Taking a higher valuation means giving up less of the company. But in this myth, you'll learn how taking a higher valuation might actually cause you to give up more of the company, in the long run. By digesting this myth, you'll also learn about some standard "tricks" that Venture Capitalists play on entrepreneurs.

For example, a company that is worth $4 million goes out to raise $1 million in Venture Capital financing. After the $1 million is put in, the company is now worth $5 million ($4 million + $1 million). This is because the day after the financing, the company has $1 million more in the bank than it did before the financing; thus its value has gone up by $1 million.

At the end of a financing, the equity structure is determined by what percentage of the post-money valuation each of you owns. In our example, the company has a post money valuation of $5 million. The Venture Capitalists put in $1 million and so own 20% ($1 million is 20% of the total value of the company, $5 million). The people who used to own 100% of the company now own the remaining 80%.

For the sake of simplicity, we'll deal only with pre-money valuations in discussing this myth.

This seems like a silly scenario. Of course I'd go with the $8 million! But, let me ask you, are there any reasons why you might go with the $5 million valuation? While you consider this, let's look at Scenario B.

Now, let's change the scenario a little bit, and see how that changes your thinking, if at all. In this scenario, there are two Venture Capital firms who want to invest in your company. The first offers you a pre-money valuation of $5 million, and the second one offers you a pre-money valuation of $8 million.

Suppose you were raising $2.5 million. Which one would you raise financing from?

For many entrepreneurs, the answer to this question is almost as clear as the answer to the first scenario. If you take the $5 million pre-money valuation, you'll end up owning two-thirds (67%) of the company, and the new investors will end up owning one third. If you take the $8 million pre-money valuation, you'll end up owning 80% of the company, and the investors will end up owning 20%.

Clear cut, right?

Don't be so fast to jump to conclusions on this one. The myth says to take the highest pre-money valuation you can find (in this case, $8 million). That's what most entrepreneurs are inclined to do, because they want to own as much of the company as possible after the round. But you have to be very careful about taking too high a valuation for the stage of the company that you're at.

Dean Redfern, who has run and sold several technology companies in MA since 1990, was an important advisor to Brainstorm when we raised our first significant round of financing. We looked at our bank account the next day and felt exhilarated - we had never had so much money before!

Dean noticed our upbeat attitude and quickly warned us, "Many entrepreneurs have a party when they finally complete a big round of VC financing! While there's nothing wrong with having a party; this is not necessarily the time to celebrate. Sure, you have money, which you didn't have before. But, just remember: the real work starts now!"

In the first scenario, where the company is being sold it is appropriate to celebrate. You've put in many long years of work and have just personally received your reward for doing so. It's your money, and so it's OK to go out and blow some of it! You should work hard to get that valuation up as high as possible so that you'll be well rewarded.

In the second scenario, though, when you receive outside financing, you've just put your reputation on the hook in a way that you never have before. Someone has just given you $x million (if it's Venture Capital money, and perhaps several hundred thousand if its private, angel money) to spend wisely. When raising financing, a valuation is simply a set of expectations that you are setting up for yourself and your investors.

Have you seen high-flying public companies which report stellar earnings (50% improvement in a quarter or more), and then their stock price stays the same or even goes down? Why would a company's stock go down if earnings went up 50%?

The reason is that although they did well, industry analysts were expecting improvements to be at that level or higher. In some cases, they might have been expecting 70% growth in profits, and had already bid up the price of the stock to account for 70% growth!

The same is true with small, private companies. It's very easy to get an extremely high valuation if you set up extremely high expectations... If you are a $1 million company today, and you expect to be a $10 million company next year, then it should be pretty easy for you to get a $5 million valuation today because the company should be worth at least $10 million (if not more!) next year. This means that even at a $5 million valuation (5 times your current revenues),

What happens, though, if you don't meet your aggressive growth projections? In fact, 9 out of 10 Venture Capital financed companies DO NOT meet the numbers they've outlined in their original business plan.

You suddenly become a villain, and you now need to get another round of financing (because, as we've discussed in Myth #3, If only I had more money, you've already raised your expense structure and may have stepped on the Endless Wheel).

In the next round, you will start to be measured not just on what you will do, but on what you have done. And because you didn't measure up to performance, your valuation in this next round is likely to be worse than the valuation you received in the first round.

This means that everyone stock is now worth 10 times less than it was before, and the VCs get 10 times the share of your company they got the first time, for putting in the same amount of money! So, if they got 5% of the company in the first round for $1 million (which would've been a $20 million valuation), they would now get 50% for putting in another $1 million! But, the expense structure by the second round is likely to be so high that $1 million won't last you very long!

But, wait ... it gets worse!

What's worse is that most VC's have anti-dilution built into their first round deal. This means that if there's a round of financing at a valuation worse than what they put their money in, then you have to give them more shares to compensate. This is akin to buying a public stock at $5 per share, and if the stock goes down to $2 per share, then you get more shares to make up for your losses! This is an insurance policy that mitigates the risk of giving you a high valuation for the VCs. And most first-time entrepreneurs don't realize they're giving this insurance policy.

