Given all the talk recently about rising seed valuations and AngelGate, I wanted to do a sequel to my old post on how VC’s Value Early Stage Companies.  The valuation dynamics are even more puzzling at the seed stage, where there is even less to value.  Rather than provide a very structured formula for seed stage pricing, I just want to offer some principles of seed stage pricing to help entrepreneurs navigate this process better.

Principle One: Early stage company valuations are a negotiation exercise.  It’s not a quantitative analysis of intrinsic value.  The best way to create pricing power as an entrepreneur is to create competition for your equity.  Cases in point? Foursquare, Quora, etc.

Principle Two: Price is not everything.  Actually, not even close.  Two subpoints: 1. There are a lot of other valuation mechanisms and terms that can really impact a deal.  Many others have blogged about this, so please do your homework. 2. Being overly fixated on price can be a really bad sign to investors and spook them if you don’t handle the negotiation properly.  It can be a signal that the entrepreneur is going to be focused too much on control and preserving ownership than building large scale economic value.  It may mean that the entrepreneur will be too conservative at the wrong time, or have trouble bringing on great people and letting go of enough control and equity to help great people thrive. The advice I’ve heard from both VC’s and successful entrepreneurs is to focus more on finding great investors to work with, get a good and fair deal, and get back to work building the business.

Principle Three: High pricing has its costs. When capital is plentiful, it’s easier to raise money and pricing is more favorable.  But there is also greater competitive rivalry as it’s easier to enter and copy, and there is more competition for talent.  Also, there will be more competition for follow-on financings unless capital is also expanding among later stage investors as well (which isn’t happening now).  It’s not a completely rosy picture.

Principle Four: Pricing ebbs and flows.  And given how long it takes to build great companies, entrepreneurs are likely to see both attractive and unattractive pricing environments over the course of a company.  So when the getting is good, I think entrepreneurs should absolutely take advantage of it.  But remember it’s a long term game, and raising a big round at a super high valuation has its drawbacks. 

One final thought.  I’m of the opinion that early stage VC’s typically overpay for a company’s equity.  It’s just the nature of this market.  The failure rate of early stage companies is very high (even with very strong founders). So on a risk adjusted basis, my view is that an early stage company’s NPV is usually below even low single-digit million pre-money valuations.  And from a different perspective, very few early stage companies could sell for their pre-money valuation at the time of investment.  That’s why I think it’s not surprising that the venture industry as a whole hasn’t performed well.  It’s not an asset class that is attractive as an index.  But it IS a distribution of performance where the best managers can produce (and have produced) stellar returns.

What this means to me is that as an investor, you shouldn’t get too hung up on price at the seed stage.  You are overpaying anyway. As I’ve said before, this isn’t a value investing business.  This is a back the best, build value, and make 100x business.  It doesn’t really pay to pass on a deal at the seed stage because of price.  If it does great, you just missed a great opportunity.  If it does poorly, valuation didn’t matter anyway.

On the flip side, as an entrepreneur, remember that getting a deal done with an investor that you want is more important than optimizing on valuation.  In both cases, focusing on building a meaningful and enduring company trumps focusing on a great “deal”.