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Using Rules of Thumb as a Business Valuation Starting Point

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Business owners frequently use industry rules of thumb to estimate what their companies might be worth. These formulas offer a quick and convenient reference point. However, business valuation rules of thumb should serve as a starting point rather than a valuation conclusion. Most rules rely on a multiple applied to either revenue or earnings. Earnings measures may include EBITDA, SDE, cash flow, or another industry-specific measure.

Understanding What the Multiple Represents

A rule of thumb reflects observed relationships within a particular industry or market segment. For example, an industry might commonly reference a percentage of annual revenue. Another industry might focus primarily on a multiple of earnings.

At first glance, these formulas appear straightforward. Two companies with identical revenue, however, may have substantially different values. Profitability, growth, customer concentration, management depth, recurring revenue, and competitive position can distinguish one company from another. Company size, geography, capital requirements, and industry conditions may also affect value.

Historical Industry Benchmarks

In the prior year 2010, Business Valuation Resources (BVR) provided revenue-based rules of thumb for several major industry groups. The reported multiples for the period 2008 through 2010 included:

Industry                         2008             2009            2010

Construction                0.39x              0.40x             0.35x

Manufacturing            0.53x               0.61x             0.52x

Transportation            0.69x               0.43x            0.55x

Wholesale Trade         0.46x               0.45x            0.52x

Retail Trade                 0.36x               0.33x            0.34x

Services                         0.56x               0.53x            0.56x

These historical figures illustrate how broad industry benchmarks can change as market conditions change. The variation also reinforces the limitations of relying on a single rule of thumb. Across this period, transaction activity and overall private company valuations were affected by the financial crisis and constrained credit markets. BVR reported fewer private company transactions during 2009 than 2008. Its broader transaction data also showed declining net sales multiples during that period.

However, industry averages cannot account for meaningful differences between individual businesses. Profitability, growth, customer concentration, management depth, and other characteristics may produce substantially different values.

Understand the Transaction Assumptions

Owners must also understand exactly what a particular rule of thumb measures. A multiple does not automatically determine which assets and liabilities transfer to a buyer. Cash, debt, working capital, real estate, and other items depend on the transaction structure. Accordingly, applying a multiple without understanding its underlying assumptions may produce a misleading estimate.

Move Beyond the Rule of Thumb

An experienced valuation professional can analyze the company’s specific financial performance, risks, assets, and market characteristics. An M&A advisor may then evaluate how prospective buyers may view those characteristics during a sale process. Business valuation rules of thumb may provide a useful perspective. However, they cannot replace company-specific analysis or determine what qualified buyers may actually pay.

Rules of thumb provide a reference point. A properly developed valuation provides context, and the marketplace determines the transaction price.

Navigating the Sale and Acquisition of a Distressed Business

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The current economic environment is creating acquisition opportunities involving troubled and financially distressed companies. Declining revenue, excessive debt, restricted credit, and liquidity problems are forcing some owners to consider alternatives. For buyers, distressed business transactions may provide access to assets, customers, employees, technology, products, or geographic markets. However, an attractive purchase price does not necessarily make a distressed company an attractive acquisition.

Understand the Seller’s Situation

A distressed seller rarely has the flexibility available in a traditional sale. Cash requirements may create significant time pressure. Lenders may also influence the company’s decisions and available transaction structures.

Under financial pressure, preserving value becomes increasingly difficult. Employees may leave, customers may become concerned, and suppliers may tighten credit terms. Owners should therefore evaluate alternatives before liquidity problems eliminate viable options. A sale, recapitalization, refinancing, restructuring, or Chapter 11 proceeding may provide different paths forward.

Evaluate More Than the Purchase Price

Buyers should determine why the business became distressed before pursuing an acquisition. Temporary financial problems differ significantly from a fundamentally broken business model. Diligence should examine operating performance, cash requirements, debt, customer relationships, contracts, employees, assets, and potential liabilities.