The result is that after a "cram-down" valuation in the next round, and the anti-dilution from the first round is that the entrepreneurs end up owning a small share of the company.

I remember once being incredulous that an entrepreneur ended up with only 3% of his company after two rounds of financing. "Only 3%!!" I cried out. I couldn't comprehend how that could happen, especially because his company was getting such high valuations.

The answer? Don't set the first round valuation bar so high that it'll be difficult for you to jump over it. It's much better to set expectations that you know you can meet with your eyes closed! This way, you can beat those expectations easily, and you won't end up having to go out for more rounds. Then you will be a hero, and not a villain! More importantly, you won't have to give up more of your company than you care to give.

You may even decide that now would be a good time for you to sell your company and make some real money!

The principals at Brainstorm used to joke with each other about our personal net worth after our first round of financing. We once got a $5 million pre-money valuation in a round of financing. Well, since I owned approximately 40% of the company at that time, we reasoned that it was worth almost $2 million! So, almost instantly, (on paper anyway) I was a millionaire! This was a running joke with us for a long time - "Yeah, I'm the poorest millionaire I've ever met! I have no money in my bank account, and even if I did, I can't take more than a day or two off anyway!"

Of course, my co-founders and I weren't really millionaires. If we had sold the company for $5 million, then it would've been true, and I would've been worth almost $2 million. But we didn't sell the company; we raised money, and that's when the real work began...

This brings us to one of the most important reasons for not taking too great a valuation: The only valuation that matters is the one when you sell your share of the company. That might happen if the company is sold or if the company goes public and you sell your stock.

I remember two young entrepreneurs in California who had their company for only a year and were doing about $1 million in revenues. They figured that they could get a valuation of $7 million in a round of financing.

Now, if they got that valuation, they were potentially about to do themselves a disservice. Because even if they tripled their sales in one year, to $3 million, it was unlikely that anyone would buy them for more than $3 million, based upon their financial performance. If the company was sold for $3 million, they might each get a million dollars for two years worth of work. Not bad for two years worth of work!

But ... they won't be able to sell their company for $3 million. Because they've already taken a $7 million valuation and set the expectation that they're going to be a $100 million company someday. The Venture Capitalists don't want to sell for $3 million! And it's pretty unrealistic that a $3 million company could be sold for $14 million (a valuation the Venture Capitalists might be willing to accept, because it would theoretically give them double their money).

And worse, even if the company is sold, you may not get the share of the company that you thought you would, because of another standard Venture Capital trick, the double-dip.

A "double-dip" is another insurance policy for investors when they think the valuation is too high.

Under a standard (single-dip) type of financing, the question of ownership is rather simple. For example, if you sell the company for $6 million, and the investors own 33% of the company, then they get 33% of $6 million, which is $2 million. The other $4 million get split between whoever owns the remaining 66% of the stock (hopefully the entrepreneurs and employees).

But, under a double-dip (which is legally called 'participating convertible preferred stock'), first the venture guys get their money off the top of the deal. Then, they get their percentage of what's left.

Using the same numbers under a double-dip yields slightly different results. First, the venture guys get their money out. This means that if they put in $1 million to buy that 33%, then they first get their $1 million back. This leaves $5 million. Then, they get 33% of what's left, which would be 33% of 5 million (approximately $1.7 million). This now leaves $3.2 million for the people who own the other

Again, this is an insurance policy for the investors so that they get their money back.

What does a double-dip have to do with taking too high a valuation? Well, the higher the valuation, the more strongly VCs will insist on the double dip. If the valuation is lower, you can negotiate the double-dip out of the deal by showing them how little risk they have in taking that valuation.

In particular, experienced entrepreneurs who have done very well with their own companies can offer you quite a bit of guidance and help, particularly if they've been through some tough times and you haven't yet. And if they've been in the same industry, then they can probably help you get customers.

But, individuals like that will most often give you less of a valuation than someone who doesn't know much about your company or industry. The first is a value-added investor; the second is simply a financial investor.

The flip side of the non-financial help is the non-financial pain-in-the ass factor. There are a number of investors who may give you a very high valuation but will be a pain in the ass for you as the CEO. They will be constantly calling to given them an update, to suggest that the company make deals and do things that aren't always in the company's best interest. You'll have to gauge the "pain-in-the-ass" factor by speaking with companies they have invested in before.

In general, investor involvement in the company isn't a bad thing: it's good to have experienced investors who are overseeing the financial and operational results of the company and giving the CEO honest feedback. The trick is to try to determine how much real "value" your investors can provide you and how much "honest" as opposed to "distracting" feedback they can give you.

If you honestly think they can help you considerably, then you may need to take a lower valuation to work with them. You are in part, discounting the valuation to account for their expertise. This is a perfectly reasonable approach to take, because they will be intimately involved in helping the company grow.

"Take the money and give up the least amount you can of the company" is the gut reaction of most entrepreneurs. But keep the following principles in mind when negotiating a financing deal: