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Rule of Thumb 101: What is It and How to Use?

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Rule of thumb refers to a set of assumptions that can be used in various scenarios. Specific rules of thumb can be developed in almost every context – from everyday tasks to business and investments.

What is the Rule of Thumb in Business?

Businesses use ‘rule of thumb’ as a simplified guideline for a specific business aspect, for addressing tasks, or for achieving an objective. These guidelines may not accurately define a subject or scenario but can be used for understanding a business or process. Typically, rules of thumb use variables that are relevant to businesses regardless of their industry.

In general, rules of thumb are not based on specific calculations, theory, or science; instead, they are established based on practice, experience, and/or observation. These rules provide a quick check for business owners or investors when it comes to their decision.

Different Business Rules of Thumb

Various rules of thumb can be applied in different business aspects – starting, growing, evaluating, and selling a business.

Rule of thumb for starting a business

When starting a company, expect at least five years to liquidate your equity investment. As a rule of thumb, new businesses need to develop a five-year financial projection. This will help investors explore the potential opportunities and risks when they put their money into the business.

This rule of thumb is particularly useful when seeking investment. Typically, investors prefer to exit investment positions within seven years.

Rule of thumb for growing a business

Pareto’s Principle of 80/20 is the most common rule of thumb for growing a business. According to this principle, 80 percent of the company’s revenue is earned from 20 percent of its customers.

An Orlando Business Broker explains that by using this principle, a business can identify and focus on the clients or customers that offer the most profit. By knowing the most and least profitable customer segment, a business can make improvements to boost value and increase revenue.

Rules of thumb for selling a business

When selling a business, proper valuation is vital. You need to use various metrics to evaluate your business net worth. The standard rule of thumb is applying your business multiple earnings. The most common parameter used is the EBITDA (earnings before interest, taxes, depreciation, and amortization).

Rule of thumb is a common practice used when measuring the net worth of a company. As mentioned above, these procedures are not exact calculations but rather based on estimates in the specific industry and past valuation experiences. It uses multiples that are relevant regardless of the industry the valued company is in.

Using Rule of Thumb in Business Valuation

Rule of thumb practices are particularly useful to get a clear picture about certain industries and what is considered normal. They can be used as planning tools but do not provide an accurate business valuation method. But while rules of thumb can be used across different applications, they may not be applicable in some unique situations. An in-depth analysis of the specifics and unique aspects of a company is necessary to get the precise business net worth. Rules of thumb rely on general assumptions; hence, they may be prone to errors.

Rules of thumb are most commonly used in the business valuation of main street companies. However, various other considerations can potentially impact business value. Meanwhile, mid-market businesses prefer to use standard valuation methods in assessing their business worth.

Overall, business owners and investors should only use a rule of thumb principles for a quick overview and understanding of a business.

At best, the rule of thumb only provides a quick, reasonable check of a business’s net worth. It cannot be used alone or relied upon. If you merely want to know the potential value of a business for general knowledge, then rule of thumb principles may be enough. More robust and accepted valuation methods should be done when making crucial business decisions such as setting up a buy-sell agreement, developing an exit plan, planning business acquisition or sale, and transferring shares through marital dissolution or shareholder litigation. For all other reasons with economic and legal consequences, it is recommended that you consult professionals for an in-depth business valuation.

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