Valuation optimization vs maximization – what is the real goal?

One of the most confusing and misunderstood concepts to entrepreneurs is around valuation – not only in how it is determined (that is an entire post itself which I won’t try to tackle right now) but more importantly, what should the goal be?

I think for entrepreneurs who haven’t been been through fund raises already, the first and obvious reaction is the get the highest valuation possible and if you do, you’ll have “won the battle”. I guess it makes sense that this viewpoint is commonly held – in many other areas of negotiations, auctions, grades, sales deals, etc, the goal is to get to the extreme (either lowest or highest) and the closer you get, the better you did. Its how they got to where they are now – by winning and excelling in everything they did. They view the “valuation negotiation” with a VC just another competition to win.

So, why isn’t this the right approach for entrepreneurs? (and the answer is not because I’m the VC writing this and I’m trying to convince you to take a lower valuation – but good try!). The reason is because a) the funding is a financing event, not an exit (the exit is when its decided whether you win or lose) and b) the prior valuation has a significant impact if and when another financing round is required. The exception to this is if this is definitely the last financing round the company will need before exiting – and even this has it pitfalls when it comes time to exit (see my earlier post about entrepreneur and investor alignment specifically regarding exits and the VCs need for high returns and a multiple on their investment).

For the entrepreneur, the financing event and resulting valuation merely puts a number on the company value which then affects the percentage ownership the founder has in the company – but this doesn’t translate to real money that the owners can walk away with (I’m sure those of you who were at startups during the bubble but didn’t exit before the crash can relate to this quite well…). Its paper wealth. Funny-money. Remember 100% ownership of nothin’ is still nothin’…

Valuation becomes a real issue for those companies that need to raise another round of financing (this may be where many of the entrepreneurs who raised money in the last 18 months before the market crash last fall start to perk up…). A high valuation (which 12 months ago seemed like a huge success) is now feeling like a huge albatross – a heavy burden on the company that may stifle their ability to raise money from an outside investor. This occurs because the prior round investors want to be rewarded for putting money in earlier through getting a higher “step-up” valuation in the next round. The new investor is often wary of companies with valuations too high as their expectations for a smooth round getting done is put at risk as they worry about spending a lot of effort for a down round that gets resistance or just gets done by the insiders (prior investors). In a startup, momentum is very important on how the world perceives your succes. When things continue to be on the “up-and-up” across all areas of the business – great team is built out, revenues increase, customer base grows, metrics improve….and valuation continue to rise round-after-round, everyone is happy.

Now, just to be fair, on the other side of the table, it isn’t in the best interest of the VC to drive to the lowest valuation possible either. This is because if the founder/entrepreneur doesn’t have enough of an ownership stake in the company (especially after several financing rounds), there is a real risk that the founder may leave if he feels like the reward for staying isn’t big enough vs doing something else (starting another company, taking the big corner office at a cushy large company job, etc) – remember, being an entrepreneur is hard work and people need to be rewarded for their commitment.

Somewhere in the middle between a valuation so high it risks future financings and a valuation so low it dis-incentivizes (I know this isn’t a word but it should be….) the founders is the optimal valuation. For the entrepreneur and VC, the goal should be to find a fair valuation for everyone. The entrepreneur/VC relationship is a long-term one, often 5+ years. Raise these concerns with the VC and get it on the table so both of you see each other’s perspectives and motivations. Its a good initial step in a very long journey that will ultimate be in both of your best interests. Remember, “winning the war” is the goal – exiting the company so that both you and your investor makes money through an exit. The fund raises and valuations are just a step along the way towards the final goal.

As this topic can be a bit confusing, feel free to sign up for my office hours to discuss at greater length.

[Update: 6/19/2009 Thanks to Ben Kuo at SoCalTech for the posting. ]