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Goldilocks Valuation Matrix
Runway, price, and dilution risk trade-offs in pre-seed valuations
In astronomy there is something called the “Goldilocks Zone” when a planet is optimally distanced from its sun such that the temperature for water can remain liquid. It’s not too hot, and not too cold; it’s just right. In pre-seed valuations there is also a zone that optimally balances runway, price, and dilution risk.
Many myopically focus on valuation only at the pre-seed, and debate it going up and down. The truth is that this is a red herring, and overlooks much of what matters. Valuation is just a function of two things 1) runway that cash can provide an entrepreneur to build and de-risk the business, and 2) the cost of that runway in terms of equity sold, otherwise known as your “dilution.” In other words, venture capital investors who are taking risk buying part of your company have a model that makes their fund math work, and this means they require some amount of “ownership.”
Ownership to the investor, is dilution to the entrepreneur.
As pre-seed rounds price, the post-money valuation is always a bit of friendly tug-of-war between these two counterparties. The founder typically wants to raise more money. The right motivation for more money is that it buys you more time on the same burn rate. Cash raised / Monthly cash burn = Months of runway. More money shouldn’t mean higher wages or more expenditure unless this trade off genuinely de-risks the business. The investor typically also doesn’t mind if the founder raises more money under these circumstances, up until a point. As mentioned, the cost of raising more money is that it costs the company equity, otherwise known as dilution. Beyond around 20% or 25% dilution at the pre-seed a new risk emerges. This is the risk that your cap table becomes imbalanced. You’re taking too much early dilution and this means that the long run incentives become imbalanced. To build a great company the founding team, and employees, must be incentivized, and this is in the form of founder equity (common shares) for the founding team, and an employee stock option pool or ESOP for employees, typically granted in the form of common stock options with a one-year cliff and vesting schedule over four years. If the company takes on too much early dilution by raising too much capital on too low a valuation, this imbalance can manifest itself later in an imbalanced cap table that requires a “recap” that hurts all existing insiders. As such any good early stage investor will not focus exclusively on the startup’s runway and valuation, but rather also the dilutive cost.
On the margin, at Everywhere Ventures we are “valuation-aware, but runway and dilution sensitive.” In other words, we leverage what I call the Goldilocks Valuation Matrix when coaching our founders. The Goldilocks Valuation Matrix takes into account these competing risks to help founders thread the needle by raising enough capital that they can de-risk their business, but not at too low a price that they harm their own cap table by taking too much early dilution, and also not at too high a price that they create a burdensome hurdle rate.
On the cash raised, aka your runway, you need to be able to 2-3x your post money valuation on the next round. So if you’re taking in $1.5M at a $15M valuation you might think that it’s good because, 1) $1.5M of runway is ample, and 2) only taking 10% dilution is maybe at the lower end of what’s possible, but the emergent risk is that building a $30-45M business to 2-3x your $15M post money on only $1.5M of runway is a very tall order. In other words you maybe avoided dilution risk, and are raising a good amount of cash for runway so that’s helping you find product market fit and minimize existential, or survival, risk, but the new risk is price risk. You’ve created price risk for yourself by pricing your valuation too high, and now this is a hurdle rate or price you need to build in excess of, or in multiples of.
We might recommend you 1) either take a bit more dilution and raise more cash at that same price, or 2) lower your valuation, trading off a tiny bit more dilution for the easier future path of 2-3x’ing a lower valuation hurdle. In other words taking in $2M at $13.3M post would cost you another 5% dilution, but gets you an extra $500k of runway and a $1.7M lower valuation hurdle to need to 2-3x. A good investor can think with you along multiple vectors and trade-offs, as every marginal dollar has a dilution cost, and also has the benefit of greater runway and less existential risk, if you’re managing that cash well. Have an open mind about valuation because a good investor isn’t just trying to lower your valuation to own more of your company, they are genuinely trying to thread this needle and set of competing risks with you.
The above matrix is illustrative, not a prescriptive road map for founders. But the trade offs in pre-seed post-money valuations to consider are the following:
Treat dilution as a constant. You’re raising money and you’re going to have to sell somewhere between 10-25% of your business to raise smart money.
Focus on runway. The reason you’re raising money is to buy yourself time to build your business, so treat every dollar as sacred. If you spend a month negotiating a SaaS contract to spend $1k a month, don’t just go hire someone for $10k per month on a few interviews. You only have one shot, so be smart with your cash. Runway is your lifeblood, and is your defense against existential, or survival, risk. For more thoughts on how to manage your burn rate and runway, see this post on making hard decisions early in the OR to avoid ending up in the ER.
Don’t price too high. You might think that pricing up your valuation is smart as it saves you dilution, but the diminished cost of that dilution is the greater challenge of building a company in excess of this valuation “hurdle.” In other words, even if you can get away with a high valuation, you’re setting your own water mark, or line in the sand, and you need to be able to 2-3x your business on the capital you’re raising. Be smart about not pricing yourself too high, because you can get into a horrible rat race with yourself leading to flat and down rounds that come at far greater dilutive (and nasty legal provision) costs to founders.
Don’t dilute too heavily too early. The Goldilocks zone is not pricing yourself too high and also not taking in too much early cash that you dilute yourself too heavily. Above 20% dilution at the pre-seed becomes long-run harder to make the cap table work, so if you’re taking in more cash early you’re buying yourself more runway which is good, but the cost of that is likely a more broken cap table in the long run that might need to be reset, ESOPs topped up, or re-capped. The cost of your capital goes down as your valuation goes up, so if you can de-risk your business at all and take in more cash later, the cost of this capital will be lower. Be conscious of taking in more that 20% dilution, and know what every marginal dollar is going to get you, because it’s also coming at a very hefty dilution cost.
Overall like the English fairy tale warns, the Goldilocks zone isn’t too much and it isn’t too little, but it’s just right. Consider the above trade offs in your pre-seed post-money valuations. Sometimes entrepreneurs have the pricing power to issue their own SAFEs and establish these terms. Other times your investors, especially your lead investor, will set terms for you. But in all things, this is a conversation. Have an open and candid conversation with your investors about these trade-offs, and send them this post. We hope that this framework can serve as a basis for conversation. In pre-seed valuations and pricing there are a tug-of-war of risks and incentives, and no right answers. It’s about having an open dialogue with your investors. If your investors are adversarial or can’t talk to you about this, they’re not good investors. Move on, because we’ve now identified the final and biggest risk: partnership risk. Make sure you’re selecting not just funds, but partners, who you love and will support you. It’s not about them always being friendly, but them being candid, open, and very real.
In summary, the various risks to consider and manage at Pre-Seed are:
Existential, or Survival, Risk: Raise enough money to find product market fit
Price Risk: You’re creating a hurdle rate for yourself with your valuation
Dilution Risk: Don’t take too much too early and kill your cap table
Partnership Risk: Talk about this with your investors. Good ones will listen.
For more thinking about the trade-offs between Existential and Price Risk, see my prior post on the way investors think about these changing risks from Seed to Growth.
Special thanks to Kelli Fontaine of Cendana Capital, Neha Khera of 2048, and Alicja Siekierska of Yahoo! for helping me crystalize these thoughts at Collision 2023.
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