The term ‘rule of thumb’ generally refers to the idea of a principle with a broad application – something that is not intended to be exact or strictly accurate. In the business world, the term ‘rule of thumb’ refers to a guideline that provides simplified advice about a particular subject.
The ‘rule of thumb’ definition is considered to be a general principle that provides guidance for accomplishing or approaching a certain task or reaching a certain goal. Rules of thumb never describe an exact or strict method, but rather a broad and general approach to completing the task.
More often than not, rules of thumb are established based on experience, involvement, and/or practice, and not from science or theory. Rules of thumb exist in nearly every context – from cleaning and cooking, to investments and business. Here, we’ll explore some examples of common rules of thumb as they relate to starting, growing, and selling a business.
Starting a business rule of thumb
The average time to liquidity of an equity investment in a startup company is about five years. This means, that as a rule of thumb, a new business owner should prepare a five-year financial projection. Most investors will ask for a five-year projection in an effort to understand the opportunity as well as the risk they face while their money is tied up.
Private Equity and Venture Capital Firms typically prefer to exit their investment positions in businesses within seven years so this rule of thumb has a practical application when seeking this type of investor.
Growing a business rule of thumb
As a rule of thumb, 80% of a company’s profits comes from 20% of its customers. Known as Pareto’s Principle, the 80/20 Rule is instrumental in understanding your customer or client-base, and where your business has the most potential for growth.
The practical application of the Pareto’s Principle to your growing business allows a business owner to evaluate which customers or clients deliver the most profit. Knowing which customers or clients are most profitable and which are the least profitable will allow you to improve the value of your business effectively.
Selling a business rule of thumb
In the event you are preparing to sell your business, you’ll need to have a good idea of what the business is currently worth. Applying your business/industry multiple of earnings, typically measured as EBITDA (earnings before interest, taxes, depreciation, and amortization) is a standard rule of thumb used in the process of valuing a business.
Keep in mind that rules of thumb usually apply under general circumstances to a wide audience and may not necessarily apply to every unique situation.