Putting off the valuation can be to everyone's advantage.

This is Alex Gove's first in a series of columns on entrepreneur–venture capitalist relations. Mr. Gove, a founding editor of Red Herring, is now a vice president at Walden VC.

Valuations are a black art. For a VC, a company's valuation is always too high, but in this overheated startup environment, where the P in a P & L statement is silent, who's to say what's fair and what's not?

Recently I asked a group of entrepreneurs what the valuation of their company was, and they threw the question back at me: How would I value their company? I did what any good VC would do -- changed the subject -- but the truth is, it's guesswork. Sure, you can cite a bunch of different numbers. Some entrepreneurs come up with a valuation for their company by blending the market capitalizations of comparable public companies, the valuations of startups in similar markets, the size of the market in which their company is playing, and their company's projected revenues. But valuations are just as often based on gut feel. As one entrepreneur told me, "It's as if everybody just settles on a number that they're comfortable with."
 

ROLLING FUNDER
A growing number of companies attempt to build their valuations by manufacturing buzz. Taking a page from the Hollywood screenwriting playbook, CEOs have started to attach various goodies to their business plans. A startup recently sent us a disassembled bookcase with its business plan attached. It's still sitting in my office, mocking me.

Ric Fulop, founder and chairman of Arepa, a Boston-based company that hosts a wide array of applications for broadband networks, favors a more sophisticated approach. If Mr. Fulop were to start a new company today, he would raise money through what he calls a "rolling round." In this arrangement, he says, entrepreneurs solicit money by issuing a promissory note with a $4 million to $5 million cap that is convertible into Series A shares at a 30 percent discount. (In order to encourage investors to put up their money immediately, the discount would decline pro rata until the date of the first Series A close.) The individuals or strategic investors are buying an option to participate at a discount in a company's Series A round, or its first formal financing round. Thus, if a VC firm received 10 million shares for every $1 million it invested in a company, the chosen few investors who had rolled their dice with Mr. Fulop early would receive 13 million shares for the same amount of money. The beauty of this scheme is that, unlike raising capital from angels, Mr. Fulop would not have to set a valuation for his company, or carve out stakes in his company for others, when it might not be worth that much.

Obviously, rolling-round investors are taking a big risk. With no real stake in the company at the time they invest, they have to expect that the valuation will rise dramatically. But Mr. Fulop argues that money gathered from rolling-round investors would have an exponential effect on the valuation of his business. He could build a better product and hire great people, thus having a more developed company at the time of its first valuation.
 

WORLD SERIES

Mr. Fulop would further pump up his company's valuation by securing a corporate investor to lead the Series A round's first close (when investors establish a valuation for a company and contribute the first chunk of money). Because he places great value on the connections and leadership that VCs provide, he would then solicit VC money for the second, final close of the Series A round, when he would be dealing from a position of strength -- corporate investors, he says, invest primarily for strategic reasons and thus would be unwilling to let VCs prolong the investment process by arguing over terms like liquidation preferences.

Why go through all of this?
Mr. Fulop believes this structure could increase a company's valuation from $2 million in a traditional early-stage angel model to as high as $50 million for the Series A round.

Mr. Fulop acknowledges that most investors would avoid this kind of deal structure unless the entrepreneur in question had a proven track record. And some VCs state that the entire scenario is too improbable for most entrepreneurs to even consider. However, in an era of such wildly arbitrary valuations, it never hurts to try to create a market for your company by any means you can.

Source: Alex Gove, RedHerring, February 2000