Why Capital Efficiency Matters
One of my first forays into entrepreneurship was a capital inefficient business, and I recently had to drudge up the memories when my son decided it was a good time to ask about what it was like when I was starting out.
It was painful to reflect back on a time where my business spent too much for our scale, invested in the wrong areas, wasn’t profitable, and ran into serious cash issues. Layoffs, debt negotiations, crunching numbers endlessly, counting pennies (literally), sweating payroll, and running to the mailbox every five minutes to see if there were any new customer checks to deposit.
I had always been a bootstrapper, but I emerged from that experience with a new understanding and respect for capital efficiency. From that point forward I developed a deep sense of pride in running a business that balanced spending on growth with profitability. And later when running funded businesses, I maintained that laser focus on making sure we were never spending more than we were making.
My mantra is that I want to earn customers through efficient acquisition, not buy customers through excessive spending. This is hard to do when you are facing funded competitors who seem to be outspending you at every turn.
For any startup, balancing business growth with capital efficiency is a struggle. That struggle has only grown more acute as capital becomes more readily available. The more capital up for grabs, the greater the perceived pressure to raise it, spend it and burn it on growth with little regard for efficiency.
But you can still win while being efficient. And when you do, you can retain more control over your business and be better prepared for the various twists and turns of entrepreneurship.
What is capital efficiency?
When I co-founded my first business I didn’t even know what capital efficiency was.
As a financial layperson, I came to think of it simply as not spending more than the company is making.
Technically speaking, capital efficiency is the ratio of how much a company is spending on growing revenue and how much they're getting in return. For example, if a company is earning one dollar for every dollar spent on growth, it has a 1:1 ratio of capital efficiency. You can also call it the return on capital employed, or ROCE.
At the most basic level, capital efficiency is just a question of how efficiently a company is using its cash to operate and grow.
Why is capital efficiency so important for startups?
That depends on who you talk to. There are plenty of investors and entrepreneurs who don’t regard capital efficiency as important for startup businesses in the early days.
It isn’t like they don’t have examples to point to, either. Many large, successful companies have had tremendous luck with a spend-your-way-into-growth strategy. Hubspot, Salesforce, and Box come to mind.
The problem is, there are also countless companies that have tried that strategy and failed. You just don’t hear about them as much as the ones that succeeded.
There are numerous benefits to building capital efficiency into your startup from the get-go. Here are just a few.
1. It fosters sound decision making.
In my personal experience, capital efficiency forces me to make better business decisions about where to spend. I test and optimize pilot programs to see that they are working before increasing investments.
The constraints of capital efficiency allow me to get creative in finding ways to steadily grow without wasting money.
When doing more with less is a necessity, you’ll force yourself to put better business practices in place. You’ll dip your toe in the water to make sure it’s the right temperature before jumping all the way in and regretting it later.
2. It gives you more control over your business.
Having the right partner to invest in your business and help grow your company fantastic. The flip side is that the bigger the outside investment in your startup, the less control you’ll have. Capital inefficient businesses need to raise more money than efficient ones. When that happens your ownership becomes diluted, and you won’t have nearly as much say in business operations.
By being cautious with your capital, you can retain more control of your business in the long run and give yourself more options for running, scaling, and exiting your business. That can make all the difference when the time comes for a liquidity event. Let’s just be real—an entrepreneur who owns 50% of a $100 million business gets the exact same payout as one who owns 5% of a $1 billion business—and the former is a much more realistic goal.
3. It helps you weather the ups and downs.
When things are going well it’s much easier to be free with spending. But if the unforeseen happens (like a global pandemic) or your business hits a road bump, it’s much easier to navigate problems if you’ve been capital efficient.
if you’ve been burning money you may be faced with deep cuts to budgets, including layoffs and constricting spending to the point that it becomes hard to grow at all. Without having practiced the discipline of growing efficiently your company may not even know how to do so and will be scrambling to figure it out.
4. Inefficient spending probably isn’t worth the extra little bit of growth.
What you give up in terms of profitability and options probably isn’t worth the extra bit of growth. I often find that a major chunk of a given business’ cash burn is spent chasing just 10% more revenue. The company that could grow 80% by spending a reasonable amount, but instead, they spend a much higher sum—only to increase its revenue growth from 80% to 90%.
That’s why I always prefer to help companies maximize their growth without compromising their cash position. I don’t ask, “How quickly can this company grow?” I ask, “How quickly and efficiently can it grow while maintaining efficiency?”
So, how efficient is efficient enough?
There are a wide variety of views on that topic. Ask five entrepreneurs or investors what capital efficiency means to them, and you’ll probably get five different answers.
In many cases, it’s defined as a 1:1 ratio. For every dollar a company is spending on revenue growth, it’s getting a dollar back. That’s still relatively inefficient, though. Many of the companies we work with have a 3:1 ratio—earning three dollars for every one dollar spent on growth.
That said, there's no one-size-fits-all ratio for capital efficiency. It can change based on the details of your business and market. In fact, there are times when it’s possible to be too efficient.
Usually, that happens when a unique marketing opportunity shows up. For example, if your company offers educational software for K-12 students, right now might be a good time to invest in spreading awareness of your product. Even if it appears to reduce your capital efficiency ratio in the short term, you'll likely make up for it with time.
And, not all businesses are created equal. There are industries and business structures that make capital efficiency more complicated. Even in the world of software companies alone, there can be a significant range.
For another example, software marketed to healthcare providers such as hospitals and doctor’s offices can often come with a $1 million+ price tag just for signing up. The catch? Those sales don't usually happen overnight. It can easily be a year before a prospective customer is ready to pay.
A software company in that position might have a low capital efficiency on paper since they’ll probably need to invest heavily in customer acquisition for some time before seeing a return.
So, yes: there are exceptions. But for most entrepreneurs in normal circumstances, I recommend a higher capital efficiency ratio than 1:1.
Put your money to good use, and use it wisely.
Capital efficiency is worth it.
You can debate what the right ratio of capital efficiency should be. What's clear, though, is that most entrepreneurs are better served by being as efficient with their capital as possible. It boosts profitability, builds good business habits, helps you weather storms, and most importantly keeps you in the driver's seat of your company.