Often, as a private business owner starts to consider exit strategies and succession planning, the potential sale value of the company becomes an important factor.
Occasions can arise during this period when a company owner wants a rough estimate of business value, and fast. So, what is the rule of thumb for valuing a business? Is it three to five times EBITDA? Five to six times earnings? Some multiple of annual sales?
Without engaging a business valuation professional, it can be tough to accurately calculate the value of a company, because along with hard numbers like EBITDA, earnings, assets, and annual sales, many other variables matter, too:
- Industry sector and concentration
- Geographical location
- Earnings history
- Competition
- Management team strength
- Reputation
In this article, we’ll take a look at some of the most commonly used rule of thumb business valuations, and why it’s important to get an objective, realistic idea of your company value before starting down the path of business ownership transition.
Typical Rule of Thumb Valuation Approaches
Before diving into a few of the most common rule of thumb valuation approaches, let’s remember what a rule of thumb is, and what it’s not. The history and etymology of the term highlights the idea of inaccuracy: it refers to the practice using your thumb as a measure instead of a standardized unit, like an inch or centimeter.
A quick look at your thumb, and someone else’s thumb, makes the concept abundantly clear.
A few common ways of getting a rough estimate of business value involve discretionary earnings, annual gross revenue or sales, and/or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
Discretionary Earnings Rule of Thumb
The discretionary earnings method starts with the annual cash from the business that’s available to the owner after taking out essential operating expenses. It then multiplies that number by a factor usually between two and four, depending on the business type.
To keep things simple, let’s say a business makes $1 million a year in revenue, and the cash to the owner is about $250,000. Depending on the type of business, the seller’s discretionary income is multiplied by somewhere usually between 1.25 and 2.5, so that business might sell for $312,500 to $625,000.
Annual Sales or Gross Revenue Rule of Thumb
The annual sales or gross revenue approach assumes that a company is worth some percentage of its annual gross revenue or sales, again depending on the type of business. The same is true for the EBITDA multiple rule of thumb — different industries and sectors can experience different multiples as a result of varying market conditions and other factors.
Most rule of thumb valuation approaches rely on reference books, websites, or databases to access comparables, or comps, for a somewhat accurate frame of reference. Referencing comps is similar to the practice in real estate, in which a property is compared with several nearby, recently sold properties with similar characteristics.
All these rules of thumb rely on plenty of assumptions, leave out a lot of detail, and can be pretty misleading to the business owner. Case in point: consider the difference in our example between $312,500 and $625,000 — especially if that sum represents your retirement nest egg.
Those are two very different thumbs.
What Good is a Rule of Thumb Business Valuation?
Considering all the limitations of rough estimating, is there any point to starting with a rule of thumb valuation?
Maybe.
For one thing, a business owner might find it a useful exercise to check their emotional reaction to a value range. If it “feels” way off in either direction, that could be a good starting point for a conversation with a valuation expert—and a gut check about how you really feel about succession planning, and what your business means to you.
Getting a realistic idea of the potential market value of a business in the early stages of ownership transition can help a business leader make changes that can improve company value before the sale. Comb through financials. Find ways to eliminate waste, improve efficiencies, ensure compliance with any relevant regulations, and make sure all company records are in order.
What Else Should a Business Owner Consider Before Selling?
There’s plenty to think about in advance of selling a business, so the earlier you start investigating your options, the better.
For one, the ownership transition doesn’t have to be an event; it can be a process that takes place over the course years, and it can even offer the seller meaningful control over their succession plan and exit. In addition to the flexibility in timing, some sale options can also provide financial flexibility that can add up to the seller actually netting more over a period of time than they would at a once-and-done third-party sale.
Selling a closely held company to an employee stock ownership plan (ESOP) can provide a business owner with greater control over the sale process, the transaction structure, and the succession planning timeline.
An ESOP sale’s flexible sale structure terms, combined with significant tax benefits, can in some cases lead to net a higher profit on the sale when all is said and done, compared with after-tax proceeds on a third-party sale.
But you wouldn’t be able to realistically reflect on any of these options using just a rule of thumb valuation. That’s why it’s smart to start investigating ownership transition options early. Learn more about the factors that contribute to value at sale, and how selling to an ESOP could help you realize the best possible outcome when you download our eBook, How an ESOP Maximizes Value When You Sell Your Business. Just click the link below to claim your own free copy.