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  • Writer's pictureEric Williams

10 questions to ask when using a rule-of-thumb for valuing a business

business value considerations

One of the most common questions I get from owners of small businesses is “what’s my business worth?” Frequently I hear other business brokers, CPAs, or business buyers answer this question with something like “your business should sell for 3 times Seller Cash Flow”, “businesses in your industry sell for 1 times revenue” or “a rule of thumb for your industry is 5 times EBITDA." I cringe when I hear people look at value in such a simplistic manner.

The approach to value they are using is a basic rule-of-thumb derived from reviewing a broader set of industry average sales data and comparing data such as sales price, revenue, and cash flow from other similar businesses that have sold. For example, if the average business in industry XYZ had a sale price of $1 million, revenue of $1 million, $500,000 in seller cash flow, and EBITDA of $380,000 then the average business in the industry would be said to have sold for 1 times revenue, 2 times seller cash flow, and 2.63 times EBITDA. If your business had $400,000 in revenue, $150,000 in seller cash flow, and $30,000 in EBITDA than it would be estimated to be valued at approximately $300,000 based on seller cash flow, $400,000 based on revenue, and $78,900 based on EBITDA. Given the incongruity in estimates, some people would then average these to arrive at a value estimate of $259,633, and others might view the EBITDA multiple value as an outlier and use a value estimate of $300,000 - $400,000.

Many people are familiar with this approach since a similar methodology is commonly used for more homogeneous assets. Unfortunately, this approach doesn’t work as well for unique assets and businesses that have more "moving parts" and greater variability.

Following are 10 questions to ask before using a rule of thumb approach for valuing a business:

  1. Is the business really an average business that has very similar characteristics to the businesses that have sold?

  2. How much data was collected to establish the multipliers, and is it complete enough, and representative enough of businesses truly similar to the business being valued to make a valid comparison? If the data used to develop the multiples consisted of a couple hundred businesses that are described in a similar manner, are of roughly the same size, and have margins that are within a tight range it might be a good rule-of-thumb.

  3. Is the business model of the company being valued truly similar to the business models of the sold comparable businesses that the rule-of-thumb is based upon?

  4. Are the rates of growth similar? If Company A and Company B both have $500,000 in EBITDA and a market comparable multiplier of 4x EBITDA is utilized it would indicate a value of $2 million for both businesses. However, if Company A had average historic and projected annual growth of 5%, while Company B had average historic and projected annual growth of 15%, and you paid $2 million for each business, then two years later Company A would likely have $551,250 in EBITDA, while Company B would likely have $661,250. Yet, the industry comparable businesses may have had an average annual growth rate of 10%, so the average business in the industry would likely have $605,000 of EBITDA for the same time period. Different growth rates warrant different prices, if not, you'd be receiving dissimilar returns on investment for these two businesses that are in other respects similar.

  5. Are there different risk factors? An example of this would be if Company A had one client that provided 40% of its revenue, whereas the average business in the industry had diverse clients with the largest average client providing only 5% of a typical comparable business’ revenue. If Company A lost their top client it would be devastating to the business. This level of comparative risk should result in a price that reflects such risk.

  6. Did the comparable businesses upon which the rule-of-thumb was developed sell during the same part of the economic cycle? Do you suppose a business that sells in the middle of a recession will command the same price as a business that's near the top of an expansionary period?

  7. Are the sold businesses upon which the rule-of-thumb was developed of a similar size? This is a particularly important question when looking at very small companies. If, for example, the average comparable business had seller cash flow of $120,000 and the business being valued has $500,000 in seller cash flow than the business being valued should command a higher multiple. The reason is that if you were to hire someone to run the business you may be able to do so for around $120,000. For the business that only had $120,000 in seller cash flow that would leave it with $0 in EBITDA remaining after paying the seller's salary. For the business that had $500,000 of seller cash flow If you had to pay replacement CEO $120,000, it would be left with $380,000 of EBITDA. Buyers will pay more for a business that provides a real return on investment after paying for management labor.

  8. Does the business have initiatives underway that will likely lead to future increases in revenue and/or cash flow? A rule of thumb is a backward-, rather than a forward-looking, approach to value, so it will not take into consideration strong unproven increased future earnings potential.

  9. Does the business have un-utilized or under-utilized assets? For example, if a business acquired a $200,000 piece of equipment but then decided not to utilize it but had it sitting in the warehouse, a market comparable approach to value will not recognize the additional value of that non-income-producing asset.

  10. Were sold comparable business’ financials upon which the rule-of-thumb was created reported accurately? When a business is sold, usually the financial statements have been re-cast to reflect adjustments for non-recurring or personal expenses. However, those aren’t always accurate adjustments. For example, a business owner may have failed to accurately adjust the financials to reflect the under-payment or over-payment of compensation to him- or herself. A business owner who only pays himself a $40,000 annual salary, when a market rate of compensation for his position would be $100,000 and who fails to make this adjustment on the financials would show EBITDA that is $60,000 more than it should have been if an owner were being paid a market salary. If an EBITDA multiplier were utilized this may produce an inaccurate estimate of value.

These are just some of the types of issues that make the use of a simplistic rule-of-thumb derived from an average of a large quantity of sold comparable businesses, trickier than many people initially perceive. This is exacerbated when a rule-of-thumb is utilized that is industry agnostic, a custom manufacturer with lots of equipment, slow growth, one-time sales, and low margins is a much different business from a high-growth, recurring revenue, high-margin, software company. A knowledgeable business appraiser, business broker or investment banker can help you explore other approaches to value and examine issues that may impact valuation and marketability.


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