Launching a successful startup isn’t about getting huge investments, sky-high valuations, or experiencing massive growth. It’s about sustainability.
As a founder, you can’t only be concerned with how your startup does this quarter or this year — you want to be in it for the long haul, either to grow toward a successful exit, IPO, or simply remain a successful private company.
Sustainability is key, and capital efficiency is the mindset for getting there.
What is Capital Efficiency?
Capital efficiency is a set of tools used to compare the money a company makes against how much it spends in a specific period of time. There are several metrics that both investors and founders look at when determining a startup’s capital efficiency. These metrics are a good indication of whether a startup has what it takes to make it in the long run.
Metrics for Measuring Capital Efficiency
Below are several metrics to evaluate your startup’s capital efficiency. Bear in mind that they should be adjusted for a B2B SAAS company and your particular product/service.
The Burn Multiple
The Burn Multiple (net cash burn / net new ARR) measures how much you spend to generate each incremental dollar of ARR. While this can end up shining a spotlight on ugly matters like risk, the high cost of acquisitions, inefficient operations, failing growth strategy, and more, it’s crucial for founders to confront these issues in order to improve and move forward.
Rule of 40
The Rule of 40 is especially important for SAAS companies, and it dictates that investors should only invest in companies with a combined growth rate and free cash flow rate above 40%. The Rule of 40 tells investors the proportion of growth to profitability and whether it’s sustainable.
Venture Capital Efficiency Ratio (VCER)
The Venture Capital Efficiency Ratio divides a company’s exit valuation by total capital raised. The higher the ratio, the more capital efficient the company has been. The VCER is a simple but efficient tool when a company heads toward an IPO to see its ROI and spot areas that need improvement.
Return on Invested Capital (ROIC)
Return on Invested Capital (net operating profit / invested capital) assesses how well a company used its money to generate profits. An ROIC higher than the cost of capital suggests a growing company, whereas an ROIC lower than the cost of capital suggests the company is in trouble.
The CAC Ratio (net new ARR / customer acquisition cost, CAC) is specific to the sales and marketing efficiency of a company. This metric can indicate the strength of the product-market fit, the efficiency of sales/marketing with regard to growth, and more.
Capital Efficiency as a Predictive Factor for Startup Success
Capital efficiency measurements offer a snapshot of how well a company uses its funds to invest in development, sales, marketing, operations, etc. The efficient use of funds has nothing to do with the amount of funding you raise or how much revenue you earn in the first year. It has to do with your ability to use money efficiently in any given time period.
Running your startup with a capital efficiency mindset can help you focus on activities with a high return and promote sustainable growth. It can also steer you toward caution with your capital and help you choose the right investment partner.
How a Reasonable Valuation Can Help You Focus on Capital Efficiency
For many in the VC industry, the higher the valuation of a startup, the better. This, however, hasn’t been our experience.
Sure, it’s a good feeling to get a really high valuation — it means you have the potential to retain more control of your company and get more money. Moreover, it means that important people have a lot of faith in your company.
However, there are downsides to getting a very high valuation in the early stages. These include:
- Incredible pressure
- Harder to raise the next round of funding
- Harder to sell
- Expenses can skyrocket seemingly overnight
Startups that garner reasonable valuations have the benefits of:
- Growing without immense pressure
- Naturally increasing their funding rounds
- Finding appropriate buyers
- Focusing on capital efficiency so they can scale gradually as their expense increase
Remember, fast growth is often unsustainable and a poor indicator of future success. Capital efficiency, on the other hand, promotes fiscal responsibility and strategic thinking, both crucial factors for sustainable success.