The Long Lost Myth of Capital Efficiency

I miss capital efficiency. It seems like you were our best friend just yesterday.

Were you a myth? A lie? A justification by VCs to explain away their lack of capital to invest? A rationalization by entrepreneurs to explain away their inability to raise capital?

Do you remember all the blog posts about how companies needed so much less money? All the articles about how capital efficient businesses were a result of AWS, better software development tools, easier starting points, better scaling technologies, and lots of other things.

Do you remember when it was “all software, all the time?” There was no discussion of hardware, or any need to build hardware companies. Internet of Things wasn’t yet a buzzword. If you had any notion of manufacturing in your business VCs would immediately say “you can’t build scale and value like a software-only company.”

This was all just five years ago. Oh how things change.

Was it just bullshit? Or is it actually a parallel universe of happiness?

I’m going to assert it’s a parallel universe of happiness based on the successful companies in our portfolio that I would categories as capital efficient. We have a bunch of them. And we’ve learned that it is a lot easier to make a 10x return on capital on a company that has only raised $10m then it is to make a 10x return on capital when a company has raised $100m.

And we like that. We aren’t afraid of going for a 10x (or more) return of capital on companies that have raised a lot more money, but when a company can become cash flow positive on a small amount of capital (say $5m – $10m) and grow over 100% year-over-year without raising another nickel of equity, well that’s a silent killer.

If you want a few more discussions about this, I did a quick search on “venture capital capital efficiency” and came up with:

Seems like our little corner of the universe might need an episode of Mythbusters.

  • DaveJ

    Probably I’m not your target audience but I was not able to pierce through the sardonic tone and understand your point. Has there been a move away from “capital efficient” companies?

    • There has been a massive move away from capital efficiency. The new excitement is “becoming a unicorn” and “raising a ton of money.”

      • I always wonder raising a ton of money should be build on some basis right? Right? or am I missing something?

        • It should and it is. Some of the time. But a lot of time it isn’t.

          • well, I have never had the luxury of not having capital efficiency so I would not know. It has always been hustle, bootstrap and do what it takes to see another day.

        • J franta

          absolutely true it takes less capital than ever to launch a company. Note that VCs self-marketing cycles oscilate between hippyish optimism (we’re all going to start companies with $0 someday!!) and then scale these statements back to things they can actually make money on. Everybody bootstrapping on AWS, this is sexy to hippys but less so to VCs. pushing growth over cash flow companies is sexy, because as a VC you have a bigger pipeline. This thinking was rewarded to some extent because goog/fb and the like acquihired a lot of the growth companies, and then facebook’s and now twitter’ss IPOs finally went positive which gave unicorn investors more confidence. It sort of reminds me of the other posts going around about how now how cashflow businesses get referred to as lifestyle businesses. Cashflow businesses don’t need to fill an investment pipeline or pitch their book, but they also tend not to be billionaires with lots of free time on twitter… “not that there’s anything wrong with that.” 🙂

      • DaveJ

        Thank you.

        This is consistent with my sense that there is too much capital – not just in venture capital, but everywhere. I remember the trend toward bigger rounds and deals back in the late bubble days because there was just too much capital and “nowhere to put it.”

        Is it “irony” that they actually use the term “unicorn” as a strategy? “We are looking for the kind of companies that are not a real thing.”

        • Yes – that is irony. I will use that in my post about Dragicorns that is coming up.

          • ha! will look forward to see the ‘Dragicorn’ post.
            Dane Stangler, VP here at the Kauffman Foundation, got a really funny post on ‘entrepreneurial zoology’

            https://medium.com/@danestangler/entrepreneurial-zoology-6eb8f7fe0a9a

          • Jeremy Riley

            “Dragicorns” I belive that is my new favorite term for anything ever. Not to overexpose my impeccable nerdism but that just took me back to my youth and spending endless hours running D&D campaigns. Thank you. I needed that.

          • Any chance I can make a sideways D&D reference is a good moment.

          • A plant engineer I know uses the term – “As rare as rocking horse shit!” – I find it somehow picturesque and the meaning unmistakeable.

