On Startup Capital Efficiency

Posted on: April 6, 2019Posted in Strategy

There are occasionally news events about a startup being acquired for around the money-in after raising large amounts of venture capital.

One of the conversations around funding that isn’t really ever discussed much from my experience — and I even mean between founders and their investors — is the discussion of capital efficiency and the complex relationships of investor and founder psychology to long term success, startup growth and return on capital.

You don’t need a job at McKinsey to do these basic equations. Capital efficiency either means getting more money / revenue from customers (which leads to higher multiples for efficiency) or spending less.

More specifically, total money burned relative to your variable contribution margin should be low. After I tweeted about this, Jeff Lu from Battery replied with the best analogy on how to think about this I’ve heard: run rate burn is a snapshot, but total burn since the startup’s inception is like a video. I agree: CEOs and founders are effectively resource allocators, and their past capital allocation is the strongest signal of their ability to be efficient in the future if given more.

Every investor reading this agrees. They just don’t encourage this behavior when they talk about investing in your startup. Sure, they want to see a detailed cost model and will evaluate whether you understand how to spend, but conversations about venture capital are about “dreaming big”, and projected revenues drive more exciting conversations than costs. By default, if any investor is going to give you a term sheet, others are ready to as well. It’s much sexier to talk about what big things you can do with the capital.

One of the reasons investors respect founders with fiscal discipline and the ability to do more with less is that during downturns they believe those entrepreneurs will be able to better stay the course. Additionally, both growth and capital efficiency are relatively abundant in isolation, but a company having both attributes is incredibly rare.

If you think I am making this up, capital efficiency is actually Lead Edge’s (Uber, Spotify, Alibaba) most important criterion for investing in companies.

Unfortunately, being capital-efficient is both extremely rare and difficult. Many people say growth is the only important metric, and that’s actually wrong. The reason is simple—only 5% or fewer of startups are growing so fast that efficiency doesn’t really matter. I think there are primarily three reasons that capital discussions tend to be really distorted and startups tend to spend poorly:

Money makes people insane and the temptation to raise and spend more become impalpably strong during markup events. This extends to after the raise, when money in the bank causes much anxiety. For example, if Google and Amazon are coming in to your market, it really messes with founders and they tend to make decisions they regret later out of fear. The reality is these big companies are as schizo as anyone and jump in and out of markets like no one else. Your focus on doing fewer things well is imperative to winning. The bottom line is it’s the precise time that people have money when they tend to naturally justify all the things they can do with it, often completely irrationally. I call poor spending on decisions you can’t back out of ‘Trapdoors’ – wasting money on these can be a near death wish. For example, staffing up a team to work on a new product that will expand burn 1.5x but not lead to contribution margin for the next few years, then cancelling that product team and laying people off. Investors are also to blame. They make you do wacky things (okay, encourage you) around spending money while you have it; and then if you don’t have it later they generally wipe their hands. To be totally clear, an early investor in your company does not get harmed if your company goes to zero. This has nothing to with an investor being malicious; they are not. This is just basic fund math. Investors are generally good people and have some emotional resonance around it all but as soon as the event is over they move on (as they probably should). Lastly, growth capital (Series B onward) has a weird relationship to investor incentives from a psychology perspective. Early investors don’t care if their investment goes to zero (common stock wiped out or returns cents on the dollar) because they are trying to hit a home run. And very late growth-stage investors who get preferred don’t expect a big return (4x is outstanding) but a requirement for their risk profile is they do return cents on the dollar in the case of a “failure”. So if they get $0.70 on their preferred for every $1 invested that is a salvaged investment. This combination (early investors not caring about being wiped out, and late stage investors being okay with getting a crippled return) are why startups are pushed to raise more. Both sides would rather move to the next startup du jour and move on from the investment. The irony here is the next set of smart investors will indeed measure you again later based on capital efficiency.

Obviously you can think about the mandate for capital efficiency at the ‘corner store’ level but that is not the point of this post. You can also do it at the VC and startup scale. Really your requirement as a startup is to return capital for every dollar you accept. In fact this is the general rule of thumb for what you should be thinking about returning:

There are a multitude of reasons why this equation makes rough sense, starting backward from what VCs want. A friend at a top VC firm once told me that his firm does not do series B’s unless partners believe they can get 10x ROIC confidently. 4x at a minimum but a shot at 10x. They would much rather pass and pay more later once it’s closer to obvious that the company has broken out. Some may call this being de-risked.

What this means is if you are raising your series B at $100M valuation, they need to be able to believe you have a legitimate shot at being a $1B unicorn. That particular partner was probably pretty confident he could win deals at that higher price—which is both right and wrong. Once the startup is growing at that rate what people will pay becomes distorted.

The lesson and takeaway is though they don’t lead with it, investors do care about capital efficiency, and the entire video of how your company is doing since inception will be played. And outside of pure growth, capital efficiency is the most powerful leading indicator for whether you are going to be successful in the future. Not enough appreciation these days goes into this simple equation.

I’m particularly fascinated with the misconceptions and psychology that goes into how founders and VCs think about all this. The interplay is complex. Many times it’s all seemingly ignored in decision-making because of the fact that people are not rational emotionally when financing events occur, even though a financing event is supposed to drive a rational price.

Nothing in this post should be construed as against capitalistic forces, anti-venture capital or any such tripe. This is a post about the facts and what really goes on so you can navigate it if you decide to build something and fund it by selling stock to investors who will buy it.

It’s beyond scope here, but there are a number of ways to address and navigate all this. But it all comes down to getting more money from customers or spending less. And although there are ways to spend money more efficiently, only about 5% of Silicon Valley companies try to do so. Being able to do this will become more important if and when there is a downdraft in macro conditions, which will inevitably hit startups harder than capital-returning businesses.