In my 16 years of experience as an investor in startups, it’s clear to me that most founders are really focused on valuations. They want a higher valuation, always. On the surface, it makes sense. If you’re going to raise $5m, the higher the valuation, the less you’re diluted.

Plus, the higher the valuation, the more the bragging rights, the more likely you’ll get a nice write-up in the press (journos get a sense of the valuation even if it’s not public), the more your employees feel like there’s momentum. I get all that.

I’m not against high valuations per se. But all founders should understand that they are a double-edged sword.

The higher the valuation before an exit, the higher the likelihood that the founders will see nothing for all their efforts.

The root cause of this trade-off for founders is the classic preferred equity structure to venture capital.

Preferred equity gets paid back before the founders and other common shareholders do.

Preferred equity is tied to the amount of venture capital raised. Typically, 1-2x.

In theory, the amount of the preferences is untethered to the valuation. I’ve had many founders over the years ask me (when I wasn’t investing in their startup, of course) how to value their company. They are thinking in terms of NPV analyses or revenue multiples.

So if that’s how the startup is getting valued, based upon fundamentals, then the valuation isn’t tied to how much venture capital is coming in.

In the real world, that’s not how it works. When founders ask me how to value their startup, I reply “How much are you raising?"

Because the reality is that VCs value a startup as much based upon the amount being raised as upon any theoretical (and for a startup, it’s always HIGHLY theoretical) fundamentals.

If a VC wants 25% of your company, any you’re raising $5m, your startup is worth $15m.

It’s really that simplistic and it really is how the venture capital valuation model works. Within reason (I’ve seen extreme examples, of course).

To illustrate: I once saw a solar startup get a “10 on 20” term sheet ($10m raise, $20m pre-money) trumped by a 20 on 60.

Were the lower bidders idiots? Were they undercapitalizing the startup, or stupidly valuing the company at less than half of the post-money valuation that the winning bidder was?

No, it’s just how VC works. One group was trying to keep valuation low(er), the other wasn’t.

Here’s why the founders should have taken the lower bid anyway:

It’s easier for $10m of preferences to be digested at time of exit than $20m. Because both bidders were insisting upon their capital being “preferred”, ie, getting paid back first.

This was an early-stage solar company, of course. It was way too early to predict a wildly optimistic outcome. So given the odds for ANY early stage startup, the chances were that the eventual “exit” would be a trade sale. And while some of those are $1B, most are <$100m.

Hypothetically, let’s say that right after that venture round, the company got sold for $20m. Not exciting, but not bad for a nascent startup.

If they took the lower bid VC round, the VCs would take their $10m back, and the common shares would take $10m.

If they took the higher bid VC round, the $20m exit would result in $20m to the VCs, and zero for the founders.

Zero versus $10m.

This is an extreme example. And more venture dollars in theory accelerate growth and raise valuations. It’s never this simple.

But over multiple venture rounds, the preferences really add up. $5m Series A, $20m Series B, $40m Series C, and then you need to see an exit valuation of $65m+ before the founders see a single dollar. For years of effort.

The preferences therefore drive decision-making too.

Because at that point with such a big preference stack, no one is in it for a reasonable trade sale exit. The VCs didn’t want to spend years just to get their money back with no return, and the founders don’t want to get zero return at all.

So the more money raised, and the higher the valuation, the more it both increases the pressure on the startup to go BOOM OR BUST (most likely bust, as always), and the higher the likelihood that the founders don’t see anything worthwhile from even an industry-standard exit.

IMHO, after a decade and a half of this, I think most founders are better served keeping their total VC dollars reasonable and thus also keeping their valuations reasonable.

I have the “tombstones” in my office from venture rounds that led to zeroes to prove it.