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Business Valuation Rules of Thumb and Service Companies
A commonly abused yet potentially useful tool of business valuation is the use of "rules of thumb", which are rough, industry driven value approximations. An incredible array of rules is applied to almost every type/size of company in existence. As new industries are created, new rules of thumb follow. Internet service providers are a recent phenomenon, but rules quickly emerged for use by interested parties. Today we focus on rules of thumb for service companies.
The great majority are based upon multiples of earnings or adjusted cash flow (ACF) or multiples of annual revenues (AR). Some rules are seemingly irrelevant and others may exclusively determine business value. Accounting/tax practices are valued almost exclusively by multiplying the anticipated AR by between .9 and 1.2. Science turns to art when an attempt is made to choose between a lower multiple and a higher multiple.
|In practice, accounting/tax firm multiples are influenced by the following:|
FMV of tangible assets|
Degree of monthly write-up versus seasonal tax work
Growth in accounts and revenues
Profits/ACF relative to AR
A practice with ample, state of the art technology and a preponderance of high paying monthly accounts billed at above average rates in a rapidly growing practice with substantial cash flow will generate higher multiples. A shoddy office with only tax work billed at low rates generating declining revenues and minimal cash flow will attract low multiples. However, the majority of practices will sell for about one times gross earnings. Every business type possesses its own unique characteristics that drive the multiples.
The typical accounting/tax deal is financed through a down payment of 30%-50% with the balance paid over 1-3 years subject to an "earnout". If the actual sales for the new accountant are less than the agreed upon anticipated AR, the final selling price will be adjusted downward through the seller's note. In effect, the seller guarantees a certain sales level. It is rare for profitable businesses of any other type to be sold with a guarantee regarding sales, profits or cash flow. Typically only marginal, unprofitable companies will be sold with a revenue guarantee in order to attract buyer interest (or rapidly growing companies requiring compensation reflecting the future growth).
Realizing that other factors like down payment, payback terms (interest rate, number of years, collateral, personal guarantee), stock versus asset purchase, training period, FMV of included assets, covenant not to compete and the size of the company's cash flow can impact the final price for a business, application of rules of thumb requires years of skill and experience.
An empirical relationship exists between the amount of ACF and the relevant multiples. For example, a business with $50K in ACF may sell for 1-3 times cash flow and a business with $500K in ACF will sell for between 3-6 times cash flow and a business with $5 million in cash flow may sell for between 6-10 times cash flow (all other things equal). The rules presented here apply to the smaller end of company size with AR up to $1 million and ACF of up to $200K.
1) Advertising Agency 75% of AR, may require earnout
2) Collection Agency 3-5 times MR
3) Construction 4-6 times EBIT
4) Day Care/Child Care 1 to 3 times ACF or $1K-$2K per enrolled child
5) Dental Practice 60%-90% of AR
6) Dry Cleaners 2-3 times ACF or 70%-100% of AR
7) Employment Agency 1-2 times ACF or 2-5 times EBIT or 50% of AR
8) Engineering/Architectural 40% of AR plus FF&E
9) Funeral Homes 2 times AR plus FF&E
10) Golf Course 3 times AR or 4 times golf revenue only (no food/alcohol)
11) Internet Service Provider $200-$400 per account (premium for business accounts)
12) Landscaping 30%-50% of AR or 1-2 times ACF
13) Law Practice 40%-100% or AR, may require earnout; or 2-4 times after tax "excess earnings"
14) Medical Practice 20%-60% of AR (larger practice, higher multiple)
15) Pest Control 70%-120% of AR
16) Property Management 5-8 times MR
17) Publisher 3-6 times EBIT or 70% of AR
18) Real Estate Brokerage 25%-50% of gross commissions or $10K per agent
19) Restaurant/Cafe/Coffee Shop 30%-55% of AR
20) Travel Agency 3%-8% of gross commissions
It is critical to stress that a company's cash flow is ultimately the most important factor impacting business value. Firm specific characteristics also can materially impact valuation results, typically requiring an industry expert to assess their ramifications.
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