business and valid sales and use license (cuts out all international fakes)
- Private label products that the supplier agrees in writing they will only sell to you and no one else
If your products require money to be spent upfront, you are eliminating so much competition.
Plenty of people out there will try to teach you Aliexpress dropshipping. Stay away unless you want to build a site for 3 months and then have it get murdered. Focus on evergreen business models that China and India won’t copy.
8. eCommerce Website Valuation
We analyzed data from 42 dropshipping businesses and 107 eCommerce (physical products) businesses and determined what averaged monthly profit multiple they sold for based off of: the price they sold for, how old they were, how many pageviews they got, and how many hours per week they require.
Here is the data for Dropshipping businesses:
Analysis: the average dropshipping business sells for 26.2x average monthly profits from the trailing 12-months. Bigger sites sold for higher multiples. Sites requiring less hours per week sold for higher multiples. Sites with more traffic sold at higher multiples. Older sites data is a bit variable.
NOTE: This data is from businesses sold through brokerages which means they are high quality sites! Advertising arbitrage sites don’t sell anywhere near these levels and usually sell for less than 12x with heavy seller financing.
Here is the data for physical product fulfillment ecommerce sites:
Analysis: physical product ecommerce sites are valued less than dropshipping, with an average of 22.5x. This is because they cost more money, and usually take more time to manage (although data here isn’t great to support that). Consistent with above, bigger sites sell for more, and sites with more traffic sell for more. These sites were also on average older than dropshipping sites since most of them sold unique or custom products that took time to develop and create.
NOTE: same as above, these sites are also all brokerage sold businesses.