There are two ways to deal with this phenomenon. If you're feeling really confident, you can try to ride it. You can start by asking a comparatively lowly VC for a small amount of money, and then after generating interest there, ask more prestigious VCs for larger amounts, stirring up a crescendo of buzz, and then "sell" at the top. This is extremely risky, and takes months even if you succeed. I wouldn't try it myself. My advice is to err on the side of safety: when someone offers you a decent deal, just take it and get on with building the company. Startups win or lose based on the quality of their product, not the quality of their funding deals.
Venture investors like companies that could go public. That's where the big returns are. They know the odds of any individual startup going public are small, but they want to invest in those that at least have a chance of going public.
Currently the way VCs seem to operate is to invest in a bunch of companies, most of which fail, and one of which is Google. Those few big wins compensate for losses on their other investments. What this means is that most VCs will only invest in you if you're a potential Google. They don't care about companies that are a safe bet to be acquired for $20 million. There needs to be a chance, however small, of the company becoming really big.
Angels are different in this respect. They're happy to invest in a company where the most likely outcome is a $20 million acquisition if they can do it at a low enough valuation. But of course they like companies that could go public too. So having an ambitious long-term plan pleases everyone.
If you take VC money, you have to mean it, because the structure of VC deals prevents early acquisitions. If you take VC money, they won't let you sell early.
The fact that they're running investment funds makes VCs want to invest large amounts. A typical VC fund is now hundreds of millions of dollars. If $400 million has to be invested by 10 partners, they have to invest $40 million each. VCs usually sit on the boards of companies they fund. If the average deal size was $1 million, each partner would have to sit on 40 boards, which would not be fun. So they prefer bigger deals, where they can put a lot of money to work at once.
VCs don't regard you as a bargain if you don't need a lot of money. That may even make you less attractive, because it means their investment creates less of a barrier to entry for competitors.
Angels are in a different position because they're investing their own money. They're happy to invest small amounts—sometimes as little as $20,000—as long as the potential returns look good enough. So if you're doing something inexpensive, go to angels.
VCs admit that valuations are an artifact. They decide how much money you need and how much of the company they want, and those two constraints yield a valuation.
Valuations increase as the size of the investment does. A company that an angel is willing to put $50,000 into at a valuation of a million can't take $6 million from VCs at that valuation. That would leave the founders less than a seventh of the company between them (since the option pool would also come out of that seventh). Most VCs wouldn't want that, which is why you never hear of deals where a VC invests $6 million at a premoney valuation of $1 million.
If valuations change depending on the amount invested, that shows how far they are from reflecting any kind of value of the company.
Since valuations are made up, founders shouldn't care too much about them. That's not the part to focus on. In fact, a high valuation can be a bad thing. If you take funding at a premoney valuation of $10 million, you won't be selling the company for 20. You'll have to sell for over 50 for the VCs to get even a 5x return, which is low to them. More likely they'll want you to hold out for 100. But needing to get a high price decreases the chance of getting bought at all; many companies can buy you for $10 million, but only a handful for 100. And since a startup is like a pass/fail course for the founders, what you want to optimize is your chance of a good outcome, not the percentage of the company you keep.
So why do founders chase high valuations? They're tricked by misplaced ambition. They feel they've achieved more if they get a higher valuation. They usually know other founders, and if they get a higher valuation they can say "mine is bigger than yours." But funding is not the real test. The real test is the final outcome for the founder, and getting too high a valuation may just make a good outcome less likely.
The one advantage of a high valuation is that you get less dilution. But there is another less sexy way to achieve that: just take less money.
Ten years ago investors were looking for the next Bill Gates. This was a mistake, because Microsoft was a very anomalous startup. They started almost as a contract programming operation, and the reason they became huge was that IBM happened to drop the PC standard in their lap.
Now all the VCs are looking for the next Larry and Sergey. This is a good trend, because Larry and Sergey are closer to the ideal startup founders.
Historically investors thought it was important for a founder to be an expert in business. So they were willing to fund teams of MBAs who planned to use the money to pay programmers to build their product for them. This is like funding Steve Ballmer in the hope that the programmer he'll hire is Bill Gates—kind of backward, as the events of the Bubble showed. Now most VCs know they should be funding technical guys. This is more pronounced among the very top funds; the lamer ones still want to fund MBAs.
If you're a hacker, it's good news that investors are looking for Larry and Sergey. The bad news is, the only investors who can do it right are the ones who knew them when they were a couple of CS grad students, not the confident media stars they are today. What investors still don't get is how clueless and tentative great founders can seem at the very beginning.
Investors do more for startups than give them money. They're helpful in doing deals and arranging introductions, and some of the smarter ones, particularly angels, can give good advice about the product.
In fact, I'd say what separates the great investors from the mediocre ones is the quality of their advice. Most investors give advice, but the top ones give good advice.
Whatever help investors give a startup tends to be underestimated. It's to everyone's advantage to let the world think the founders thought of everything. The goal of the investors is for the company to become valuable, and the company seems more valuable if it seems like all the good ideas came from within.
This trend is compounded by the obsession that the press has with founders. In a company founded by two people, 10% of the ideas might come from the first guy they hire. Arguably they've done a bad job of hiring otherwise. And yet this guy will be almost entirely overlooked by the press.
I say this as a founder: the contribution of founders is always overestimated. The danger here is that new founders, looking at existing founders, will think that they're supermen that one couldn't possibly equal oneself. Actually they have a hundred different types of support people just offscreen making the whole show possible. [3]