Too many seed-stage entrepreneurs think carelessly about valuation. They see it as merely a means to protect themselves from dilution or worse as a representation of current achievement. The reality is that valuation represents a commitment to future achievement. Investors don’t care what you did yesterday or today. They care what you are going to do tomorrow.
Entrepreneurs should see current valuations for what they are: a pricing spread based upon a current discount to a future valuation. This is a future valuation they will need to reach. Keep in mind that the goal post continually moves until there is an exit. Fall short of the spread and your financing ability dies along with your company.
A high valuation may feel good and allow an entrepreneur to boast at cocktail parties, but the astute entrepreneur sees its potential to be a gun to the head. Building companies is not a linear curve of progress. Operating flexibility is needed and the higher the valuation, the less flexibility.
Sophisticated VCs understand this. Yes, we don’t want to over pay and potentially hurt our ROI, but we also don’t want to invest in a company that has no wiggle room to adapt. Entrepreneurialism is an iterative process of constant intelligence gathering and execution. Capital structure, including valuation, must accommodate this process.
VCs also know that too much dilution to the entrepreneur kills incentive. No VC wants an unmotivated founder. The simple fact is that entrepreneurs who build great companies in partnership with VCs of integrity get richly rewarded.
A correct valuation should reflect a targeted and achievable operating plan aligned with a strategic capital plan. Valuation must be milestone driven. Successful entrepreneurs ask what milestone needs to be achieved in order to trigger the subsequent financing event after the current round. Capital planning should not be an afterthought to operations.