Rules of Thumb are either a single or tight range of multiples assigned to an income stream generated by a particular business. They are also available for just about any business and do vary from industry to industry.
Rules of Thumb should not be considered synonymous with transaction data points or multiples derived from specific transactions usually reported by a party involved in an actual business sale such as a business broker or other intermediary.
Although there may be some limited exceptions, the fact is while easy to apply and understand, valuing or making a purchase offer on any business by relying on a Rule of Thumb is not a good idea. There are several valid reasons why:
- At best, a Rule of Thumb is an anecdotal average and if applied across the board it tends to penalize the best performing businesses and reward the poor performers.
- In a related sense, although some massaging may be attempted, Rules of Thumb are fairly static and do not go far enough in accounting for variations from business to business. Examples of these key variations may include differences in customer and employee loyalty, lease terms, location, cash flow trends, supplier relationships, the nature and quality of the FF&E, and barriers to entry.
- Reliably developing the correct income stream to apply against a Rule of Thumb can be tricky. If this important task is incorrectly developed and the Rule of Thumb is subsequently applied, it could very well be equivalent to a double mistake.
- Ray Miles, the creator of the largest and oldest business transaction database and founder of the Institute of Business Appraisers suggests using a minimum of ten data points or transaction multiples in valuing a business under a Sales Comparison oriented approach. How convincing is that single Rule of Thumb or tight range looking now?
- A certain mystery surrounds Rules of Thumb. For instance, like urban myths, who actually creates them and under what circumstances are they formulated (based on completed deals or general expectations, cash or seller financed transactions)? And how do Rules of Thumb stack up against empirical transactional data?
Whether you are a business owner or looking to buy a business, no doubt somewhere along the line a Rule of Thumb or two will be placed on the table. If you are inclined to partake, just remember to reach for and apply a little salt.