There’s this dance that entrepreneurs and venture capitalists do when it comes time to negotiate the economic terms of an investment. And it all revolves around valuation.

The question is what is the fair value of the business? This supposedly establishes how much of the company the venture capitalists will own for their investment.

But I think the concept of valuation is often misunderstood by the people engaged in this process. And it’s particularly true in early stage investing.

I do not believe that negotiating a valuation on an early stage venture investment has much to do with the current value of the business. If it did, why would a venture capitalist agree to a $10 million value for a business that will lose money for the next 2-4 years and has little, if any, revenue?

The fact is that almost all venture capital deals are done as convertible preferred stock investments. That means that the money we invest is more like a debt instrument in the event the business doesn’t work out very well. We get our money out before the entrepreneurs do if the deal goes sideways or down.

It’s only in the event that the deal works out that the percentage of the business (the thing that valuation is supposed to determine) matters in terms of how much money we make.

Another important factor to consider is that only a relatively small portion of early stage venture investments really work out in the way they were supposed to when the investment was made. In my experience, which is based on 17 years in the business and over 100 different early stage investments over that time period, there is a 1/3 rule.

The 1/3 rule goes as follows:

1/3 of the deals really work out the way you thought they would and produce great gains. These gains are often in the 5-10x range. The entrepreneurs generally do very well on these deals.

1/3 of the deals end up going mostly sideways. They turn into businesses, but not businesses that can produce significant gains. The gains on these deals are in the range of 1-2x and the venture capitalists get most to all of the money generated in these deals.

1/3 of the deals turn out badly. They are shut down or sold for less than the money invested. In these deals the venture capitalists get all the money even though it isn’t much.

So if you take the 1/3 rule and add to it the typical structure of a venture capital deal, you’ll quickly see that the venture capitalist is not really negotiating a value at all. We are negotiating how much of the upside we are going to in the 1/3 of our deals that actually produce real gains. Our deal structure provides most of the downside protection that protects our capital.

I think it is much better to think of a venture capital deal as a loan plus an option. The loan will be repaid on 2/3 of our investments and partially repaid on some of the rest. The option comes into play in a big way on something like 1/3 of our investments and probably no more than half of all of our investments.

There is more to this whole issue of valuation because there are often follow-on rounds where the deal between the venture capitalists and entrepreneurs gets renegotiated. I’ll save that for another post.

