As a startup founder, you care a lot about the dollar value placed on your company. So it’s natural that negotiating that value with investors is typically a fraught process.

For example, founders often get so concerned with the amount of dilution they’re going to experience as a result of taking on new funding that they focus almost exclusively on getting the highest valuation possible. I’ve even seen founders practically fall on their swords in order to eke out a $7.7 million valuation instead of the investor’s proposed $7.5 million. Come on! Really?

Let’s take a look at a more reasonable approach to valuation. We’ll see how investors think about valuing a startup, and how you can think like them to negotiate effectively.

How Investors Think About Valuation

Investors use a combination of art and science to determine the “right” valuation for your startup in a given round of funding. If you find yourself discussing valuation, it is mostly a good sign. That’s because investors don’t focus too much on valuation until they’ve learned enough to decide whether they have some interest in investing in the first place. If they determine they have interest, much of the information they discovered during their evaluation goes into an assessment of a reasonable valuation.

It’s probably obvious that each investor has their own approach to assessing valuation. This is especially the case with angel investors. But when it comes to institutional investors, family offices, and highly disciplined angels, I’ve found there is a common sequence of events that typically occurs behind the curtain.

1. Comparables

Active investors see tons of deals. This means that, after completing their initial evaluation, they are able to pattern-match your opportunity with several others. They have an ability to compare various aspects of your business plan and strategy and then magically match it up with prior deals they invested in, ones they decided to decline, and ones they lost to other lead investors. They are essentially identifying other deals like yours and their associated valuation. This evaluation of comparables gives them a general starting point for valuation.

“Deals like yours” means other companies with similar levels of traction, similar team skills and track record, and similar market size. It might also mean companies in the same industry or with the same business model. These are the key attributes of your business plan and business opportunity, so it’s logical they also serve as the basis for identifying similar prior investments and their associated valuation.

2. Adjustments

Since the pattern-matching exercise surely didn’t result in an exact match to other recent deals they felt had a fair valuation, the investor will make some adjustments. During their initial evaluation, they likely discovered some things that especially impressed them or especially concerned them. These become additions or subtractions from their starting valuation. Maybe you have a superstar on the founding team or have already landed a significant strategic partnership. Those would serve as valuation boosters. Or maybe you had a recent pivot that’s not yet proven or an excessively high churn rate. Those would be valuation subtractors.

3. Target equity test

Many institutional investors have a target percentage of equity in your company that they need to get when they invest. Some investors have a fairly strict and narrow equity target, whereas others have a more flexible and general rule of thumb. If their target is 18 to 22 percent and their valuation assessment to this point would result in them only getting 15 percent, they will likely reduce their proposed valuation to get their equity back into the target range. You might be wondering why they can’t just invest more money to reach their target. They can; you just have to convince them to do that instead.

4. Potential exit returns

Early-stage investors take much more risk than those who invest during later stages. As a result, they often make investment decisions based on the likelihood of getting at least a tenfold return (you might hear investors refer to it as a 10X return). So, the next step in their process involves running various exit scenarios. With this, they are trying to answer a very specific question: What valuation would you need to be acquired for (or go public for) in order to give them a tenfold return? To run this calculation, they also need to make some assumptions about the number of future rounds of funding you will need to raise and how much dilution they will experience from each. But the formula is based on simple algebra that you will see in figure below.

Regarding dilution, my personal rule of thumb is to expect 25 to 35 percent dilution with each real round of funding. Equity rounds of funding are typically real rounds, but bridge rounds—a smaller round to keep things going between real rounds—aren’t. Bridges usually dilute less than average if they are truly just to bridge a gap.

Let’s run the exit return calculation for an investor whose $2 million investment yields them 20 percent initial equity, and let’s assume two more rounds of funding that are each 30 percent dilutive before an eventual exit. Perhaps this is an investor in your Series A round, and they assume you will need to raise both a Series B and Series C in the future before becoming profitable and sustainable. The calculation is as follows:

Using the assumptions in this scenario, the company needs to exit at a valuation in the range of $200 million in order for the investor to get a tenfold return on their investment. Now the investor’s assessment is clearer. What are the odds your company can successfully grow to the point of attracting an acquirer willing to pay $200 million?

Hopefully, you now understand why professional investors seek businesses that can grow to the point of being able to exit for hundreds of millions of dollars and not just tens of millions. You additionally should conclude that the investor will be thinking about the evolution of the company all the way to an exit and not just through the next round of funding. You must be of this same mindset.

Time to Negotiate

Since the valuation you’re able to negotiate is such a key aspect to your funding round, why not go ahead and go through the same steps the investors go through? Find other recently funded companies that look like you—similar funding, amount of traction, stage, market size, experience among the founding team, and so on. What sort of valuations were they able to negotiate? What positive and negative adjustments can you identify as likely?

What sort of future exit will you need in order for your prospective investor to get a tenfold return with the valuation you’re hoping for? You’ve got the formula. Run various scenario calculations before the investor does.

Anchoring the desired valuation

During any negotiation in which the price is not already known, the two negotiating parties have a choice of who utters a suggested amount first. Which is the best approach to take? Well, you can find lots of articles and books on negotiation that explain the pros and cons of anchoring the conversation. The first suggested or offered figure creates a cognitive bias that causes the other party to more heavily rely on that initial piece of offered information. If the buyer goes first, they usually suggest a lower number than they are actually willing to pay. If, instead, the seller starts the negotiation, they will do so with a number higher than they are truly willing to accept.

Don’t assume you can be the one to first anchor the conversation at an $8 million valuation in hopes that negotiating down to $4.5 million will leave the investor feeling like they got a great deal. Your mention of a valuation that seems ridiculously high can quickly terminate the investor’s evaluation. You’ve got to at least be within a reasonable range.

I don’t have a single recommendation in regard to who mentions valuation first, because every situation is different. I do believe you should decide on a range of valuations you think is reasonable and would be acceptable to you and your key stakeholders. And if you did your homework during the planning phases of your fundraising campaign by having penalty-free conversations with investors before officially launching the campaign, you should have gained some valuable insights about the acceptable valuation range.

After the term sheet from a lead investor

Let’s say a prospective lead investor gives you a term sheet that includes reasonable terms in general but the valuation is measurably lower than you expected and also below the range you and your key stakeholders previously agreed would be acceptable. Now what?

Your first and most significant negotiating tool comes from having alternatives. Many negotiating articles and books talk about the importance of understanding what’s called your BATNA (best alternative to a negotiated agreement). Do you have any other term sheets for a similar amount of funding? If not, are others likely to come soon? Are there alternative forms of funding available, such as grants or venture debt?

Must you raise money now, or do you have an option to execute for at least a few more months before needing fresh funding? If you don’t have other active investor prospects but do have some runway left, you could put your head down and execute like crazy while fixing some of the things that prevented you from getting the valuation you needed. Or maybe you’ve got some exciting milestone accomplishment coming soon that you can achieve first to help justify your desired valuation.

If you don’t have one or more of these alternatives available, you are pretty much at the mercy of the single investor proposing a term sheet, and you’ll need to use additional negotiating tools.

Your second negotiating tool comes from decoding the investor’s evaluation of your company and debating anything that genuinely doesn’t seem valid. Most likely, this involves finding out the concerns they had (valuation subtractors) and trying to convince them they shouldn’t be as concerned. You will also want to make sure they are giving you credit for things you feel are deserved (valuation boosters).

Investors have alternatives too

It is possible that your desired valuation is completely reasonable, but it is a competitive market. Active investors have lots of alternatives. They might be considering other investments that have similar potential to yours but at a lower valuation. Your valuation is not assessed in isolation but, rather, among a list of opportunities the investor is considering.

There’s a time to stop arguing

You are only worth what investors will agree you are worth. Additionally, your mission is not to find the absolute highest valuation you can get from a single investor. Instead, you need to find a valuation that lets you efficiently close your full round of funding so you can get back to running your business.

If you find yourself arguing about valuation with all or most of the prospective investors, I’m sorry to say it, but your valuation is too high. You aren’t worth as much as you thought. But if you are forced to reduce your valuation, it is not the end of the world. Find a good investment partner that can help you grow a great company. They are far more valuable than a mediocre one that will give you a slightly higher valuation. Your mission is to optimize for growth, not dilution.

Debating Is a Good Sign

If you reach the point of debating or negotiating valuation for your funding round, congratulations! You’ve made it a long way. That’s because, as I mentioned, investors don’t usually put much emphasis on valuation until they’ve decided they are legitimately interested in your opportunity. You don’t take a new car out for a test-drive if you hate the style or it’s missing features you consider critical. But lots of fish wiggle off the fundraising hook during the valuation negotiation step. It is a very important term to both parties, because it often carries the biggest long-term economic leverage for both.

Active investors, both angel and institutional, are savvy pattern matchers, and that can be a good thing or a bad thing for you. If the comparables they identify yield a favorable starting point for your valuation, great. But if you are so unique that they can’t really think of a similar company, it might be hard for them to figure out what a reasonable valuation is. They take some comfort in having comparables as a starting point for their evaluation.

It is easy to get excited about the prospect of a nice, high valuation. But your mission is not to spend every last bit of time and energy to eke out every last bit of valuation. Time kills deals, and the longer you’re on the fundraising trail, the longer your company is without your complete operational focus. If you find yourself arguing the valuation with every investor, your desired valuation is wrong. If, on the other hand, you have multiple highly interested investors, you probably have something to work with. Just don’t try to get too fancy playing your poker hand. Instead, identify the investors who can best help you continue to grow a great company, get the funding round closed, and put your focus back on creating that great company. The only equity percentage that matters is the one you have when you eventually exit. And if you’ve built a great company by then, the super-huge exit multiplied by almost any equity percentage is still a huge number.