I want to address the use of Rules of Thumb when performing a business valuation. First, business valuations follow Revenue Ruling 59-60 (you should look this upon the internet), Professional Standards and a number of treatises have developed and should be followed by business valuation experts. The Rule of Thumb is a pricing multiple, not a valuation multiple. It give a price, which does not follow the development standards of Professional Standards. It is a quick inexpensive way to probably get a wrong answer. The Rule of Thumb can be used as a sanity check on a business’s value but it is not recommended as a primary source for arriving at a “value”.
Rule of Thumb Overview
A “rule of thumb” is a procedure based on experience and common sense. It is a general principle that is roughly correct but is not intended to be scientifically accurate.
A valuation rule of thumb is usually a multiple of revenue or earnings that is a rough and ready method of calculation or measurement of the “price” of a business or business interest which is not necessarily rooted in formal valuation principles.
Assume a law practice has a Rule of Thumb of law practices .8 times to 1.0 times revenues and the annual revenues are $700,000. The value of the law practice would range from $560,000 to $700,000.
Pitfalls of Using Rules of Thumb
There are some overall cautions with respect to Rules of Thumb. Some of these are as follows:
The data is often based on surveys. It is unclear what the response rate of the survey was.
Surveys may not be a representative sample.
The data collected is for smaller companies.
It is unclear whether or to what extent data has been peer reviewed or vetted.
Rules of thumb do not reflect/adjust for the various stages of a company’s life cycle
Rules of thumb do not adjust for differing product mixes among companies
Revenue multiples in particular do not adjust for varying levels of profitability between companies
For smaller businesses, revenue may not be fully reported (unreported cash sales) and, therefore, multiples of revenue may not be accurate
Do not reflect geographic differences between companies
Do not reflect operating characteristics, employees, customer and other differences between companies
Implications of an asset vs. stock sales
Does not reflect fair market value owner’s compensation
Changes in industry regulation that may render previously ubiquitous rules of thumb inapplicable
Does not indicate intangible assets and/or proprietary data/software
Does not indicate marketability and/or minority discounts
No two thumbs are the same. In the same manner, no two businesses are the same.
Blind application of a generic rule of thumb from one business to another business without considering the unique contextual similarities and differences between the businesses could result in the possible mispricing of assets/business interests due to the misapplication of a generic rule of thumb to a specific circumstance.
The database of multiples should be comparable to your company. This information is generally not provided.
You do not know if the data is before or after taxes.
You do not know if the data is a C Corporation or a pass-through entity.
You do not know what adjustments, if any, were made to account for anomalies in the operating expenses.
Do not know the assumed terms of the transactions.
Do not know the level of profitability of the companies.
The multiples change over time.
Do not know if the Rule of Thumb is derived from an accrual or cash basis of accounting.
Do not know the tax structure of the companies used for the Rule of Thumb multiples.
Over the years, I have had attorneys call me about performing a business valuation and they tell me that they have three years of financial statements. Revenue Ruling 59-60 states five years and a business cycle is considered to be five to seven years. The attorney should discuss their case with a business valuation expert early in the case to obtain the appropriate information needed for the valuation.
Comment from the Courts:
The Court noted “The court has reached the conclusion that the rule of thumb multiplier used by Mr. xxx is not appropriate. The reliability of the information base was not established. No evidence was given as to its content. In fact no direct comparables were utilized. Obviously under these circumstances no adjustments could be made to explain any difference between comparables and the subject company.”
A rule of thumb could be dangerous if used as a primary source to determine the value of a business. It is a quick and expensive way to get yourself into trouble. Looking at the eight factors in Revenue Ruling 59-60, it can be seen that the Rule of Thumb pricing multiple is not a Fair Market Valuation business valuation.
It is difficult to obtain an understanding of the business without having at least five years of balance sheets, income statements. Five to seven years is considered to be business cycle. Why use less than one business cycle. If the information is available, I will get ten years, or two business cycles to have a better understanding of the business.
The issues discussed above should provide ample information for the attorney to use in a deposition or trial to discredit a business valuation expert if they have used a Rule of Thumb as the primary source for determining the value of a business.
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