Why You Should Not Use the Asset Approach for Start-ups
Initially, most start-ups utilize the savings of founders or internal sources. However, when they fail to pool sufficient funds, they resort to external avenues like incubators, angel investors, and micro-venture capitals. To approach the external sources for investment, start-ups should figure out the seed amount requirement with a business valuation.
A business valuation is crucial to start-ups as it helps decide the amount of equity the company should give to an investor in exchange for required funds. So, if the business value is higher, its founders need to provide a lesser amount of equity or shares to the investors in exchange for their invested amount.
A valuation for the start-up is essential for entrepreneurs, but it is also vital for investors as it helps them gauge the amount of return they should receive on their investment.
What is the Asset Approach?
Asset-based valuation focuses on the value of a company’s assets or the fair market value of its total assets after deducting liabilities. Companies in the investment sector, such as financial or real estate investors, use the asset approach.
It involves examining the company’s balance sheet, listing the business’s total assets, and subtracting its total liabilities to determine the book value of assets. It also helps to determine the company’s liquidation value after the sale of all its assets and clearing of all its liabilities.
The Net Asset Valuation Method, or Book Value, calculates the total value of assets less the total amount of liabilities. It is highly effective in determining the value of petroleum corporations, natural resources companies, real estate firms, and the like.
Whereas the Adjusted Net Book Value Method (or Adjusted Book Value) of the asset approach helps derive the value of the going concern by adjusting its tangible assets and liabilities to their current fair market values.
Start-up Valuations Using the Asset Approach
While a business valuation for any privately owned company is difficult, ascertaining the value of a start-up is notoriously hard. Assigning a valuation is particularly tricky for start-ups with uncertain revenues, profits, and futures.
Many business owners believe that the value of their company is its book value or its assets minus liabilities. However, the asset approach does not always work. It is especially not practical to determine the value of a start-up. Let us try to understand this argument with an example.
Suppose a manufacturing start-up owns machinery worth $4 million and has outstanding debt amounting to $1 million. Going by the asset approach, the purchase price for this start-up would be $4 million – $1 million = $3 million.
But is the start-up worth $3 million?
What Goes Wrong When Applying the Asset Approach for Start-up Valuations?
Not having ample assets for valuation
The asset approach requires the company to include all types of assets for calculation, such as physical, financial, intellectual property, brand value, customer contracts, and theoretical salaries not paid to founders and executives.
However, most start-ups do not have tangible assets, and they rely primarily on intangible assets like software, patents, and team skills, which are difficult to value. Even if the start-up has tangible assets, their value in comparison would be significantly less.
Specifically, in the case of start-ups, analysts should look for the value as a combination of tangible assets and internal factors such as the organizational processes, the rollout of products and services, research and development, etc. As the combination creates the possibility of generating revenues, it helps create value.
For example, when trying to value a management consulting firm, using the asset approach is meaningless. It is because the total tangible assets form a small part of the value-driving assets of the company. A combination of the team’s skills and intangible assets like brand, expertise, and client portfolio is also the value-driving assets of the company.
In addition, the asset approach for business valuation disregards the prospective earning potential of the company. When analysts consider the company’s earnings potential using other valuation methods, the value of the company thus obtained is much more reliable than when they go by the asset approach.
Not knowing the book value of intangible assets.
Another shortcoming of the asset approach is that it involves a complicated process to value intangible assets like patented technologies, domain names, etc. This is complicated because, typically, these assets do not have a book value.
So, an analyst performing the asset approach for a start-up valuation needs a high level of knowledge, experience, attention to detail, and accuracy. In the case of start-ups, the Discounted Cash Flow Method is more appropriate.
When Does the Asset Approach Work?
The asset approach does not consider the future potential and the company’s expected cash flow; instead, it reflects the historical cost of building the business. Whereas, for start-ups, investors are interested in identifying the risks associated with the business and estimating its earning potential.
However, the asset approach works very well in cases such as:
Companies where the key revenue driver is the assets themselves, such as the real estate companies managing the buying and selling of properties, are perfect for applying the asset approach.
To value such a business, the analysts can take the book value of the assets from the balance sheet and add them using the asset approach.
Business Under Liquidation
If the company is about to cease its activities, and the combination of the assets is not sufficient to generate operating revenues, it can be valued using the asset approach.
The goal here is to understand the sales value of the assets rather than valuing the business as an ongoing concern.
How is a Start-up Valuation Different?
Start-up valuation processes and methods help calculate the value of a start-up company. At a pre-revenue stage, business owners hope for a high valuation, and investors prefer a lower value that promises a higher return on their investment.
Analysts need to consider many things, from the management team and market trends to the demand for the company’s products and services and the marketing risks involved.
Unlike a mature, publicly listed company, a start-up does not have a steady stream of revenue and financial records such as earnings before interest, taxes, depreciation, and amortization, which usually help with the valuation process.
The asset approach considers the startup in its current state and not how it will be in the future. Investors are more interested in the latter, and since an asset-based valuation does not take that into account, this method has some limitations.
It is difficult to determine the accurate value while it is in its initial stages as there is high uncertainty about its success or failure. However, there are many methods to determine the value of a start-up. Even though asset-based valuation is one of the approaches, it does not work very well.
Factors Influencing the Valuation of a Start-up
Analysts need to consider factors such as the effectiveness of marketing efforts and the growth rate of the start-up to find its value. Also, they need to recognize the value in the founders’ prior experience, the diversity of their skills, and their dedication and commitment towards the start-up.
A working model, a Minimum Viable Product (MVP), and some early adopters help start-ups attract early funding. The company could pool more funds if it reviews with the valuation-by-stage method, which many venture capitalists and angel investors use.
The market in which the start-up operates also impacts its valuation. For instance, a competitive market with many companies in similar businesses reduces the value of a start-up. In contrast, a business with a unique and trending idea is much more valuable.
A start-up can be worth more in a booming industry such as mobile gaming or Artificial Intelligence, where investors are willing to pay a premium. Also, if the start-up offers high margins and forecasts indicating substantial revenue growth, it can attract more significant investments.
Getting professional help and arriving at a more reliable business value can help start-ups negotiate better investment deals. Other than the asset approach, many methods can value a start-up more effectively and accurately.
Unlike any valuation method, the asset-based approach is also not without its pros and cons. The entrepreneur or the founders of a start-up need to employ the right people with the requisite experience and expertise to identify and determine business value to their new venture.
The stage of the start-up also helps determine the method that can most effectively determine its business value. Based on the age of the company, the purpose of its valuation also changes.
Analysts need to identify the right approach and method for business valuation depending on the age of the company, the purpose for valuation, the industry and market conditions, and the uniqueness of the business.