  • Building companies with first principles and foundations are a good thing irrespective of whether capital is cheap or not. We had to learn this the hard way in Iceland and I guess everyone did when it was difficult to raise money. I like the difficulty party, it weeds out the bad from the good. It was a natural filter that built the right entrepreneurial muscles and the hustles. Capital efficiency should be a founding principle. Of course all this depends on the scale, early stage read Product/Founder to Market fit companies rarely need a lot of capital. I like those teams, you see the real struggle, the real hustle…

    • I always naturally err toward capital efficiency also. I think it’s because I blew up so much money in 2001 and 2002. And, I’m a bootstrapper at heart since that’s how we ran my first company.

    • Weeds out – a natural filter that built the right entrepreneurial muscles and the hustles! – Love it

      • Thank you James, call me old fashioned but I see the hustle as probably one of the best indicators of a successful founder. It can be learnt and you are not born with it just like all the muscles in our body, if we don’t work it they atrophy.

  • This is almost certainly tied to the macroeconomic cycle. I would hazard a guess that once Yellen starts raising rates, this behavior will become less efficient, eventually bankrupting those who’ve made poor bets. The question is what happens to prudent VC firms that have maintained efficiency in the meantime. Will they be able to survive until then?

    • Only time will tell.

      • If due diligence and prudence, or compliance and prudence, or weighing options and prudence are related – it is hard to figure out how non-prudence can have an expected positive outcome except under transitory inefficient market conditions.

        So yes – time will tell !

        • There are two parts to this: investor prudence and startup prudence.

          My hypothesis is that there is currently severe investor imprudence due to cheap money from quantitative easing and general easy funding. That does not necessarily mean that the startups themselves will become imprudent and pursue bad ideas (although it is possible and we are seeing some evidence of that in the markets).

          However, the question I’m raising is: What happens to startups who are making good decisions (i.e. building great product, achieving product-market fit, etc.) that are raising money in the current environment? If they become overly attracted by the money and go to VC firms that are investing imprudently, it’s possible that the prudent VC firms will have simply missed out on opportunities to invest during this frothy market period. Because of the nature of the time value of money and the dynamics of fund vintages, prudent VC firms could be damaged despite refraining from making imprudent decisions.

          • Ok Got it. Yes being attracted to take too much money (leading to profligacy and down rounds) will hurt less prudent VC and less prudent equity alike. The outcome on the better in both cases should be that they outperform – but will have lower volumes of deal flow / be necessarily more selective but good deals are still better, Outlier good performance will remain just that and Funds attracted to outliers (who simply went big and got lucky) will get burned. That is the nature of imprudence.

    • prudent : acting with or showing care and thought for the future.

      Tell me how anyone cannot invest without prudence – yes you can gamble without prudence, and yes you can avoid all risk (and return) but that is also not prudence.

      By definition ONLY prudent Ventures are good ventures. But also outliers good and bad will be non-prudent (but impossible to spot a-priori)

      IM (not so) HO

  • It’s also the education at the bottom of the industry (for example poor accelerators) that have a “cause” and “effect” relationship to capital disbursement.. The attitude is go big or go bust (and go lite with a mobile app), and sadly sometimes an honest entrepreneur who clearly knows he isn’t riding a unicorn is brushed aside for the flashy same t-shirt wearing unicorn wannabes. Fundamentally I think innovators will need to spend money and differentiate their products, so the amounts just depend on the products of the ‘times’.

    • It’s all a continuous cycle. No one knows the lengths, heights, or depths in advance. That’s part of the “fun” of it.

  • Brad, I’m curious if you have any perspectives on the book “EARLY EXITS” by Basil Peter? I’m hearing some chatter about it locally.

    • Some things about it are great. Others are not so great. It’s worth reading but recognize that it’s only one perspective and not absolute truth.

      • Thanks. I agree 100%. It seems like the capital strategy is derived in response to an assessment of the market the business is addressing, the state of the business, the strategy of the competitors, and the motives of the owners. I believe the market and business strategies are the most important influences.

