Capital efficiency

I met a friend and fellow investor for breakfast last week and the topic of capital efficiency came up. In the current economic cycle - where venture capital investment seems to flow like water - old fashioned considerations like capital efficiency may sound like foreign concepts, but they remain fundamental to building sustainable and enduring businesses. In the early stages of a business, one way to measure capital efficiency is revenue generated by the business versus paid-in-capital. Paid-in-capital, otherwise known as contributed or invested capital, is the capital contributed to a corporation through the purchase of stock from the corporation. (Capital invested via secondary sales that buy out prior investors or employees would be excluded from a paid-in-capital calculation.) Comparing revenue to paid-in-capital measures how efficiently the team has used the capital investors have given them and how quickly they’ve recouped it for the business. On a fundamental level, capital efficiency is a leading indicator of how well entrepreneurs invest money and how far they make each dollar go.

Capital efficiency in the early days looks differently than capital efficiency at growth stages of a business. Many businesses burn a lot of capital on R&D before generating any revenue. Others are able to turn a small seed round into revenue worth multiples of paid-in-capital. There is no “right answer” since every company grows and evolves differently, but we recently committed to invest in an enterprise software business that generates 2.2x the paid-in-capital in annual recurring revenue and I gotta say - it feels good. I have a high degree of confidence this management team is going to be prudent with the capital we invest and do their best to maximize our return. In the current environment, it seems like the slightest bit of promise often results in oodles of dollars flowing into a given business. Some of these businesses haven't found product-market fit. And for those that have, many of them will reach a natural point of diminishing returns where each dollar invested returns less either because the model reaches peak scale or complexity of growth results in less efficient investment. With the amount of money chasing deals and the size of early stage funding rounds we're seeing today, I think we will see many cases of early signs of promise attracting large amounts of capital that proves overly exuberant and never materializes into lasting revenues. Bill Gurley makes the point in this article that “it’s almost tautologically easier to execute a company that loses money than one that’s profitable.” I would take it one step further and say there are cases in today’s climate where it's easier to fundraise and focus on product while postponing any real focus on sales growth or revenue. As we know, in certain consumer-facing businesses that rely on massive networks of users, this may be an okay strategy, but for most businesses with a product in market, it’s not.

In the spreadsheet attached, I assembled capital efficiency ratios (as defined above) on eight companies in my universe - data is anonymized the protect the innocent. As you’ll see, they’re ranked by years in business. Thankfully, the most mature businesses in my universe are also generating the most revenue relative to capital invested. After that, the numbers are all over the map. Bear in mind, I am extremely bullish on all these businesses (but not necessarily in control of how much money they raise nor broader market dynamics). The outlier here is the company at the bottom, which is both the youngest and among the most capital efficient. That’s the company in which we recently committed to invest and we’re excited about that.