Optimising for valuation is a strategic mistake for early-stage entrepreneurs.

In my limited experience, many founders consider valuation their top priority, even at stages as early as seed. They tend to treat a working hypothesis as an end in itself and put effort on getting this assumption “right”, rather than making it work. I believe such an approach is shortsighted, ill-conceived and eventually against an entrepreneur and her company’s interests. Here are some reasons why.

On the monetary side of things, what really matters for an entrepreneur is to receive after all a significant value out of what primarily she has created. In this context, it is far more important to get there than getting the absolute most out of it. Especially for entrepreneurs without a successful exit before, the difference does not lie in getting, say, 3 millions versus 5 millions at exit, but in 5 millions versus zero. In other words, a founder needs to maximise the chances of creating a successful company, not the amount she would be receiving if she ultimately makes it.

What remains unclear to many entrepreneurs though, is that the bigger the valuation in a previous funding round, the less chances a company has to raise a subsequent one. This is because a down round, which valuation is lower than the previous one, is most typically a catastrophic event for a company. A round that doesn’t take place at a sufficient multiple of the previous round, say 2-3x at early stages and 1.5x at a later stage, isn’t for most partners a very happy event either.

So, before one gets really excited about a very large valuation she received on a term sheet, or depressed as it’s not large enough to brag about it, it is useful to take a step back and peer at the big, long term picture. The question for an entrepreneur to ask is, if she is comfortable enough that, given resources, the company will be able to increase its valuation 2-3 times within the next 1-2 years. If this is not the case, I argue that it is more reasonable to go for a smaller valuation, than jeopardise her and the company’s future.

It is also of interest to understand the other side of the table. Partners of a venture capital fund typically receive 20% of the profits, when the fund has returned the full amount consumed plus interest to its investors. So, for example, if the the fund makes an exit in one out of every three portfolio companies at three times the original valuation, then its investors and partners make zero gains. This very fact suggests that an institutional investor is expected to be more sensitive on the valuation issue, as a fund’s economics suggests.

I’m not making here the case that entrepreneurs should not care about early stage valuations at all, or accept any valuation they might end up receiving. After all, the safest way for a partnership not to work out is one of its parts not to feel happy, or actually excited about it. I am suggesting though that valuations are not what should keep founders up at nights, making a product that works and creating a great business out of it is primarily what one should aim for — valuation will follow suit.