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The rules of thumb problem

Jerry F. Golanty

Two times gross. Ten times net. Twenty times monthly billings. Thirty times daily receipts! All of these are rules of thumb for valuing various types of businesses. But what do they mean? The answer: Very little.

Virtually every business in bankruptcy has had gross revenue. A major reason for their being in bankruptcy is that they’ve had no net profit. Gross revenue without a net profit is meaningless. As for “net”, what kind of “net” is being referred to: “Discretionary net earnings”? “Net” before or after profit-and-loss adjustments (non-operational income and expense, excessive or insufficient operating expenses, owner’s perquisites, non-recurring income and expense, working owner’s compensation, etc)? Or are we talking about EBITDA (earnings before interest, taxes, depreciation, amortization), or some variation of EBITDA? Unless we’re all speaking the same language, “gross” and “net” have no meaning.

Rules of thumb are intended to provide an owner or an agent with a quick and dirty way of estimating a value without having to face a reality check. In many cases they could just as easily have thrown a dart at a dartboard in order to achieve the same degree of accuracy.

Many of the rules of thumb were developed by industry experts, brokerage agents, and franchisors and licensors, whose primary functions are to sell businesses, franchises, licenses, and to collect commissions, royalties and transfer fees. Many of the rules were compiled by averaging data, which means that the rules include losers as well as winners. We all know that if we put our head in the freezer and our feet in the fire, we cannot say that, “On average we feel pretty good.”

There are really only two concerns when valuing a profitable, closely held, going concern:

* What are buyers paying (a market approach)?

* What are investors paying (an income approach)?

There are no public records that provide even a clue as to what buyers are paying for businesses. Even if a person knew the price at which a business sold, it would have no meaning without the business’ financial statements, the purchase contract and the escrow closing documents. There are proprietary databanks that provide reliable transaction data to members and subscribers. However, their services are quite expensive.

The most important test for an intended owner-operator is to answer the following question:

“If the business is valued and sold for X dollars, and based on prevailing terms and conditions in the marketplace, will the business pay for all of the operating expenses, pay for the required debt service, pay a working owner a reasonable compensation and still leave over a reasonable return of, and a return on, the owner’s investment?”

A franchisee of an elevator-music business was told by his franchisor that the rule of thumb for his business was 20 times monthly billing, or $400,000. The net discretionary income (before owner’s compensation) of the business was $90,000. The prevailing marketplace terms for a sale were a 35 percent cash down payment with the seller financing the balance at 8 percent interest for five years. The annual debt service was approximately $34,000. The net income after debt service was approximately $56,000. Reasonable owner’s compensation (what he would have had to pay someone else to operate the business) was $65,000 annually. In other words, had he hired a manager at market rates, he would have had to dig into his pocket $9,000 annually for the privilege of owning this business. What about the return of, and on, his investment? Forget it! Without a major increase in sales and profits, he would never see it.

The appraiser must also look to the marketplace to determine what investors are paying for businesses or interests in businesses based on risks characteristic in a subject investment compared with risks inherent in other investment opportunities?

Mr. Investor has an opportunity to invest in a well-secured second deed of trust on an income producing property that he can buy with a 16 percent yield. He also has an opportunity to invest in a business where he will be an owner-operator. The business will produce a discretionary profit (including his compensation) of 22 percent. The question is this: Which investment presents the greater risk (return of and return on the investment)? Only the marketplace, not rules of thumb, will tell what investors expect and require.

Typically a rule of thumb may be acceptable only when there are no other options. While business valuation is an art rather than a science, it certainly is not voodoo science. It is based on informed judgment, reasonableness and common sense.

A test case that appeared before the U. S. Supreme Court addressed the issues of expert’s opinions and methods to be used when valuing a business. The decisions handed down in Daubert v. Merrill Dow Pharmaceuticals and reinforced by Kumho Tire v. Carmichael, established criteria for business appraisers. The criterion asks:

* Can the theory and technique be tested or has it been tested?

* Has the theory been subjected to peer review or publication?

* What is its known or potential rate of error?

* Are there established standards to control use of the technique?

* Is the technique generally accepted in the technical community?

Rules of thumb do not meet the Daubert test. Raymond C. Miles, founder of the Institute of Business Appraisers put it well when he said, “Rules of thumb are great … for valuing thumbs.”

Jerry F. Golanty, president of Reno-based BizVal, is a master certified business appraiser, business valuator accredited in litigation, and serves as governor of the Institute of Business Appraisers. Reach him at 775-332-4881, jerrygolanty@bizval.net.


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