Stu Phillips calls it The Valuation Trap and also “the hot button of the week” in his most recent post on Soaring on Ridgelift. I call it surprising, counterintuitive and, therefore, more interesting and more important. For the record, I would have said the opposite of what he does. Here’s what he says:

Never answer the classic VC question, “So, what valuation are you looking for?” with a specific number. Got that? Never!

And let’s say this too: If you’re dealing with venture capitalists, seeking financing, listen to what Stu says first, he knows better.

The subject hits home with me because I’ve been favored by being a judge at multiple venture contests, not as an investor, and I want the contestants to come up with a proposed valuation as part of their financial strategy. I get frustrated when they seem to have forgotten about valuation as one of the key factors.

Stu, however, is very convincing, particularly since he’s talking about real investment deals, not just hypothetical:

Whatever number you give in answer to this question, you wind up negotiating with yourself (a fool’s errand in anybody’s book of strategy):

  • If you give too high a number, the prospective new investor might start thinking, “Boy, these guys are being totally unrealistic…” or worse. Many VCs don’t relish being the bearer of bad news and so tend to nod politely and then go chase other deals where they don’t have to be the bad guy who brings you back to earth.
  • If you give too low a number, do you think the prospective investor is going to say, “Oh, that’s way too low, we were thinking of a much higher number…”?

So, never give a specific number!

OK, I’d say, but isn’t that naive, for reasons I put above? Don’t you just look like you don’t know the territory and haven’t done your homework? He has a good positive suggestion of what to do instead:

The question itself is a fair one and has one of two answers:

  • If you have raised money before, the answer runs along these lines… “Our last round was at $X million post money. We think you will agree that we’ve made substantial progress in building the company since then and that will translate into the valuation that the market will set.”
  • If this is the first money you have raised from institutional investors… “We’re realistic about the valuation that the market will set and look forward to hearing your opinion of a fair valuation.”

VCs ask this question to test the waters and see how realistic you are about the fundraising process–think of this as a pass/fail question, remember the answers above and you’ll do fine.

So OK, I’m convinced. Take his advice, not mine … unless you’re competing in a venture contest and I’m one of the judges. For this coming year, that would be contests at Rice, University of Oregon, Notre Dame and University of Texas.

Tim BerryTim Berry

Tim Berry is the founder and chairman of Palo Alto Software and Follow him on Twitter @Timberry.