  • I hear ya and you are preaching to the choir here. But there are certain things in perception we need to align with reality. Cost of infrastructure and tools went down. But other operating costs are up and sharply.
    Let’s take Boston and top 3 costs in ascending order:

    * Health insurance – per employee I would run about 50% more now for bottom barrel HMO, but then I stand zero chance attracting folks who care about it, so I have to have decent HMO and now it costs me 2-3X what it did in 2010. I was really surprised to see only like 5% increase in costs last year. Usually I see high teens %. And even invincible 20-somethings, once they are off their parents’ insurance (which is nice cost saver for a short while), they are going to be mighty pissed, if you try to put them in high deductible HMO.

    * 5 years ago I could get space in Kendall Square for less than $20PSF. Today $60PSF will not get you anything. Downtown Boston, where we are, 5 years ago was somewhere in teens PSF, not without mid 30s or even 40s you won’t get so so space. Gone are the days of landlord-financed improvements, so that is out of your pocket. You can tell me to move to Waltham or somewhere like that. Sure. Then my talent pool drops to almost nothing and now I am competing with large companies and deep pockets.

    * I pity folks on the West Coast, because market there is beyond unsustainable. Boston salaries are up every year more than 10%. And you have to look at costs of other benefits. Burning up your employees with 100-hour weeks is not only shortsighted, but also gets you some of the buggiest product possible, so you need to have proper team. And in B2B there is certain expectation of the quality of even Beta. MVP is cute dream and maybe achievable, as envisioned, but in B2C. So again, you need to put in proper product development investment before you can land that MRR. Such is life. We deal.

    So when we add all of this up, you are left with maybe 25% of your total burn left to optimize. If you are really frugal, you are more like 10% left to optimize. Not much to work with.

    We all find compromises and having investor, who is aligning with your success metrics, truly helps. Then both of us are chasing same goal.

    • RBC

      Well thought out and elaborated comment! The reason I go into the comments section every day 🙂

  • Goodness gracious. This make you sound very smart doesn’t it? Ooooh, capital efficiency, what an important sounding term!

    As usual, with respect, I call revisionism. What happened was the VCs were facing the financial crisis just like all of us. This meant they were having trouble raising their multi hundred million dollar funds. So most (before making investments) figured out that software companies don’t require much capital to get off the ground and that makes those 10xs a lot easier so they jettisoned looking at hardware companies.

    I rolled my eyes then when they used flowery language to deflect this. I’m just shaking my head now listening to how you describe it.

    • Except for there are wonderful examples of very successful
      Companies that haven’t raised much money.

      And I think you kissed some of my sarcasm in the post.

  • I love this, Brad. Thank you for sharing it.

    I think it is like an availability heuristic/survivor bias thing: we hear mostly about companies raising bunches of capital because they make for good headlines. The sexy stories get more airtime in the media precisely because they are sexy. “Silent killers,” by definition, do not. They are silent.

    So most folks go by thinking truly successful entrepreneurs look like the ones they see on the news. Except they mostly don’t.

  • Jeremy Riley

    I certainly can’t claim any amount of expertise in this field but I do wonder if the cycle that we have experienced here in the US has been mirrored in the overall world economy. What I mean is if we find equity financing here shifting away from manufacturing would other economies throughout the world find themselves in an opposite shift to fill the void created here. I know that many other countries are experiencing rapid growth in their manufacturing. I wonder how much of that is driven by foreign equity financiers and what ROIs are they receiving.

    • Not sure I can be definitive, but I tried comparing average seed round sizes and growth between US and Europe and saw eye watering differences.

      If a spotty youth (sorry whoever you are) with a bunch of enthusiasm, some engineering and a bit of chutzpah is worth crazy salaries for his team and wildly expensive office space is not my concern.

      However, that it is more capital efficient to compete in less competitive markets, stay modest until something is selling, and ideally growing with a business model, must be beyond doubt.

      So your thesis about diversification exhibiting a complementary pendulum pattern (for want of another analogy) probably has merit

      If viable investment theses suggest to invest where others do not, be different, spot the mavericks, then surely going somewhere where people routinely pay OTT for mediocre talent is plain head-up-your-ass dumb.

