Capital Efficiency, the less discussed term in startup circles. Often lost in the din of valuations and capital raise.
The Discipline of Finance has evolved based on publicly traded companies with many minority shareholders. This learning is then extrapolated to every other business, assuming that a CEO’s role is to increase business value (manage an outcome). This is not so.
There is a big difference between a listed company and a startup. Startup capital is the crucial driver of growth and value. Capital is usually raised every 18–24 months. Startup entrepreneurs submit themselves to be frequently scrutinized by investors. They must show their skills of managing and monitoring capital deployment; they are using an input, capital. The only metric they have is — efficiency of capital deployment, of well they are using an input. This is something they manage on a month-on-month basis, nearly real-time.
Whereas big company listed CEOs learn skills of deploy capital after they become CEOs. The tools they have, measuring different investments like options, are rarely monitored month on month. Once committed capital is often labeled as a sunk cost. Invisible in the financial reports.
What is Capital Efficiency?
Startups raise capital with a single motive — growth. The use of capital should create revenue (accelerated). Therefore, the metric must connect the capital raised and the revenue created by using the capital.
Capital efficiency is different from Return on Invested Capital (ROIC). ROIC is a metric for assessing “return” on capital allocation to see how much was invested in each business area for incremental returns over time. It is a hindsight measure usually calculated based on “investment in fixed assets and working capital.” This might work for smaller businesses, but investment in assets and working capital has little meaning in a startup.
Startups also differ in another fundamental way from established businesses. Startups measure the efficiency of capital deployment with metrics in the customer funnel before revenue is earned; management of the customer journey from interest to revenue (depicted below). Large companies (unless they are digitally evolved) rarely track funnel metrics.
The real measure of capital efficiency is ROIIC — Return on Incremental Invested Capital. A founder (and investor) wants to assess the return on incremental invested capital (ROIIC) quarter by quarter regarding sales/customer/user growth. Founders also need startup metrics to dynamically manage their capital allocation, not for a hindsight annual analysis.
ROIIC recognizes that sunk costs are irrelevant. What matters is the relationship between incremental performance/earnings and incremental investments.
Warren buffet brings it all together: “for every dollar retained by the corporation, must create one dollar of market value for owners.”
Why does something so simple get lost in the “noise” of the startup world?
Valuation is a measure of the success of startups that are “similar” to listed businesses. However, startup value on their potential growth rate, with much less emphasis on current financial data. In contrast, established businesses are valued on actual cash flows and a firm reliance on financial data. The valuation of startups is a “negotiation” between investors and entrepreneurs. Valuation of listed companies on traded price.
In this ambiguous environment, startup press overemphasizes the “value” side of the story, and value becomes a “social” measure of startup success. And startup valuation, signaled by capital raised by the startup, has become is becomes a measure of startup success. A company that raises $ 10 million is outwardly better than a company that raises $2.5 million.
The meaning of hype
The amount of capital raised, based on “perceived and negotiated” valuation that is centered on “growth potential” is “hype,” an expectation of what may happen in the future. Two persons can have a diametrically contrasting perception of startup value.
Often venture investors discuss the deals they passed, did not invest in.
Hype or startup “excitement” is assessed as a number. It is = capital raised / current revenue — capital raised as a multiple of revenue. “Hype ratio” — the “value” that investors assign to the company, reflected by their “willingness” to give it capital. It is measured as a multiple of current sales — Capital Raised / ARR (Annual Recurring Revenue). Higher is the multiple (number); it makes the founders feel they have succeeded.
Burn Multiple
An accurate measure that shows what is happening in a startup is Burn Multiple. It is an indicator of the capital being used to generate “incremental” sales. Cash Burn is also a multiple of “new” revenue. Burn multiple is = Net Burn / Net New ARR
Burn Multiple shows the effectiveness (and efficiency) of capital deployment in generating incremental sales. The trend of Burn Multiple can show whether a startup is becoming effective and efficient in generating incremental revenue. Higher is the burn multiple more the startup is using capital to achieve growth. A burn multiple less than one shows that a startup generates higher sales per unit of capital deployed. A decreasing burn multiple suggests a startup uses less capital to generate sales; it is getting better at generating sales. Smaller is the burn multiple better is a startup.
The following table labels a business performance based on the Burn Multiple.
Burn Multiple by startup evolution.
Historical analysis of Burn Multiple is an indicator of how an entrepreneur has been using capital over time.
The Burn Multiple should improve as a startup matures. A seed-stage company might have a Burn Multiple of 3 because it has just started selling (consuming capital as it learns the ropes). After Series A, it might drop to 2. After Series B, the sales team should be operating at scale, with increased efficiency, Burn Multiple should be even better.
Suppose the Burn Multiple is going in the wrong direction as the startup matures. It is an indicator of inefficient sales. Sales are consuming capital. Is the product ready for growth? Is an attempt being made to quicken sales before product-market fit?
Quality of sales revenue is about revenue predictability (how consistent it will be and margins/profitability). If a startup targets a customer segment that lacks the ability to pay, then the selling process will consume capital.
The nature of the customer directly impacts how customers are acquired, the speed of customer acquisition (managing the customer funnel).
A reduction in burn multiple requires managing growth by targeting a reasonable level of growth and courage to give up unprofitable customers to keep burn healthy at the cost of sales.
Entrepreneurs can also continually improve their Burn Multiple by cutting costs. Burn Multiple (mathematically) adjusts to the most recent time period being evaluated (New Burn by Net New ARR).
The Burn Multiple does not care about sunk costs. The capital that has not realized results is not factored in the metric. The Burn Multiple is a measure that shifts the focus of entrepreneurs on what they can do.
Investors use the Burn Multiple trends to understand an entrepreneur’s judgment.
Burn multiple shows how well the burn is being managed. The Hype Ratio is based on how much capital is raised. A “high” Hype Ratio and a “low” Burn Multiple show the entrepreneur's capital raising and capital deploying ability.
