Lenders often finance mergers and acquisitions, and sometimes after the buyer and seller have agreed on the selling price and terms. Always inquire about the due diligence that a buyer has performed prior to your involvement. Too often, the parties are eager to close, so they sidestep the formal valuation process. Instead, they may rely on industry rules of thumb to negotiate price.

Pitfalls abound

No matter how well known an industry rule of thumb is in regard to selling price — such as one times annual revenues or five times earnings — it should never be the sole method of valuation. Rules of thumb can be off point, to the extent that they are:

Oversimplified. There’s more to valuing a business than “magic” formulas imply. Otherwise, thousands of trained and experienced business appraisers would be out of business.

Valuing a business requires consideration of three tried-and-true methods: the cost, market and income approaches. These techniques require appraisers to analyze rates of return, expected economic benefits, comparable transactions and financial performance. Appraisers also adjust financial data for comparables and the subject company. And valuation discounts may apply to the business interest, depending on the buyer’s unique circumstances.

Ambiguous. Rules of thumb fail to provide an explicit definition of the variables used. For example, does “earnings” refer to net income; pretax income; earnings before interest, taxes, depreciation and amortization (EBITDA); or net free cash flow?

Some formulas also provide a range of values. How do you know where a specific company should fall within this range?

Rules of thumb may not specify what’s being valued, either. For example, the formula might generate the value of the subject company’s assets, equity or invested capital (which requires you to subtract interest-bearing debt to arrive at the value of equity).

Outdated. Recent stock market turbulence demonstrates how volatile a private company’s selling price can be. A rule of thumb set during the peak or trough in an industry’s business cycle can quickly become outdated.

Discrepancies require explanations

In spite of their shortcomings, rules of thumb can be an important sanity check for formal appraisals. Suppose you read in a trade journal that companies in a particular industry sell for about three times EBITDA, and a borrower in that industry offers to pay six times EBITDA to purchase a competitor. Would you be willing to finance the deal?

When discrepancies happen between a rule of thumb and the borrower’s offer price, hear the prospective buyer out. There may be compelling reasons why the rule of thumb is off point.