      Recent blogs on AVC, referencing old school traditional industry disruption acknowledge that domain knowledge and “growth hacking” are for example different. For one type of asset, the scarce one – the diamond – sometimes you need to look deep in the rough.

      I am not an investor (except in myself and team), but when I started up I moved to where UNTAPPED talent was (and for me it was not london or SV but to find a few smart guys I knew about in the middle of nowhere

  • RBC

    OT @bfeld:disqus do you see an impact from matermark in your traffic via analytics? Their newsletter is v well done, and regularly highlights you and some other very helpful resources (I’ve been digging the ones on hiring lately!).

    • Yup – plenty of traffic to the blog from it.

  • kermit64113

    Brad, do you have any thoughts on Andy Rubin’s start-up (Playground Global)? Looks like they raised $48 million from local folks (talk about parallel universe). More of an IdeaLab for hardware, right? – Jim Patterson

  • Mahendra R

    Brad – {begin smartass sarcasm} The best way for you to “get over this capital efficiency flu” is to follow this 5 step process:
    (a) First inflate your ego by a large factor – 10X is a good number. 100X is better. This may be harder for your DNA but it has worked very well for a large population of VCs (b) Use the word “Unicorn” in every 4th sentence (c) Remind your LPs that new innovation will lead to trillions of value creation. Guessing you have heard of that buzz – Internet of Trillions? (d) Rai$e your next fund in the order of $2.25 bn. (e) Make very large $150m investments in exotic companies. Encourage “burn” and “world dominance” with equal enthusiasm. After all, like all entrepreneurs, VCs should go big or go home. {end sarcasm}. Seriously, thanks for another wonderful + thoughtful post. A few of us miss the near-extinct species called frugal entrepreneurs. May their (and your) tribe increase!

    • i hate the word unicorn. hate, hate, hate it

      • Whats not to love???

        • it trivializes the process of building a great company

          • Mahendra R

            Fred – And wait, there is a new word / animal in the mix – its called the “White Lion”. Welcome to the zoo!. Building a great company is now akin to spotting an exotic animal. It’s totally random and really has nothing to do with teams / investors and such. Next up = Sasquatch / Big Foot.

          • exactly! you expressed what i was having trouble expressing. it is such a shitty word for this

  • oh, what a great topic. i’ve held onto capital efficiency and it’s now massively out of favor in our business. but i’m not giving up on it.

    i heard a very successful and well known VC say a few weeks ago “we are shocked at the capital intensity of this sector” and that sector was all software, not one ounce of hardware in it.

    i think entrepreneurs and VCs believe they can win a market with money so they raise a war chest, and that tends to force everyone else in the market to do the same

    i think its best to avoid playing that game. win the market with a better product, a better go to market strategy, a better business model, and a weaker balance sheet.

    at least that’s what i preach. and what i believe

  • Bernard Desarnauts

    Brad – what happened to your silent killers of 2011? where are they now in the aggregate?

    • All are doing great. One of them – Gnip – was acquired by Twitter and was a 10x return for us. Another one – Sympoz – completely dominates its market. And the others probably are happy not to be named as they continue on killing silently…

      • 🙂

      • Bernard Desarnauts

        you should write a book on those. they’re the right/true models for all of us aspiring entrepreneurs

  • Joah Spearman

    Brad, come down to Austin where capital efficiency is still alive and well and not just here at Localeur, but at many of the startups in this city.

    • Praise to Austin! I love what a bunch of yall are doing there. We were investors in the very capital efficient Spanning Cloud and Jason Seats is a star in my world.

      • Joah Spearman

        With Austin Ventures gone, it will be interesting to see if out of town VCs care about capital efficiency for Austin startups or if they’ll be as loose with it as they appear to be with startups in SF.

  • Brad, I think capital efficiency is a must for certain markets that are seeing a lot of innovation like Florida. Necessity is the mother of invention. It is really tough to raise big rounds in Florida so you have to be capital efficient and work hard at making sure your customers are your investors. Definitely a different model from the silicon valley raise huge rounds model. As an entrepreneur, I favor the efficient capital model also, makes you more focused. I think it also provides a customer centric focus since you have to monetize early on.