Fred Wilson, Chris Dixon, & David Lee On High Valuations & Competing

The problem with a cap - or rather calling a cap a valuation - is that unsophisticated entrepreneurs don't understand the consequences of the cap. To you point about entrepreneurs offering terms, I find that terms are negotiated and that angels are the ones who suggest a cap (and call it a valuation). The problem comes when the naive entrepreneur finds out what a cap really is. This is where they lose focus on building the most value with the capital they have raised and start focusing on the investors who "screwed" them. Once this realization is made, entrepreneurs will try to raise a series A _at a valuation equal to the cap_. After all, why try to add more value when it will go disproportionately to those investors who added a cap and called it a valuation.

Anyway. I understand that caps are a way for investors to avoid dilution in massively up rounds. I just think they are the worst way to do it. It gives the entrepreneurs the incentive to raise their next round at the cap and not a penny more. In my opinion, a good deal will give the entrepreneur the incentive to raise the next round at the highest valuation possible and not at some arbitrary number. If you want anti-dilution protection as an investor, I think warrants are a much better tool. They allow you, as an investor, to maintain a desired percentage of your portfolio company without removing the entrepreneurs incentive to go for the highest valuation possible in the next round.

At the end of the day, the most important thing is the relationship between entrepreneur and investor. And this is where I have the biggest problem calling a cap a valuation. It can really destroy the bond of trust and leave an entrepreneur feeling screwed. That's just not a good mindset to start a company from.