In recent years, capital efficiency has become top of mind for both investors and startups. This is all due to the changing investment landscape—where once common sky-high valuations and easy-flowing capital have been substituted by cautious look and lower cheques.
Investors now want to see efficient capital management. They are no longer so easily hooked by the promise of high growth. This means if the investors see your company as lacking success, making the most out of every dime, you miss the raise.
A few years ago, 9 out of 10 VC meetings were about growth. Today, 9 out of 10 VC meetings will ask you how efficient your growth is. Thus, if you want to adjust to a new reality and outperform your competitors, embrace your new North Star—Capital Efficiency.
In this article, we’ll discuss capital efficiency, how to calculate the efficiency ratio (we’ll provide the best efficiency metrics), why this measure is so important nowadays, and how to make your capital cash work more effectively.
What is Capital Efficiency?
Capital Efficiency is a measure of how much your company is spending on growing revenue vs. how much it gets in return. In other words, it shows how efficiently your business uses cash to grow. You can also think about it in terms of Return on Capital Employed (ROCE).
Very often, most of the founders we speak to assume a healthy growth rate equates to capital efficiency. This, unfortunately, couldn’t be further from the truth.
To re-emphasize – capital efficiency is the king of all other measures of business success, and here’s why:
An efficient GTM strategy doesn’t necessarily guarantee capital efficiency when you’re scaling.
A good sales-to-capital ratio doesn’t always mean you’re making efficient use of human capital – thereby being ‘capital efficient.’
Even proof of continuous product-led growth doesn’t mean you’re being capital efficient if your Capex ratio shows you’re sinking too much into ongoing R&D.
How to calculate Capital Efficiency?
As you can guess, Capital Efficiency is a very general concept with lots of potential ways to measure it and a number of other efficiency measures that make up overall Capital Efficiency. But let’s look at the five main efficiency metrics that investors look at:
1. BVP Multiple
Developed by a leading US VC, Bessemer Venture Partners, this simple revenue efficiency metric gives you a general, ‘bird’s eye’ view of your company’s Capital Efficiency. It’s an all-encompassing metric that will always respond to any big problem in your finances. Instead of concentrating on your growth multiples, you want to look at this number to check your business’s spending habits. Your outstanding growth rates actually won’t be properly valued in a bull market (even more so in a bear market) if it took your company unjustified amounts of funding to get where you are now.
Check out the capital efficiency formula with benchmarks below:
2. The Rule of 40
This is a widely used financial efficiency metric for software companies to know if they’re Capital Efficient. Say, your growth margin is high, but excess spending for that growth (and thus Capital Inefficiency) will be reflected in this metric and put you below the sought-after 40% mark. Monitoring this metric is a good way to know how to balance between growth and short-term profitability.
Although it is easy to beat this benchmark in your first years of operation, it is more challenging to keep above the 40% threshold year on year. As your company gets bigger, it will be harder and harder to sustain high growth margins. Figure below from BCG’s research of this metric gives you a good view of that.
3. The Magic Number
Your company’s ability to efficiently run sales and marketing operations, which are one of your biggest expenditures, directly impacts your overall Capital Efficiency. You’re looking at how much revenue your company gets for every $1 spent on sales and marketing.
Here’s the Magic Number, an efficiency ratio formula:
Magic Number > 0.75 shows your company is highly Sales Efficient, contributing to your higher returns per $1 spent. It is also a good indicator that shows how to plan scaling Sales and Marketing.
4. CAC Payback
CAC Payback is a popular metric that shows you how long it will take to earn back your customer acquisition costs
This one’s particularly useful to see whether or not your sales and marketing functions are operating effectively. Actually, breaking down your CAC Payback by region and segment is a great way to isolate money drains in your sales & marketing budgets.
Say you run a healthy growing software company with over 10M in revenue. However, because your calculated CAC payback is over 60 months, the investors are not going to invest in you: to them, your model is not sustainable.
5. Burn Multiple
Especially popular in SaaS, the Burn Multiple metric is tied hand in hand with your ARR. Say you set a target ARR; now, this metric allows you to see how efficiently you’re burning cash to reach that target ARR. It’s a number you update every quarter. Just like the BVP Multiple, it’s an efficiency measure that will respond to changes in any area of your business, since anything you do affects your burn.
If you’re wondering how to calculate Burn Multiple, it’s simple—just use the formula for this efficiency ratio:
Say you burn $50m to add extra $20m to your ARR. Your Burn Multiple is 50/20, or 2.5x.
