Published in the San Diego Union-Tribune, October 3, 2022
by Neil Senturia
The dreaded “D” word. Death, depression, disease, disappointment and the granddaddy of them all — divorce.
But no cigar, the word most feared by the entrepreneur is Dilution. And I would argue that the best other “D” word associated with that choice is Dumb.
Worrying about dilution is a meaningless effort. And finally, there is research to support my thesis. An article by Max Navas, an analyst at Pitchbook, goes into great depth with charts and numbers, but the bottom line is a simple one. “Serial entrepreneurs get pre-money valuations that are 1.9X higher than those of their novice counterparts.” OK, you say, that makes sense, those entrepreneurs are been-there-done-that, but the critical component to consider here is time.
Navas goes on to say, “Serial entrepreneur-led startups get to valuation step-ups and quality institutional investors faster, but it comes at the cost of greater ownership dilution.” This is a no-brainer. I will trade dilution for money and momentum every time. Do not stoop to pick up nickels.
By taking money earlier, by not arguing about the valuation, the serial entrepreneur accelerates his growth, and that is the key metric. Once you are ahead, the lead tends to compound exponentially. It is the flywheel effect at scale. The rich get richer.
The math is compelling. It is always better to have 0.032 percent of Qualcomm than 83 percent of Manny’s deli, no matter how many pastrami sandwiches they sell. This is true for the investor and the entrepreneur. One percent more or less, at an exit of a couple of billion dollars might nominally be a lot of money — but it is a rounding error. You can still buy the jet.
Time is the most powerful element. I am starting a little company (might be big, but right now, it is small), so the seed round is very investor-friendly, low valuation, who cares. If the dog dies, my only job is to clean up the mess. If the dog turns into an elephant, there will be plenty of peanuts to go around.
I am currently a member of NuFund, formerly Tech Coast Angels. In fact, I was one of the first members of the initial TCA in 2000. I quit once but have now come back for one last hurrah. During due diligence, one of the most common reasons that deals get rejected is valuation. The entrepreneur often thinks he has gold coins, but the investors suspect that those really aren’t the keys to Fort Knox.
Why is this so hard for novice entrepreneurs to grasp? Remember, the article says that serial entrepreneurs do better at all stages of financing, and they “own roughly 3 percent less of their businesses than their novice counterparts.” But, chuckleheads, they own a real business, not the walking dead.
The value that the serial entrepreneur brings is that he/she is thinking about a big enough market, with an opportunity at scale such that success is measured in multiple millions, not thousands. Always play the long game and don’t argue about dilution.
Now, one last double fishhook. The serial entrepreneur wants a “name brand investor,” and that means they will have to give away more equity because that same investor knows that his reputation entitles him to more. That name brand signals to others that your company has been blessed by their imprimatur. You can’t buy a Lambo on the cheap, but once behind the wheel, you have a very fast ride.
Finally, the last piece of this flywheel is attracting high-quality talent. As a startup, you have no buzz, no reputation, no brand, so “who you take money from has broad implications,” says Harvard professor, Shai Bernstein. A “cold startup” has difficulty convincing people to work with the firm, and it is also equally hard to convince customers that you will be around long enough to make it worth their while to start the dance.
Heads they win, tails you lose. You may not like this game and its gatekeepers. And while we all have a bit of schadenfreude when a big-time VC deal implodes (Airlift, LendUp, Katerra, Jawbone, the list continues), the real truth is that more often than not, those players keep the wheel spinning because the house wins more often than it loses.
Rule No. 732: You can name the game, just let me sit at the table.