This year will become a great filter for startup survival
Most of us heard the recent news about an upcoming macroeconomic recession, and big consequences for VC investment are imminent. In its recent letter to founders, Y Combinator outlined its vision for the next 9-12 months: Companies should plan for a prolonged decrease in VC funding, cut burn, just stay alive.
Expectations of major deflationary measures have already took a toll on the capital markets and investors are bracing for the next 9-12 months of tighter investment budgets, lower cheques and a whole new way of evaluating new investment prospects.
This means if the investors see your company as lacking success making most out of every dime: you miss the raise.
Just a year ago 9 out of 10 VC meetings would be about growth. Today, 9 out of 10 VC meetings will ask you about how efficient your growth is.
Whether you’re planning to raise this year or just stay alive: you’re steering your venture into the upcoming storm and it is essential you embrace your new North Star: Capital Efficiency.
Get a simple Capital Efficiency Calculator to estimate your key metrics
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. So, how efficiently your business is using 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 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.
- Good sales ratios don’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 solution requires continuous R&D support.
Why is Capital Efficiency so important now
1. Achieving capital efficiency prepares you for the prolonged no-funding phase and recession
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 the upcoming months.
2. Being capital efficient places you at the top of VCs’ investment priorities
A solid track record of sound spending decisions and high capital efficiency is going to be a top priority for VCs’ investment strategies this year. 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 future economic slumps easier. And no matter what stage of the economic cycle, establishing and maintaining strict capital efficiency discipline is a vital element of a sustainable and prolonged growth strategy.
How is Capital Efficiency measured?
As you can guess, Capital Efficiency is a very general concept with lots of potential ways to measure it and a number of other metrics that make up overall Capital Efficiency. But let’s look at the 5 main metrics that investors look at:
1. BVP Multiple
Developed by a leading US VC with over $10B AUM, Bessamer Venture Partners, this simple 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 get a check on 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.
2. The Rule of 40
This widely used metric for software companies is crucial to know if you’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% treshold 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, them being one of your biggest spends, will directly impact your overall Capital Efficiency. Here you’re looking at how much revenue your company gets for every $1 spent on sales and marketing.
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 Multiples
This metric is tied hand in hand with your ARR. Say you set a target ARR, now with 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 a metric that will respond to changes in any area of your business, since anything you do affects your burn.
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. Lowering your CAC, adjusting expenditure and upping margins. Targeting Capital Efficiency, you’re aiming for the Burn Multiple to cross the zero mark as you’re becoming cash positive. Here’s a benchmark to see where you stand:
You should take a look at a calculator we compiled to quickly find out how well you score on the Capital Efficiency Metrics
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.
Even if you’re default dead, it is still better to realise it early on and base your narrative to cater for this metric, as it will be asked by investors seeking Capital Efficiency with their shrinking budgets.
So, if you want to do good in these new times, you should aim for the following:
Showing off your Capital Efficiency
If your business’s got outstanding Capital Efficiency metrics to show off: you certainly should do everything you can to get the message across to the investor that you are good with money.
How do you walk your talk to the investor to show them you know what you’re about. This is a recurring theme within our clients and we’ve collected three great examples 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.
Wrapping up our discussion about Capital Efficiency, what it is and why it’s important, you’re now asking yourself (or even have a definite answer if you used our calculator above): “What do I do? My company is not Capital Efficient!”
If your company scored lower on the mentioned 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. 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 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 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.