Rules of Thumb: The Dominant Method of Goodwill Sales

Rules of thumb or formulas are a particularly popular appraisal approach for business brokers who facilitate the buying and selling of businesses. It is the least popular approach for credentialed professional appraisers.

What are Rules of Thumb?

As the name would suggest a rule of thumb is an easy to apply formula that leads to a purportedly precise value for a firm. The standard form usually involves a fixed percentage of annual revenue or net profit or some other easily accessible measure of economic benefit. Here are examples taken from a widely used source called the Business Reference Guide for the types of service business that typically develop goodwill:

As an example, suppose we have an accounting practice that has annual revenue of $500,000. The rule of thumb specifies that the practice has a value of between $500,000 (1 x $500,000 = $500,000) and $750,000 (1.5 x $500,000 = $750,000).

The Strengths and Weaknesses of Rules of Thumb

The biggest strength of rules of thumb lies in their simplicity. All the above formulas are based on annual revenue (although there are many formulas based on some measure of net income or profit). From a forensic point of view, annual revenue is much more easily verified than net profit or net income. These latter measures depend on verifying the completeness of a firm’s records and the legitimacy of its expenses, which is a more time consuming and difficult exercise than verifying total revenue.

Once total revenue is specified a simple multiplication purports to provide a precise value or fairly precise range of values for a firm’s total equity. While this appraisal method offers simplicity and precision this approach has serious conceptual problems.   The first problem with the method is the seemingly utter arbitrariness of the rules. What economic principle or condition accounts for the fact that accounting practices command 1 to 1.5 times annual revenue while veterinary practices fetch only .75 times annual revenue? Or within a single sector what economic condition or principle causes the multiplier to be .75 as opposed to say .7 or .9? Or when a rule of thumb specifies a wide range of multiples (as with accounting practices), how are we to determine which factors to consider in picking where in the range to set the multiplier? Alas the rules, in their simplicity, provide no reassurance that they are developed on a set of economic principles or conditions that would warrant treating them as legitimate measures of value.  


The second problem with the method is that, it ignores important economic conditions that ought to affect equity value. Rules of thumb are “one size fits all” formulas. A simple example will illustrate the problem. Suppose we have two accounting practices, each with annual revenue of $500,000, that generate their owner Discretionary Earnings (DE) of $100,000. The rule of thumb says that the values of both practices ought to be in the range of $500,000 to $750,000. Suppose further that the average age of the client base of one practice is considerably older than the other practice. Because the age of a client base affects the length of time the clients can be retained by a new owner, we know that the client base of the firm with the younger clients will probably be retained longer than the firm with the older clients. All other things being equal, the firm with the younger client base should generate more revenue in the future than the firm with the older client base and therefore should be valued more highly. But the rule of thumb offers no mechanism to adjust for this critical difference.  

For the above reasons, rules of thumb are looked upon with disfavor by credentialed business appraisers. There is of course another less noble reason credentialed appraiser’s disfavor the method: a professional appraiser cannot command large fees utilizing such a simplistic approach.  

Explaining the Continuing Widespread Popularity of Rules of Thumb

There are four reasons why rules of thumb remain so popular despite their severe conceptual problems:

              * Anchoring as a cognitive bias

               * Reference pricing

                * The frequent adequacy of the results

               * The inadequacy of alternative appraisal methods

Anchoring as a Cognitive Bias

One reason for the persistence of rules of thumb is the pervasive cognitive bias termed "anchoring." Kahneman, Ritov and Schkade describe anchoring effects as follows:

 "Tasks in which respondents indicate a judgment or an attitude by producing a number are susceptible to an anchoring effect: the response is strongly biased toward any value, even if it is arbitrary, that the respondent is induced to consider as a candidate answer…The necessary and apparently sufficient conditions for the emergence of anchoring effects are (i) the presence of some uncertainty about the correct or appropriate response, and (ii) a procedure that cause the individual to consider a number as a candidate answer." 1

The uncertainties associated with the pricing of equity interests in closely held firms meet the authors' conditions precisely. The widely disseminated rules of thumb with the appearance of being authoritative provide buyers and sellers a number that represents the "candidate" answer. Once a widely disseminated and seemingly credible rule of thumb becomes established, it is likely to become an anchor for most equity transfers.

Rules of Thumb as Reference Transactions for Fairness

Many economists have noted that the behavior of firms is constrained by a sense of fairness. In other words, profit maximization is not the only motivation in decision making. Examples abound. Firms do not always cut employees' salaries when their profits decline. Suppliers of goods that are backlogged do not raise their prices to eliminate the queue. To analyze how the criteria for fairness actually work, Kahneman, Knetsch and Thaler developed the notion of reference transactions:

 "A central concept in analyzing the fairness of actions in which a firm sets the terms of future exchanges is the reference transaction, a relevant precedent that is characterized by a reference price or wage, and by a positive reference profit to the firm".2

According to the authors, parties to a transaction have an entitlement to a reference transaction or a reference profit. Here is their formulation:

 "When there is a history of similar transactions between firm and transactor, the most recent price, wage, or rent will be adopted for reference…"3

The key relevant point is that deviations from reference prices will be deemed unfair. Thus, in the realm of closely held equity transfers, the rules of thumb may become reference prices for both buyers and sellers, exactly as described by Kahneman et. al... For example, in the case of accounting practices, a significant deviation from the rule of "one times gross revenue" in either direction would be considered unfair by the adversely affected party.

The fact that the rule of thumb may not be rooted in a well-developed forecast of future economic benefits will have little bearing on this perception. As long as either the seller or buyer believes they are entitled to sell or buy at the reference equity price, there will be little room for movement in actual negotiation. Furthermore, once established, it will be very difficult to dislodge the rule of thumb as the underlying price setting mechanism, because reported transactions based on these pricing "short cuts" will simply reinforce their hold on private equity markets.

The Long Term Adequacy of the Results

Another reason for the staying power of rules of thumb, despite any transparent economic logic, is that the real world outcomes from their utilization have been acceptable to both buyers and sellers. If the rules of thumb lead to exchange values sufficiently too far off the mark there would be pressure on the part of buyers or sellers to abandon the method. Buyers would rebel because the profits they realized were not adequate or sellers would rebel because the sales proceeds were not adequate. Of course, since there are not that many repeat acquirers or sellers there is not much of a potential learning curve for individuals. Nonetheless, we would expect, particularly on the buyers’ side, that news of exchanges based on rules of thumb that greatly disappointed buyers’ expected future profits would over time have some impact on their use.

The Inadequacy of Other Appraisal Methods

One final important reason that rules of thumb still are widely used is that the appraisal profession has failed to develop better cost effective alternatives.

 References

 1.  Kahneman, D. , Ritov, I., and Schkade,D. "Economic Preferences or Attitude Expressions? An Analysis of Dollar Responses to Public Issues" Journal of Risk and Uncertainty , 19:1-3; 203-235 (1999)

2.   Kahneman,D., Knetch, J.L., and Thaler ,R. "Fairness as a Constraint on Profit Seeking", The American Economic Review, 76:4, 728-41.

3.   Ibid.

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