Why Your Capital Efficiency Matters
30 companies became decacorns in 2021.
This number would’ve seemed far-fetched even 6 years ago: in 2015, there were just 9 companies valued at $10 billion or more.
Today though, startup valuations are richer than ever, and what explains this, at least in part, is increasingly available access to capital. Barely two years ago, venture capital firms worldwide poured just under $80 billion into various companies in the opening quarter of 2020. Last year, the global venture funding available to eager founders jumped, surpassing $130 billion in the first quarter for the first time.
For founders, it’s practically a feeding frenzy: there's greater amounts of excess cash and wealth in our society than ever. Of course, you’re not guaranteed it, but you have better odds than ever before. And with so much cash up for grabs, growth-minded companies can now reach Incredible-Hulk-levels of huge by flipping business orthodoxy on its head. We’re speaking about capital efficiency, or the ratio of how much money a start-up spends to grow versus how far they get with it (at Headline, we think about this in terms of cumulative cash burn versus annualized gross profit).
Capital Efficiency is No Longer the Nice-Have Metric
These days, upsetting the capital efficient balance is in vogue: You don’t need to be as efficient as possible to achieve growth. Businesses can, in a sense, operate less capital-efficiently because they're valued more for the same traction. Greater valuations mean less dilution for founders–they can raise more and consequently burn more even as they keep the same ownership. Say businesses are able to raise at twice the valuations of a few years ago: A founder can raise and burn twice as much money to get to the same traction and hold the same amount of ownership compared to their peers in the past. In other words, with founders being able to raise at twice the valuation, today's founder could burn $200M to get to $100M of annualized gross profit, whereas the founder in the past could only burn a $100M to end up with the identical ownership.
As a ratio, it works out to a two-to-one margin of capital efficiency: You’re getting one dollar out for every two dollars put in. Over the last couple years, businesses that get huge are worth far more than a billion dollars, which means spending in the name of growth is a smart play—as long as, of course, the business manages to grow.
Not only does the business have to continue growing, but it has to sustain that growth through to the next influx of cash. And in the wake of the recent economic downturn and rising interest rates, getting the next influx will be a more challenging prospect for many — some might even say most — companies. Already, Q1 2022 has been the slowest first quarter for IPOs in the last six years according to a report from Renaissance Capital. To weather leaner times, companies will need to become more capital efficient to sustain their growth through longer periods between fundraises. While the slowdown hasn’t upended the industry just yet, it might only be a matter of time. One early sign is Instacart's valuation being slashed from $39 billion to $24 billion in its latest round.
Upping the Value of Customer Value
Even in the best of times, not every startup is able to finance their way into growth.
For some founders, the metric to be concerned with over capital efficiency in today’s market is comparing the cost of acquiring a customer and the value of that customer over the course of a lifetime.
Think of any subscription-based business that offers monthly and annual sign-ups. For every person who chooses to pick an annual subscription, the company is getting 12 months of future gross profit right up front—money that’s more quickly returned in the form of higher valuations to investors who choose to jump into a financing round.
Blinkist is the perfect example. The company distills the key learnings from tome-like works of nonfiction into easily digestible snippets. And while Blinkist offers monthly subscriptions, its annual deal is priced much lower—enticing more people to sign-up for a year-long subscription. With this model, Blinkist is able to start paying back the money they spend to acquire customers.
A quicker payback cycle means that the same dollars can be reused to acquire more new customers. Ultimately the most efficient businesses are the ones that can pay their customers back within the first month. For example, if a company has instant payback on its customer acquisition dollars and it has $10,000, it could recycle those $10,000 365 times to make an annual budget of $3.65 million. These businesses are able to grow incredibly fast and become, as a by-product, cash-efficient.
While the concept of cash efficiency hasn’t totally been tossed to the wayside, it’s much easier for the founders of today to get mega-growth at more inefficient margins. Just look at the decacorns—given the valuations of companies right now, that makes sense. But these times do come with risk: taking high valuations in a moment of unprecedented capital could lead to flat or down rounds in the future, even as businesses continue to execute. With a host of indicators around the economic downturn, moreover, now might be an even riskier time than ever.