Beneath the financial distress, a buyer may find valuable operations or assets that fit its existing business. Strategic buyers may identify opportunities to consolidate facilities, eliminate duplicate expenses, or expand into new markets. Financial buyers may see opportunities to recapitalize viable businesses with unsustainable capital structures.

Structure the Transaction Around the Risks

Distressed acquisitions may involve asset purchases, equity purchases, bankruptcy sales, or negotiated transactions with creditors. The appropriate structure depends on the company’s circumstances. Buyers must consider secured debt, liens, working capital, cash requirements, transaction timing, and third-party consents (the bank). Lender cooperation may become essential when secured creditors control significant company assets. Given the compressed timeline, buyers must balance thorough diligence with the risk of losing the opportunity.

Find Opportunities Before They Become Obvious

Distressed opportunities may emerge through competitors, suppliers, lenders, attorneys, accountants, and other professional advisors. Sellers should also seek advice before financial conditions become critical.

An experienced M&A advisor can help evaluate alternatives, identify prospective buyers, and coordinate negotiations with other professionals. Buyers should involve experienced legal, financial, and restructuring advisors early. Distressed business transactions can create compelling opportunities, but financial distress changes the normal transaction process. The strongest outcomes occur when buyers and sellers recognize the problem early enough to preserve viable alternatives.

Pepperdine Private Capital Markets Project

Finding Growth Capital Beyond Traditional Bank Financing

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Many business owners are becoming increasingly optimistic about opportunities to grow their companies. However, access to capital remains a significant obstacle. The Pepperdine Private Capital Markets Project highlights this disconnect. Nearly half of surveyed business owners report insufficient financial resources to execute their growth strategies.

Meanwhile, the continuing effects of the financial crisis have changed the financing environment for privately held companies. Approximately 250 banks have failed since the financial crisis began in 2007. Additional failures and tighter lending standards may further restrict traditional credit. Against these conditions, business owners should understand the broader range of capital available to support growth.

Looking Beyond Traditional Bank Financing

Commercial banks remain an important source of financing for established businesses. However, conventional bank debt may not satisfy every company’s capital requirements. Owners may therefore need to consider alternative growth capital.

Potential sources include asset-based lenders, mezzanine funds, private equity firms, venture capital firms, angel investors, and factoring companies. Family and friends may also provide capital in certain circumstances. Each source presents different costs, risks, and requirements.

Debt financing may preserve ownership but creates repayment obligations. Equity financing may provide greater flexibility but requires owners to share ownership and future value.

Match the Financing to the Growth Strategy

Access to capital alone does not make a financing source appropriate. Owners should first determine why they need capital and how the investment will support growth. A manufacturer purchasing equipment may require a different structure than a company pursuing an acquisition. A rapidly growing company may need additional working capital to support increasing sales.

When evaluating alternatives, owners should consider interest rates, repayment terms, collateral requirements, covenants, and potential ownership dilution. Management should also understand how each financing alternative may affect future flexibility.

Use the Private Capital Markets

The Pepperdine Private Capital Markets Project provides valuable information about the changing private capital environment. The research examines banks, private equity firms, venture capital firms, angel investors, factors, and other capital providers. It also examines financing conditions, investment criteria, and the cost of capital across different market segments. For growing companies, this information may help owners evaluate financing sources beyond their traditional banking relationships.

Prepare Before Seeking Capital

Capital providers need a clear explanation of the opportunity before committing funds. Owners should prepare a business plan explaining the company’s strategy, financial performance, growth opportunities, and capital requirements. Financial projections should demonstrate how management intends to use the capital. They should also show the expected effect on revenue, earnings, and cash flow.

Alternative growth capital can provide additional options during a challenging credit environment. The objective is not simply to find available financing. The right financing should provide sufficient capital while supporting the company’s growth strategy, financial capacity, and long-term ownership objectives.

Allston Advisory Group is an experienced boutique M&A advisory firm providing a variety of services to lower middle market companies. See our footer for contact information.

(502) 742-2933
[email protected]
P.O. Box 21266, Louisville, KY 40221

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