Studies &
Opinions
Domain-Name Acquisition
Strategy & Valuation Drivers
Alex
Tajirian
September 21, 2007
INTRODUCTION
We address two questions:
-
Given an acquisition motive, what is the
best strategy?
-
Given the best strategy, what are the valuation
drivers?
VALUE-CREATING
ACQUISITION STRATEGIES
To develop a prescriptive domain-name acquisition framework,
we consider two motives: investment for development,[1] and investment for complementing
a firm’s domain portfolio. Acquisition strategies are divided into
two mutually exclusive options: buying to sell and buying to hold.
The planning stage for a buy-to-sell strategy includes
a Web site development analysis and an exit strategy. Exit is achieved
through placing the domain name for sale when certain return thresholds
are met. The buy-to-hold strategy, on the other hand, is based on
holding the domain name until such a time that an acceptable offer
is received. Thus, the decision to sell in the buy-to-hold strategy
is tactical, not strategic.
The following example illustrates the difference
between the strategies:
Options |
Before-tax
Return (annual) |
Undeveloped |
Developed by Acquirer |
Years 1-5 |
Yr 1 |
Yr 2 |
Yr 3 |
Yr 4 |
Yr 5 |
Domain-1 |
5% |
50% |
50% |
15% |
15% |
15% |
Domain-2 |
10% |
40% |
40% |
40% |
40% |
20% |
Assume that the entity making an acquisition decision
faces the above two mutually exclusive options and that the options
have been presented at prices reflecting the respective undeveloped
annual returns. An investor following a buy-to-sell strategy would
buy Domain-1, develop it, sell it at the end of year 2, acquire
Domain-2 at the end of year 2, and sell it at the end of year 4.
Given the above example, the buy-to-sell strategy yields superior
returns over buying Domain-1 and holding on to it. Thus, a buy-to-sell
strategy is value adding. Nevertheless, after the developed site
has been sold, both domain names would generate healthy returns
to the entity acquiring them. Moreover, the acquirer of a developed
domain may be able to create additional value with further development.
An acquiring firm first needs to make sure that
the role of the domain name considered for acquisition is consistent
with the firm’s corporate domain name strategy.[2] An acquisition that complements
a firm’s domain name strategy is, by definition, value adding. For
example, acquisitions under the umbrella of brand/trademark protection
can be value destroying and thus, the company should refrain from
such acquisitions.[3] On the other hand, value
creation potential from a buy-to-sell strategy is ambiguous. In
general, firms should stay away from investments that are not within
the firm’s core competencies. Acquiring such domain names is no
different than a company using shareholder money to make financial
or real estate investments hoping to generate higher shareholder
return. Moreover, a buy-to-hold acquisition is a strategic complement
to the firm’s domain name portfolio, while buy-to-sell is nonstrategic
and involves Web site development and active selling in relatively
thin markets, which are not necessarily part of the firm’s core
competencies. Nevertheless, the firm’s ultimate decision should
not conflict with its overall corporate strategy.
It should be noted that a corporate buy-to-hold
strategy does not preclude the firm from selling any of its domain
names. On the contrary, domain names that no longer play a contributing
role or are no longer part of the corporate domain name strategy
should be put up for sale.
Thus, the analysis can be summarized in the following
simple 2x2 model.
Value
Creation |
Strategies |
Buy to sell |
+ |
+/- |
Buy
to hold |
- |
+ |
|
|
Development |
Firm |
|
|
Buyer
Motives |
|
VALUE DRIVERS
For a firm, the main value driver is compatibility with its
domain name strategy. For developers, on the other hand, we outline
the impact of the following drivers: monetization venue, tax rate,
and transaction cost.
Monetization Venue
The three main domain-name monetization venues are parking[4],
ecommerce, and leasing.[5] The venue selection depends
on the buyer’s risk tolerance, competencies, and financial resources.
Nevertheless, the acquirer may delegate domain-name monetization
management to an agent.
There are risk-return tradeoffs between parking
and ecommerce.[6] Thus, an acquirer’s choice depends in part on their appetite for
risk. Also important is the acquirer’s competencies, especially
when it comes to the decision between building and managing an ecommerce
site on one hand and parking on the other. Moreover, with parking,
the acquirer may opt for a portfolio diversification[7] or a tactical domain allocation[8] strategy. The former requires
knowledge of portfolio optimization, while the latter requires knowledge
about the performance of the various monetizers. Nevertheless, access
to funds makes ecommerce and boutique parking feasible.
Tax
A domain name acquired to generate profit is regarded as inventory
(you carry it for resale purposes). Therefore, a gain on the sale of such a domain name is not
a capital gain but ordinary income.[9] In contrast, a domain name
acquired to run your Web site may be considered an intangible asset,
not inventory, thus, profit on s sale of such a domain name is generally
considered a capital gain.
On the other hand, fund managers an go around
paying the ordinary income tax rate by organizing the firm either
as a private equity or an investment trust. The current tax provision
considers fund managers’ profit as return on investment instead
of income from services. However, currently there is a US congressional
debate as to whether /span>to raise the tax rate on the investment
gains of fund managers.[10] Congress
is looking into whether this tax provision gives fund managers an unfair advantage.[11] As for investment trusts, such an organizational structure places
legal and regulatory restriction on the firm’s operations, such
as its ability to acquire public companies and the amount of allowable
debt financing. However, these restrictions do not constitute a
significant barrier to establishing domain name investment trusts.
Transaction Costs
Transaction costs[12] include searching for potential
sellers and buyers (either through direct contact[13] or established marketplaces), negotiations, and escrow fees. As
domain name markets are becoming more efficient, these costs are
decreasing. Moreover, they are not big enough to offset the advantages of a buy-to-sell strategy.
IMPLICATIONS
Ignoring the appropriate strategy and tax treatment biases domain
name valuations, and thus results in lower returns to the acquirer.
Moreover, the monetization venue options put some selection constraints
on the type of domain names that should be acquired. For a firm,
acquisitions must complement their domain name strategy.
[1] Development includes customized parking, forums, and
ecommerce.
[4] We define parking as monetization through the placement
of ads on Web sites, irrespective of who performs content customization
and to what extent.
[9] In the US, the ordinary income tax rate can be as much as 35 percent,
while the capital gains rate does not exceed 15 percent.
[10] The tax rate on investment gains for fund managers is
known as "carried interest."
[11] It should be noted that such provisions have been recently
eliminated in a number of EU countries.
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