The younger your company is, the higher your multiple will be. To reduce this ratio, try to lower your CAC, adjust expenditures, and improve margins. As you target Capital Efficiency, aim to lower your Burn Multiple towards one and, eventually, become cash-positive. Here’s a benchmark to see where you stand:
Why is Capital Efficiency so important now?
Regardless of the industry, be it e-commerce, biotech, technology, or SaaS, capital efficiency matters a lot for startups if they want to avoid unnecessary cash burn, scale sustainably, and work in the long run.
1. Achieving capital efficiency prepares you for economic headwinds
Knowing that your business will be able to operate for a certain amount of time (without additional capitalization) gives you a good idea of how and when to scale. It also determines the sense of urgency when it comes to new cash injections. This is a vital tool when planning your company’s financial runway over economic turbulence.
2. Being capital efficient places you at the top of VCs’ priorities for investment
Capital efficiency and a solid track record of sound spending decisions have recently become top priority for VCs’ investment strategies. With lower investment freedom than in the past, investors are almost certainly going to prefer sustainable profit margins over astronomical growth margins. Put simply, VC’s will be urged by their LP’s to go for sustainable profits over growth.
3. Capital efficiency gives your business a solid platform for continued growth
Capital efficiency not only keeps your business afloat through periodic economic downturns, but also provides your business with a framework of flexibility in terms of growth and financing strategies. This makes the task of weathering all the possible economic slumps easier. No matter what stage of the economic cycle, establishing and maintaining strict financial efficiency discipline is a vital element of a sustainable and prolonged growth strategy.
Default Alive or Default Dead?
In the times when Capital Efficiency is king, this is the question you’ll be asking yourself whenever you go near any financial matters of your startup, especially if it’s been operating for less than a year.
What you have to do here is find out if you can reach profitability with your runway. Yes – you’re default alive, No – you’re default dead.
Very few early-stage startups actually know the answer to this question, but very soon the funding landscape will shove founders into constantly monitoring this value.
However, even if you’re default dead, it’s not time to give up. It is still better to realise this early on and devote your efforts to improving your capital efficiency ratio. If you want to raise funding, even though investors’ budgets are shrinking, aim for the following capital efficiency benchmarks:
How to show your Capital Efficiency to investors
If your business has outstanding Capital Efficiency metrics to show off—do it. Do everything possible to show investors you’re smart with money.
But how can I prove my Capital Efficiency to investors? This is a common question we usually get from our clients. That’s why we’ve collected a great example of how to present your Capital Efficiency to investors.
Take a look at a great way to quickly show what that is about:
This slide effectively delivers what’s most important to understand about the company’s capital efficiency. All the important metrics here are at your fingertips, pleasing the eye of a picky investor with a healthy runway and a nearing Default Alive Status. “ARR added” through raises is also a great thing to add to your slides – it’s a good, straight-forward indicator of value generation.
Always keep an eye on your Capital Efficiency
Given changing economic conditions, capital efficiency has taken the front seat, confidently replacing the growth-at-all-costs approach. That’s why more and more founders keep checking if their company is capital efficient.
If your company scored low on the efficiency metrics, it is highly likely you’ve got big inefficiencies in your sales and go-to-market strategies. Some parts of your business simply don’t work as well as they should. However, you’re not doomed. Just focus on how to improve capital efficiency for your business. You might want to try the following:
Start thinking about what measures can be taken within next 3 months to stretch your runway to the maximum
Study the mentioned and other important financial metrics and break them down to identify underperforming segments, regions and teams
Heal your sales funnel and break down your LTV:CAC by channel and region
Study your Go-To-Market inefficiencies: make sure you’ve got scalable unit economics and establish a framework of leading indicators to arm your planning for the next year
Even if your company is Capital Efficient and you think you’re ready for the bump, still make sure to properly present this to your investor.
Do your best to get the message across to the investor: your financial efficiency metrics, how great your company is at squeezing all the juices from every single dollar — you should add all of this to your deck’s narrative and make it the North Star of your financial planning.
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FAQ
What is good capital efficiency?
Good capital efficiency means your company generates strong revenue growth with minimal capital investment. Practically, you’re making every dollar work hard, maintaining positive unit economics and avoiding cash burn.
What is the formula for calculating current capital?
If you want to check your working capital efficiency, here’s the formula:
Current Capital = Current Assets − Current Liabilities
This working capital metric lets you know whether your company has enough money to cover its short-term obligations. If you get a positive number, it means your company has enough assets to cover its liabilities. If the number is negative—your company might struggle to pay its bills.
Which is a measure of the efficiency of an investment?
This metric is the Return on Investment (ROI). It tells you how much profit you make compared to the money you invested.