Business valuation experts can find a great deal of useful information in the Business Reference Guide (BRG) by Tom West, which has been updated for 2021. Now in its 31st year, the book contains the latest industry-related information including pricing tips, benchmarking information with comparison data, industry resources, and general industry data on over 600 types of businesses, including franchises. There’s also an online version with a fully searchable database, and it includes the print version of the guide.
Rules of thumb
For business appraisers, the most valuable information in the book is the inclusion of pricing rules of thumb. According to the American Society of Appraisers (ASA), a “rule of thumb” is defined as: “A mathematical formula developed from the relationship between price and certain variables based on experience, observation, hearsay or a combination of these; usually industry-specific.”
Rules of thumb should generally not be relied on as a primary appraisal method. Therefore, valuation analysts should typically use rules of thumb only as a check to corroborate a value conclusion achieved via other methods.
A good illustration of this concept can be found in the franchise arena. Experts who value franchises agree about not relying completely on rules of thumb because this information misses certain elements. It does not include variations in franchise brand strength or weakness, nor does it consider location factors or differences in the franchise relationship or agreement, the experts say. Rule-of-thumb information also misses changes in management’s ability as the franchisor. However, they can address key valuation considerations. Inherent or implied in the rule of thumb is a cost of capital, a ratio based on operating costs or net profits, expectation of future growth, an assessment of brand strength or risk, an assumption about the scale of the enterprise, and other things that are necessary to complete the valuation.
Rules of thumb are best used for franchises by individuals who have a very deep knowledge of the industry, company, and geographic area. Some people who are buying and selling franchise locations regularly know what they will pay as a percentage of revenue going into the deal. Call it a rule of thumb or a market multiple, but it is simply a starting point for negotiation.
Despite all the caveats about using rules of thumb in pricing businesses, they are commonly used to do just that. They may supply a quick fix, but, if used properly, rules of thumb can come pretty close to what the business will ultimately sell for, according to West.
Typical rule-of-thumb multiples you will see include sales or gross income, some level of assets, and cash flow (sometimes called seller’s discretionary earnings, or SDE). As an example, let’s say that a rule of thumb applicable to companies in your subject firm’s industry is 1.0 to 3.0 times owner’s cash flow for the most recent 12 months, which yields the value of equipment, lease, and intangibles. After investigating the operations of your subject company, you believe that the business deserves a multiple at the high end of the range, or 3.0 times owner’s cash flow. You have the information from your subject company for the prior three years as shown in the exhibit (Year C represents the most recent year). From this information, you can determine the value of equity for your subject company based on the rule of thumb as shown in the exhibit.
The 2021 Business Reference Guide has much more than just pricing guidance for most of the industries. For many, it has benchmark performance measures, such as revenue per employee, sales per square foot, average gross sales per store, cost of goods sold, typical labor cost, transaction terms, other line-item breakdowns, and typical transaction terms.
For many types of businesses, there is an industry profile, and, for some, there are industry trends. For most, there are resource lists and approximate numbers of such businesses in the United States. There is also a list of industry experts who provided much of the information in the book.
In general, courts have been inclined to reject valuation opinions based on rules of thumb. For example, one opinion contained the following language:
[These] formulas … “are in reality the starting point of negotiation; and should not be confused with a valuation procedure.” … Formulas based on gross billings are usually converted to a time pay-out of the purchase price and, as such can be misleading because they are often negotiated more over the terms of payment than over the actual value of the business being acquired.… While “rules of thumb may be helpful to accountants or business people to gauge the overall fairness of a particular transaction,” i.e., whether it is “in the ballpark,” they are not at all helpful to the Court in fixing a specific value on a specific economic enterprise in an ancillary proceeding.… A rule of thumb by definition provides no theory. At best it is a guide or points out direction. At worst, it is nothing.
However, courts have accepted rules of thumb in one form or another. In one case, a husband’s expert simply utilized a rule of thumb multiplier of three to five times the husband’s salary and then subtracted corporate debt to reach a final value. The trial court adopted this figure as opposed to the asset-based valuation presented by wife’s expert. The decision was appealed and upheld.
In another case, a joint expert valued the husband’s physical therapy practice between $450,000 and $550,000, using a multiplier of roughly 0.42 derived from the BRG, an excerpt of which he attached to his report. The trial court approved the source but adjusted the expert’s multiplier upward, to 1.0, based on the firm’s historic growth rates, good location, and well-established clientele. On appeal, the husband challenged the trial court’s reliance on the BRG for: (1) lack of foundation for the author’s expertise; (2) lack of evidence that the joint expert included the BRG’s method in his appraisal or that the court understood it; and (3) lack of support that the BRG method was “reasonable.” The husband also claimed that the negative factors underlying the joint expert’s selection of a lower multiplier were more credible. The appellate court rejected all these reasons, finding that the BRG was a reliable method used by an “undisputed” expert.
In the book, West sums things up by saying: “The price of a business is ultimately what someone will pay for it—it is market driven. Or, as the old saying goes, the price is what a buyer will pay and the seller will accept.”
With up-to-date rules of thumb and pricing details on nearly 600 types of businesses, the 2021 Business Reference Guide, published by Business Brokerage Press, is a must-have for transaction brokers, accountants, attorneys, business appraisers, banks, business-lending institutions, professional advisors—anyone involved with privately owned business. Learn more about this annual resource.