Business Valuations – Rules of Thumb and Multiple of Sales

If you are selling your business you may be tempted to value your business (and set your asking price) based on some industry “rule of thumb” or on a percentage of sales.

Here’s why that’s a bad idea and why you must value your business based on earnings

Industry Rules Of Thumb

A “Rule Of Thumb” is the most general way to ball park the price of a business. They are so general in fact that the may be of no help at all in your particular case.

Add to that the fact that most industries have more than one rule of thumb that is used. In the hair salon industry for example, I found 4 different rules of thumb on just one industry web site:

• 1 times annual adjusted earnings.
• 4 times monthly gross sales PLUS inventory.
• 25-35{cab19ad47a04457a33f1142c065ddf840a097fdd0e7408211ca1f6540bc7ad18} of annual gross revenues PLUS fixtures, equipment & inventory.
• 10-25{cab19ad47a04457a33f1142c065ddf840a097fdd0e7408211ca1f6540bc7ad18} of annual adjusted earnings PLUS $2000 per station.

If you own a salon and apply all 4 of these rules to your business you may come up with 4 wildly different values for your business.

If your industry has one widely accepted rule of thumb you may want to use it as a starting point. But as you can see, none of the hair salon examples take into account any of the factors that are unique to a business – such as the lease, the quality of the employees or recent trends in earnings.

So the rule of thumb is just a starting point and you will have to adjust the price up or down based on your unique circumstances and how you compare to other hair salons.

Knowing your industry’s rules of thumb can be helpful though. Applying them to your business will at least let you know how realistic you are being in your pricing.

Also, they can be helpful in instructing unreasonable (or uneducated) buyers who make unrealistically low offers on your business. If you can show them how your pricing is in line with industry standards it can help them to move off of their low-ball offer.

What About a Multiple of Sales?

Basing the asking price on sales is common in some industries. Most of the rules of thumb in the restaurant industry, for example, are based on a multiple of sales. Businesses with few assets and service or sales based businesses like insurance agencies or PR firms will often use a multiple of sales.

While using a multiple of sales may be standard practice in your field, it doesn’t directly address the concerns of the buyer – who wants to make money. Two similar types of businesses with exactly the same amount of sales may have nothing in common when it comes to profits.

So if you use a sales-based valuation because that is the norm in your industry, the buyer will still evaluate your business and your asking price based on profits.

Here’s why:

Even if you are one of the lucky ones who gets an all cash deal, your buyer will probably borrow money from someone – so it’s not an all-cash deal for the buyer.

Also, in most small businesses the owner will also manage the company – they are in one sense “buying a job”. Therefore, they will be paying themselves a salary (even if they don’t officially set a salary for themselves, they will be living off money generated by the business).

Before they buy your company they will need to know that the business generates enough earnings that they can:

1.) Make payments on their debt 2.) Pay themselves a reasonable salary to live on 3.) Have some money left over to reinvest in growing the business.

If they can’t accomplish these three things than either they can’t buy your business or you will have to lower the price or offer your own financing terms that will allow them to accomplish these three goals.

You can’t sell your business unless you can justify the selling price with the earnings of the company.

So do yourself a favor and calculate you asking price based on earnings not sales or some rule of thumb.