Capital Efficient Vs. Equity Efficient

VC’s (who focus on software companies) often like to describe the companies they back as “capital efficient.”

But I think they should use a new term instead:

“Equity Efficient.” Which I’ll explain below.

First — why does being capital efficient matter? (If you’re a VC, feel free to skim, you know this part).

The reason being a “capital efficient” business matters so much, is because if you invest in a capital-intensive business a couple of things can happen:

(1) The company can need more capital to get to its next inflection point than your fund can afford to invest

(2) You have to make a big investment before you know if anything will even pan out (related to the above)

(3) BUT MOST IMPORTANTLY — you will likely get diluted in future rounds, to the point where even if you were an early investor, the company would require so much capital that you won’t end up seeing a big appreciation in your investment.

Some obvious examples of capital-intensive companies are:

  • Insurance companies — which require significant capital reserves for regulatory purposes
  • Bio-tech companies that require lots of capital to get technology built
  • Pharma companies that may require a lot of capital and runway before their drugs are approved by regulators

But some less obvious examples are companies that either:

  • Require a lot of marketing dollars for growth, because they rely on ad spend as opposed to organic growth/referral growth
  • SaaS companies with long payback periods (that need to invest in sales, and where it takes over 12 months to have received a payback on your money). Having a 5:1 LTV:CAC ratio is only good if you get the money back fast enough to re-invest it, and don’t have to keep raising dilutive equity capital to keep growth up.

But — I think we are entering a new time, where being “Equity Efficient” can be nearly as good as being “Capital Efficient.”

An Equity Efficient company is a business that doesn’t rely on a lot of equity capital to be invested for it to grow quickly.

It may require a lot of capital, but not necessarily equity capital.

Example:

  • Clearbanc is allowing consumer businesses to take out loans to finance their ad spend. This means their equity investors may invest $1.00 for every $3.00 Clearbanc invests in a business. So while the company may require a lot of money, its investors don’t have to suffer much dilution.
  • Lighter Capital and SaaS Capital are starting to fund against SaaS recurring revenue. I bet this trend happens more and more. Such that payback periods begin to matter less for VC’s than they used to, because while these companies may require a lot of money to grow, it won’t be in the form of equity
  • And ICO’s mean formerly expensive opensource dev projects/communuty projects are financed off the balance sheet via foundations and token sales.

The third example is obviously the most unproven, but the point is: as companies stay private longer-their means of being funded will inevitably get more sophisticated.

We can’t keep having multi-hundred million dollar companies, the size of businesses that used to be public, and in many cases companies with obvious product-market fit and real business models, only use preferred equity and venture debt to be funded.

And with more sophisticated capital stacks will come more efficient capital stacks.

And thus, companies that might be CAPITAL INTENSIVE, but are also EQUITY EFFICIENT. And that should be the most important thing.