Rules of Thumb in business valuations almost always benefit the seller of a business. Rules of thumb are often used to justify or validate the value of a business that is either unprofitable or uneconomic.
In preparing hundreds of business valuations for family law and commercial litigation and advising people on business valuations, we constantly come across rules of thumb as justifications for a business value.
Below are some of the reasons, why rules of thumb are dangerous to use:
- No proof for rules of thumb. How can you ever be sure that a rules of thumb is correct? There is rarely any study as to actual transactions that prove that a rule of thumb is applicable. Transaction studies in the United States shown that there is a wide variance between factors used in Rules of Thumb. I have been hearing about some of these rules of thumb for at least 20 years and there is no proof for them.
- Method of explaining a difficult concept. Rules of thumb are often used as a method for explaining the difficult concept of business valuations. People looking at small businesses do not want to spend on advisory fees to determine the real value of a business. They are often looking for any justification to buy a business that they have set the heart on buying. We have seen many instances of people buying post office franchises for up to $750,000 and the only return for working seven days per week is about 50% of award wages.
- Gross oversimplifications – rules of thumb are by their very nature gross oversimplifications of a business. The worst types of rules of thumb are sales based multiples such as 1 x annual sales income. These types are often used in cleaning businesses and truck driving contracts. Rules of thumb are dumb in that they are blind to profitability, history, trends in the business or industry.
- No commercial return – the application of a rule of thumb to a business will rarely show a commercial return that is reflective of the risk and return of a business. By commercial return, I mean a the profitability of a business after deducting a commercial salary for the business owners labour. Most small businesses do not deliver a commercial return, they provide a wage and sometimes not very good wage, for the owner and that is all. In many cases, the owners would be better off working for somone else.
Rules of Thumb have a role in screening businesses that may be suitable to buy. A rule of thumb could be considered like a key performance indicator that measures one part of a business and enables some comparsion between businesses. It should not be used as the basis for buying a business.
Questions you should ask a broker, business seller or accountant who is relying upon a rules of thumb valuation:
- Ask for the source of the rule of thumb and get a copy,
- Ask for any other published sources of rules of thumb,
- Are they personally aware of any other businesses that sold using this rule of thumb,
- Have they checked actaul transactions to the rule of thumb,
- Ask what assets and liabilities where included in the rule of thumb valuation.
A rule of thumb will almost always benefit the seller and should never be used as the justification for buying a business. Ensure that you get professional valuation advice, it will save you money and many years of grief and regret.
Remember one the reasons that rules of thumb still exist is the bigger idiot theory – it’s OK to be an idiot when you buy something so long as there’s an even bigger idiot who you can sell to.