Thoughts on Business Valuation and Rules of Thumb in M&A Transactions

By Jeffrey Lewis, on November 16th, 2021

We get a lot of questions from potential sellers regarding the value of their business. For new clients of the firm, we often know very little, if anything, about the business at this stage of the relationship. As such, it can be a very difficult question to answer since a business is generally an illiquid asset with no public market. However, based on our transaction experience, we have a multitude of real data we can turn to, and those data points are often very useful for determining a preliminary valuation range. Before we get to those, let’s briefly talk about formal business valuation.

Formal Business Valuation

I’ve had a lot of business owners ask me if they should get a formal business valuation. My normal answer is “generally, no.” Ultimately, a business is only worth what a buyer is willing to pay… regardless of what a seller thinks (or hopes) the business is worth, or what a business appraiser comes up with.

Keep in mind, one of the overarching principles of business valuation theory is that fair market value is based on a hypothetical transaction between market participants, where neither is under compulsion to act, and both have reasonable knowledge of relevant facts. I don’t know about you, but I’ve never dealt with a hypothetical buyer or seller, and I’ve not yet met a potential buyer who truly has, or is able to obtain, all the relevant facts. Often, one or more parties to a transaction is, in fact, under compulsion to act.

Therefore, when it comes to a potential transaction, you can see the problems with the concepts under which valuation professionals operate. Additionally, most valuation professionals are not actively selling businesses in the open market, and therefore have few, if any, real-life data points to base their work on. Yes, appraisers have access to databases of prior sales transactions and public company valuation, but that data is often incomplete. Since every business is unique, making accurate comparisons based on that data can yield wildly misleading results.

I’ve seen formal business valuations that were orders-of-magnitude different (both higher and lower) than the actual price received on the open market. In some cases, valuation reports set unrealistic expectations about what a business is truly worth, and may even dissuade a business owner from going to market.

That being said, I respect the valuation profession. There are many situations in which business valuations provide valuable information. I’m just not convinced it’s the best choice for a business owner considering the sale of his or her business. The best advice I can give a middle-market business owner wondering about the value of his or her business is to talk to someone that actively helps parties buy and sell middle-market businesses. They are typically a wealth of good information.

Rules of Thumb

A lot of business owners I talk to have, or think they have, some general information about what similar businesses in their industry sell for. I often hear things like, “businesses in my industry sell for X times revenue,” or “businesses in my industry sell for X times EBITDA.” While that may generally be true, every business is unique, and common rules of thumb, or rumored transaction information, can often be misinterpreted, misleading, or misapplied.

Nevertheless, there are a couple very general rules of thumb I’ve found particularly useful. One of the best books on middle-market M&A I’ve read is titled, “Mergers & Acquisitions, an Insider’s Guide to the Purchase and Sale of Middle Market Business Interests” by Dennis J. Roberts. Mr. Roberts devotes a chapter to what he calls the “Rules of Five and Ten.” Keep in mind that these are generally what he calls, “cocktail party responses” to the question about valuation when very little, if any, information is known by the investment banker. Let me briefly explain them.

Simply put, the “Rule of Five” means that most middle-market business (especially, in my experience, those with revenues of between, say, $5 and $20 million) sell for about five times EBITDA (“Earnings Before Interest, Taxes, Depreciation, and Amortization”). I would personally probably rename it the “Rule of Four to Six,” depending on the attractiveness of the business. I’ve found this to be true of middle-market businesses even when we hear about “frothy” valuations that larger companies are commanding in the market. It sounds like an easy rule to apply, but determining an EBITDA number upon which to base this rule-of-thumb is not always straight-forward. This is especially true of privately-owned middle-market businesses that often have personal or discretionary items running through the business.

Mr. Roberts’ “Rule of Ten” is based on the assumption that most middle-market businesses generate EBITDA equal to approximately 10% of revenue. He then applies his “Rule of Five” to that number. For example, if the only thing you know about a business is that it generates about $20 million of revenue, applying his “Rule of Ten” would indicate the business probably has about $2 million in EBITDA. By then applying the “Rule of Five,” you would get a valuation of somewhere around $10 million. While I agree with Mr. Roberts that the value of the business is generally based on EBITDA, and therefore applying the “Rule of Ten” and then the “Rule of Five” is technically the accurate way to perform this “back-of-the-envelope” calculation, I would have probably shortened the equation and called it the “Rule of Fifty,” which I often do. In other words, many middle-market businesses are worth somewhere in the neighborhood of 50% of revenue.

There are exceptions to every rule, and this is especially true when trying to value a middle-market business. However, I find these rules of thumb to work reasonably well for many businesses. They tend to not work so well when the business in question is smaller than $5M in revenue or larger than, maybe, $20 million in revenue. Otherwise, I have found them to be, perhaps unexpectedly, a reasonable starting point in many cases.

There are two things to keep in mind. First, a business is only worth what someone is willing to pay. Second, it’s not just the price that matters, but the structure is equally important. For example, $10 million in cash at closing is obviously worth more than the same $10 million if it’s paid in 10 annual installments of $1 million.

If you’re considering a sale of your business or have any questions on the contents of this article, please do not hesitate to reach out to our trusted experts to discuss your specific situation.

Jeffrey G. Lewis, CPA, is a partner at the Bonadio Group, a nationally ranked, Top 50 accounting and consulting firm. He is the Team Leader for the firm’s Investment Banking and Transaction Advisory Services teams, which specializes in sell-side investment banking and M&A transactions.

This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.

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