Earlier this evening, I was watching a twitter conversation that was bouncing around several top seed stage investors. It all started with an article in the Wall Street Journal that opined that pre-money valuations (what a company is worth prior to raising money) were falling, and that some startups were finding it difficult to raise money.  If you want to dive into the conversation, Alexia over at Techcrunch, does a great job of summarizing the tweets and some of the conversation around it.

For me, the conversation was a similar one that has been going on for a couple of months now. Are valuations out of wack? There are rumors of early stage companies with limited traction, unproven teams and questionable markets asking (and getting) $8 – $10mm pre’s. Is it true? Probably.

Where the conversation got interesting was not around the rising or falling valuations, but the apparent belief that there are more “janky shit” (you can always tell a kid from the ’80s because he uses janky) out there, and the real difficulty isnt necessarily dealing with over-inflated premoney valuations, but finding the diamonds in the janky shit.

Here is my take on valuations. When we raised the first round at Graphicly, or as Mark Suster likes to call it a “cracker jack comic company” (what? its like movie reviews for posters, just take the good parts! — and before you go down that path, Mark is a good friend and was just giving me a hard time),  I actually asked for a lower valuation than what was originally offered.

Was I a moron?

Here is what most first-time entrepreneurs are taught:

1) Take the money. As much as you can.

2) Give away the least amount of your company as possible.

What a conundrum! On one hand, In order to raise a healthy chunk, investors have to believe that my company is worth it (even if I do a convertible note, there will be discussion around the cap — which is still based on what the investors believe your company is worth today). But, investors want a lower pre- in order to own more of the company and protect themselves in later rounds.

As a young entrepreneur what do I do? Raise my valuation as high as I can.

And recently, investors seemed to be price insensitive, so they invested at these high valuations.

But here is where it can get sticky.

Now, you got a $8mm pre and raised $1mm. sweet. You burn through that in 12 – 18 months, so 9 months out, you decide to go back out.

With a post of $9mm, you have to ask for $12mm, maybe $15mm on the low side for your Series A pre-money. After all, you want to raise ~$3mm, and still own as much of the company as possible.

Thats a tough sell. You have to have significant traction. You have to have built a real product. You have created a world that just is generally more difficult for you and your story.

And for your Series B? You want to raise $10mm? Your post on the Series A is $18mm, so now you want to have a pre-money of $25-$30mm minimum. Probably higher.

Thats just rough. Series B is the hardest round to raise. Dont make it harder on yourself.

Starting high is great on paper, but unless your company is a rocket ship and really just explodes, you are shooting yourself in the foot by getting a high valuation on your seed investment. You are creating expectations that potentially could be unrealistic. It also, by the way, usually causes the angels that came on in the seed round to be completely priced out of any subsequent round. Not that many angels will reup, but you are wiping out a good chunk of investors.

Valuations arent like batting averages in baseball. The quality of your startup is not indicative of the valuation you got. You dont get a baseball card with your logo on the front, and your pre-money on the back when the first money is wired into your account.

Build a business for the long haul. Build it to be able to weather storms, and uncertain funding environments. Focus on building value.

Yes companies A, B and C got $8mm pre-money valuations after going through accelerator X. Fuck them. Set your value against WHAT YOUR VALUE IS not against company A, B, C. Its not a competition.

Yes companies X, Y, Z got billion dollar valuations. You arent company X, Y or Z, and will probably never be them. Money will not fall out of the sky and into your bank account. Focus on value. Build for the long-term.

There will always be debates about whether the investment market is outta wack (I honestly think it is. I think you will see valuations drop as investors stop “spraying and praying” as much as they have in the past. The bigger trend is seeing money leave the US and get invested oversees.)

Set your valuation to attract real investors that can be amazingly helpful. (If I could have lowered my valuation and gotten Jeff Clavier into Graphicly, I would have done it without blinking. Unfortunately, I couldnt convince him of our future regardless of our pre-money), and most importantly,

build real value.

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• Start-ups hit Cash Crunch in Silicon Valley (online.wsj.com)
• Web Start-Ups Hit Cash Crunch. Or Don’t, Depending On Whom You Ask. (techcrunch.com)
• So You Think You’re a Shot Caller? (learntoduck.com)
• Mark Peter Davis On The Biggest Misconception About Startup Valuations (businessinsider.com)
• I Want to be an Astronaut! (learntoduck.com)
• Pinterest Has Already Pinned Down $10M At A $40M Valuation (techcrunch.com)