What is the book value method in startup valuation?

How to calculate book value

The company's book value is calculated by subtracting total liabilities from total assets. This straightforward method determines the net worth of a business. Many banks and credit unions rely on this figure when assessing creditworthiness for debt financing.

Book value can change over time. The value of hard assets on the balance sheet is determined by taking the total cost of each item and subtracting accumulated depreciation.

Therefore, a company's book value may decrease when preparing new quarterly or annual financial statements if cash flow and revenue have not improved. Conversely, reducing accounts payable before applying the book value formula can increase shareholder equity.

Assessing the value of intangible assets

A properly prepared balance sheet should include a line item for intangible assets. Intangibles lack market prices, making them challenging to quantify. Examples include intellectual property like patents, trademarks, or copyrights. Their valuation affects overall book value, which can be assessed using three approaches:

• Market approach: Use competitor valuations as metrics for assessing asset value.
• Income approach: Utilize future growth metrics such as cash flow projections to determine potential income from intangible assets.
• Cost approach: Factor in historical costs associated with filing trademarks or copyrights.

Accurate valuations are essential because failure to include intangible assets skews overall company worth.

Book Value vs. Fair Market Value

After reading the examples above, one of the flaws in this methodology should be apparent. Book value is a fluid number only valid for the reporting period in which it's calculated. It also doesn‘t give you the company's fair market value that a buyer would be willing to pay. This is an important distinction when selling or awarding common stock. 

Here’s an example: Let’s say your company’s book value per share (BVPS) is $20 based on the shareholder’s equity listed on your balance sheet. If your startup shows good growth potential, investors may be willing to pay a fair market value of $30 per share. If you perform poorly, the FMV might be $10 per share. The book value doesn’t change in either scenario. 

The IRS requires companies awarding stock options to hire a third party for a 409A valuation to determine fair market value. This is also common when a company prepares to go public and needs to set a stock price. The book value is insufficient for that, though it may be used as a baseline for an FMV calculation. Risk to investors may also factor into that.

Book Value vs. Cost-to-Duplicate Approach

Cost-to-duplicate is an effective approach for startups looking for a short-term number for loan approvals or investment decisions. It may not be the best approach when setting a price for common or preferred stock because it doesn’t include accounts receivables. The book value method lists those in the assets column, with accounts payable under liabilities. 

The cost-to-duplicate approach also doesn’t include intangible assets. It’s essentially a liquidation value that shows the replacement cost of the company’s current assets. It does not reflect a company's true book value and can be significantly lower than its market value, so it should not be used for mergers or acquisitions. 

Startups can use the cost-to-duplicate value as an internal metric to measure their investment in the business. It's not recognized as an official startup valuation for equity investments or income tax assessments, but we included it here for comparison. The book value, which may also be called the carrying value, and the fair market value are more useful.       

Price-to-Book (P/B) Ratio

The fair market value and the book value can be used to calculate a price-to-book (P/B) ratio, which can be used as a valuation multiple when comparing companies in the same industry. It’s calculated by dividing the market share price by the book value per share (BVPS). This method is not effective when comparing companies from different industries. 

Here’s an example: Assume a company's market share price is $24, and the BVPS is $20. The P/B ratio in that scenario is 1.2, meaning the market values that company's stock at a premium. If the market price is $16, the P/B ratio is 0.80. That means the stock is valued at less than the book value, which is a red flag for investors and shareholders.

This ratio is among the most important reasons for a book value valuation. Investors use it to check whether a stock's market price is fair, and equity partners want to know if the common stock they receive is comparable to the funds they’re investing. This is particularly important for startups in early funding rounds where credibility is essential.

Wrap up

Book value can help provide insight into a company's worth based on historical data from its balance sheet. While it serves as a legitimate variable in small business finance, it must be updated each reporting period alongside new balance sheets.

Understanding that book value is just one metric in assessing overall company worth is critical for responsible financial management.

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