If you’re selling your business, you may be tempted to value your business (and set your selling price) based on some industry “rule of thumb” or a percentage of sales.
Here’s why it’s a bad idea and why you should value your business based on profit
General industry rules
A “rule of thumb” is the most general way to park the price of a business. In fact, they are so general that they may not be of any help in your particular case.
Add to that the fact that most industries have more than one rule of thumb that is used. In the beauty salon industry, for example, I found 4 different rules of thumb on a single industry website:
• 1 times adjusted annual earnings.
• 4 times monthly gross sales PLUS inventory.
• 25-35% of annual gross receipts PLUS fixtures, equipment and inventory.
• 10-25% of adjusted annual earnings PLUS $2,000 per season.
If you own a salon and apply the 4 rules to your business, you may find 4 very different values for your business.
If your industry has a widely accepted rule of thumb, you may want to use that as a starting point. But as you can see, none of the salon examples take into account any of the factors that are unique to a business, such as the lease, the quality of employees, or recent trends in profits.
So the general rule of thumb is just a starting point and you’ll need to adjust the price up or down based on your unique circumstances and how you compare to other salons.
However, knowing the general rules of your industry can be helpful. Applying them to your business will at least let you know how realistic you are being in your pricing.
Additionally, they can be useful in educating unreasonable (or uneducated) buyers who make unrealistic offers on your business. If you can show them how your pricing is in line with industry standards, you can help them abandon your low-cost offer.
What about a multiple of sales?
Basing the selling price on sales is common in some industries. Most of the rules of thumb in the restaurant industry, for example, are based on a multiple of sales. Businesses with few assets and services or sales-based businesses, such as insurance agencies or public relations firms, typically use a multiple of sales.
While the use of a sales multiple may be standard practice in your field, it does not directly address the concerns of the buyer, who wants to make money. Two similar types of businesses with exactly the same amount of sales may have nothing in common when it comes to profit.
So if you use a sales-based valuation because that’s the norm in your industry, the buyer will still be evaluating your business and your sales price based on profit.
This is why:
Even if you’re one of the lucky ones who gets a cash offer, your buyer will probably borrow money from someone, so it’s not a cash offer for the buyer.
Also, in most small businesses, the owner will also run the business; in a sense, they are “buying a job.” Therefore, they will be paying themselves a salary (even if they don’t officially set themselves a salary, they will be living off the money generated by the business).
Before they buy your business, they will need to know that the business generates enough profit so that they can:
1.) Make their debt payments 2.) Pay themselves a reasonable living wage 3.) Have some money left over to reinvest in growing the business.
If they can’t achieve these three things, then they can’t buy your business or you’ll have to lower the price or offer your own financing terms that allow them to achieve these three goals.
You cannot sell your business unless you can justify the sale price with the profits of the business.
So do yourself a favor and calculate your sales price based on profit, not sales or some rule of thumb.
