Why isn’t asset based valuation for startups?

Many entrepreneurs have the misconception that the value of their businesses is the sum of their parts e.g. assets minus liabilities. The value of an early stage 3D printing startup that owns one machine worth $2M and has outstanding debt for $0.5M seems to be the acquisition price of the asset minus the outstanding debt, or $1.5M. In the financial jargon we call this approach the asset-based valuation.

What’s the issue with asset based valuation for startups?

There are many reasons that make this method not suitable for startups. The first one is that, often, startups don’t have any tangible assets and rely mostly on software, patents and team skills, all intangibles that are quite hard to value.

Additionally, even if the startup were to have tangible assets, considering the value of the venture as their sum would be limiting. The value of the company should be looked upon as the value of the combination of tangible assets and internal factors (organizational process, quality of the idea, product rollout, etc.). The combination is the thing that creates value as it creates the possibility of generating revenues.

For a healthy company, the whole should be worth more than the sum of its parts. The assets of the company, taken separately, should then be worth less than their united configuration towards fulfilling the company’s mission.

Let’s take the example of a management consulting firm. Asset-based valuation is meaningless in this case because the total tangible assets are just a support to the value driving asset which is the combination of the team’s skills along with intangibles such as brand, expertise and client portfolio.

The same goes for intangible assets

As part of our valuation activities at Equidam, we are often asked about this method and about the way to value patented technologies, portfolio of clients or domain names, etc… Looking at these questions from the assets point of view highlights another problem of asset-based valuation approaches, their book value is unknown. Indeed, the best way to assess the value of these assets is to prove that they help in acquiring more market share, in protecting against local and international competition, and in generating higher cash flows in the future. Methods like the discounted cash flow would then be more appropriate in this case, as they take into account the impact of intangible assets directly on the financial projections.

So when are asset based valuation methods useful?

On the practical side, asset based valuation methods reflect the historical cost of building the company. In most cases however, investors bet on the future potential and the expected future cash flow; asset methods do not link the value of the business to the future performance and show how the investment can generate a return.

Valuation should be based on the future potential and risk of the company. Assets methods don’t show how the investment can generate cash flow in the future.

However, there are two cases for which reflecting past costs might be appropriate:

• Asset intensive businesses, such as real estate companies (buy and sell – not renting!), investment funds etc, where the main revenue driver is the assets themselves. In these cases, taking the book value of the assets from the company’s balance sheet and adding them is acceptable as a way to value the whole business.
• Businesses under liquidation where the combination of the assets is not sufficient to generate operating revenues or where the company has, or is about to, cease its activities. In this case, the main goal is understanding the value of “sale” of the assets, rather than valuing the business as an ongoing concern.

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