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How To Value A Business Utilizing Rules of Thumb?

Comments & Replies: 5     Views: 3141     Posted By: Timothy Cunha JD  Timothy Cunha JD: Business Broker, SF Bay Area

Topics: Business Valuation, Buying A Business, Selling A Business     Tags: business valuation, buying a business, deal structures, selling a business

Business brokers are very familiar with the two typical ways of valuing a small business, using the rules of thumb based upon historical sales of similar businesses: a percentage of gross revenues and a multiple of seller s discretionary earnings ( SDE ). These work at estimating a realistic fair market value in the majority of cases, especially when the business is not all that unique and there are a multitude of comparable sales ( comps ).

But, what about those situations where the fair market value is more esoteric because the business is uncommon or nonconforming and there is a dearth of comps? To determine the potential value to the likely buyer, I have used various methods. One is to quantify the full replacement cost (not depreciated or original cost) of the physical assets (adding 25% to cover sales tax, acquisition, freight, and installation costs), plus the cost to replicate the customer base, plus any cost to replicate intellectual property, plus a value on the time-to-market advantage of buying an existing company rather than starting from scratch.

I m curious about what other methods are used by brokers, and under what circumstances they would be used.

Contributor: Business Appraisals, Valuations Advisor

Having been a Business Broker for 23 years and now specializing in Business Appraisals I never use rule of thumbs. They basically do not give you the value of the business being appraised and at best give you the average of the business category.

In every business category there are exceptional and underachieving business. If you use a rule of thumb you may miss the good one and end up with the bad.

Each business is unique and requires a through appraisal based on cash flow, asset values and applicable market influences.

I'm often asked, "Why isn't every business worth the same 'multiples' or ratios? Profit is profit, and a dollar is a dollar, right?"

To answer, I pose a ludicrous question: "Which is more valuable, the business that involves getting up at 3 a.m. and driving through alleys of San Jose picking up recyclables, that grosses $300,000, and nets $100,000; or, the business that involves renting out chairs and umbrellas on the beach in Santa Cruz, but only on warm, sunny days, and also grosses $300,000 and nets $100,000?" Well, of course, the obvious answer is that the beach business is far more valuable. It has to do with commitments of time and the lifestyle the owner wants to enjoy.

That's where "rules of thumb" come in. How is this particular business, entity, or industry regarded by previous buyers? What value did they give to the gross and net revenue because of the type of business? We can easily calculate the numbers and find the ROI, EBIT, EBITDA, "net cash flow", and "SDE"; but, only past human behavior gives us an indication of what those abstract numbers are worth to real flesh and blood buyers.

Rules of thumb might be ok for a snapshot of the business but BEWARE; short cuts in diligence will do you a disservice. The diligence period is the time set aside for you to verify the information you have received but it's also your opportunity to see what the business can do, going into the future. This takes time and consideration. If you are going to evaluate the investment you are about to take on you should be able to visualize its future. Rules of thumb might include a multiplayer of net earnings. This can be flawed if the reported income is derived in a manner that is not fully reflective of the earnings. This also does not take details of condition, potential competition, new innovations that might cost you business to competition. It also will not show the level of reinvestment needed after the transaction to bring the business up to date.
These rules of thumb comparisons are also unlikely to guide you to that "Diamond in the Rough". For most, purchasing a business is an opportunity to crate something of your own design. The best choice may be the under performing business. It would probably fail the rule of thumb test. Other information may not be so visible. I recommend avoiding the rules of thumb approach. If you do use it be sure to back it up and be careful.

There are so many different factors in pricing a business, so "Rules of Thumb" maybe a crutch that a novice or inexperienced broker may use, but I find more experienced business brokers do not use them. It would be tempting to just use a formula for pricing, such as 3 to 4 times the monthly gross and voila, we've found our price, but it just simply isn't so. I've received calls off my marketing material where a seller will call me up and just ask, "how much is business worth?" and I tell them I have to see it, and remind them, no buyer would buy their business just going off the numbers and not seeing it, and so how can I price it and not see it.

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