Fred Wilson, the venture capitalist, explained valuation today on A VC:

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.