From time to time, we encounter business owners that sold their business at a price determined by a “rule of thumb” method. What is being gained by taking this approach? What is being lost? What does “rule of thumb” even mean?

The term “rule of thumb” originated with wood workers who used the width of their thumbs as a standard measure. That practice now gives us a popular expression that is used often to arrive quickly at a measure. It can be reliable in some instances and often it can be inaccurate. In the context of business, rules of thumb provide a shortcut to determining the potential sale price of a business. As an example, the annual turnover for a computer maintenance business becomes a
proxy for the sale value of that business.

There are different rules of thumb for the different industries. A rule of thumb is better used as a general idea of a value, on average, of a business. That is not to state that rules of thumb are bad. There is some evidence suggesting they can be reasonably accurate. But we wonder whether this is because the same piece of information is available to both seller and buyer leading to a self-fulfilling prophecy.

We do find the rule of thumb method is useful to business owners when conducting preliminary thoughts of the sale of their business within, say, the next two to five years. The resultant quick calculation often becomes a reality check. They are confronted with a “wake-up call” concerning the potential true value of the business… often less than they want. This has a positive side, as it allows the owner to make changes toward a better price as they better understand the critical link that determines value in their industry.

If someone were to ask us whether they should sell their business using a value determined by a rule of thumb, our response would be an emphatic “No”. The price of a business is simply not cut and dry based on a rough rule and it is a gross simplification of value. It doesn’t make sense that the rule would be correct for every business. It simply applies a single variable and is blind to other important value drivers in a business. If you take two businesses in an industry group with the same annual revenue, a rule of thumb would value each business the same. Yet the two businesses may have completely different cost structures resulting in very different profits and cash flows. In this context, a rule of thumb can result in overvaluing a poor business and undervaluing a quality business. A proper business valuation will mitigate the potential for either of these scenarios.

Written by Chieftains an accounting firm that performs business valuations designed for use in several circumstances such as purchase or sale of a business, management buy-outs, divorce settlements, commercial disputes, insolvency or determining value for business succession planning.