When having a business valuation performed what is the difference between a Rule of Thumb, a Calculation, and an Opinion of business value?

You “just” need a value for your business.  We hear that all the time, “just” followed by can you, “just give me a number” sometimes even followed by, “what is the rule of thumb?”  You might need this business value for planning purposes, to add a partner, a dispute or divorce, to go to market in a private sale, or for compliance purposes like an ESOP valuation or estate and gift tax filings.   But, how accurate should that business valuation really be?

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Accuracy is determined by the level of the work specified in your engagement agreement.  In my mind, the simplest way to look at the question is that a Rule of Thumb is a guess, a Calculation can be used when “good enough” will do, and an Opinion of Business Value is required when it has to be “absolutely positively right” and provable later.

Not surprisingly, there is a difference in cost.  A rule of thumb guess is often free for the asking, if you do your own math.  On the other extreme is an opinion of value, which—depending on the size and complexity of the business— can run from $2,500 to $25,000 or more with most being in the $4,000 to $10,000 range.

What level valuation do you really need?  As usual in business valuation, the answer is that it depends.  So, let me try to expand on that.

Rule of Thumb – the “guess.”  Rules of thumb are not considered business valuations at all.  They are more of an educated or, perhaps, uneducated guess.  Frankly, in some industries, they are reasonably accurate and, in most, they are almost useless.  They are often a multiple of units of production or perhaps revenues.  For instance, “accounting firms sell for 1 times revenue” is a widely quoted rule of thumb.  Depending on the other transaction terms and the underlying business, that might be true.  Years ago, another rule of thumb was “portable toilet firms sold for $1000 per toilet in the field.”  These are useful only for very speculative planning purposes.  In many cases, they cause more harm than good; however, if you just need a guess number, in some industries, this is a place to start.

Calculation of Value – “when good enough will do.”  A calculation of value is when the valuer and the client agree on specific methodologies to be applied to estimate a value.  Usually, there is a limitation on the depth of the investigation and research to be performed.  Generally, a calculation of value will cost between 50-70% of an opinion of value for the same business.  Since not all valuation methodologies are considered and there is less review of data and, perhaps, less support for assumptions, these valuations are not as reliable as an Opinion or Conclusion of value.  In fact, the engagement letter and any written report are required to state that:

“This Calculation Engagement did not include all of the procedures required for a Conclusion of Value.  Had a Conclusion of Value been determined, the results may have been different.”

If the parties are friendly (bearing in mind that friendly can change quickly, when a value is provided) and agree that the underling information is reliable, for most internal planning purposes a calculation of value is suitable.  Calculations are generally not suitable for dispute situations or for many compliance situations, such as ESOPS and estate and gift tax business valuations.

Opinion or Conclusion of Value – This is the gold standard in business valuation, when it has to be “absolutely positively right.”  The valuer is required to investigate everything from the economy to the industry to the details about the financial and operational conditions of the business.  All valuation methodologies are available with the valuer selecting the best one to use based on the facts and circumstances.  While not a financial audit, reasonable investigation is to be performed when situations or findings are questionable.  This level of review is usually followed with a report that specifies all data used and pretty much every assumption and estimate made in order to come up with the Opinion of Value.  The work should be able to be followed by another valuer and fully supportable.  This level is generally used in compliance situations, dispute situations, and when litigation is likely.

One final word.  Cost is important, but you do not save money if you really need the right answer and you need it to hold up under review possibly years later.  Many times, business valuations are prepared when people may have different views as to the proper value.  These different views tend to become louder once the business valuation is complete.  Whatever you do – do not mislead the valuer (you would not believe how many times this happens) and say the purpose is for preliminary planning purposes if you plan on buying a partner out in a difficult situation.  If that might be the case, nothing but an Opinion will really suffice.  Yet, unless required for compliance purposes or disputes, often a calculation of value will serve you well for many valuation purposes.

Connect with Harvest Business Advisors today – email info@harvestbusinessadvisors.com or call 443.334.8000