What Is Capital Efficiency And Why Is It Important?

The Mythical SaaS Unicorn

I saw this t-shirt the other day while walking down the street in the SOMA area of San Francisco early on a weekday afternoon: “Unicorns are lame — said no one ever…”

In this case we’re referring to those companies that have valuations in excess of $1 Billion. A count in mid-2015 put this at over 80 companies. 80.

While I don’t disagree that unicorns are amazing and elusive creatures, it’s getting to be a bit of a bear market for these beasts.

And the tides are shifting. Starting in the last quarter of 2015 there was an obvious withdraw in the valuations of SaaS companies across the board. Before this many companies commanded a 10x (or more) multiple on their valuations, only to see this be cut down to a 2–3x or less. This resulted in a hard hard look at the bottom line. The burn rates that were sustained to date simply were no longer possible

Added to this, much of the later stage capital that was used to fuel the burns of these unicorns was taken from mutual funds which are in fact regulated and regularly audited. And when they were — the valuations of these companies began to drop. This opened up increased scrutiny of where the money was going.

As a result we are now seeing a clearing of the market of the less fungible businesses which will require those companies that are sound to weather the coming quarters with more focus on efficiency in how they deploy financial resources.

Enter capital efficiency.

Capital efficiency is the ratio between dollar expenses incurred by a company and dollars that are spent to make a product or service. This can also be explained as the ROCE (Return on Capital Employed) or the ratio between EBIT (Earnings Before Interest and Tax) over Capital Employed. If the acronyms made you doze off, this generally shows how efficiently a company is deploying it’s cash in its operation.

Why is this important?

With a constriction in and higher scrutiny in Venture and Limited Partner markets, this is the metric to look at because the more efficiently capital is used to produce a product or service, the better chance a company has for approaching profitability. Profitability = returns for investors.

Nearly all small to medium size companies today are faced with the reality of this situation. If you are approaching profitability, you need to make your money in the bank go further. If you are profitable, you need to protect your income and become more efficient in its use to ensure you can continue to scale.

This translates to optimization in several key areas:

1. Transformation of architecture to allow for efficient supportability and scalability. — You’ve built a product, you’ve tested the scenarios and quickly iterated to get to product market fit. You are ready to scale, yet you’ve neglected your technology a bit in the process. Scale requires repeatable process and supportable code. How do you simplify your technology for scale?
2. Optimizing teams for distribution and performance. — Everything has been local in the same shop and now you simply need more horsepower but you know you can’t afford to clone your core team and be limited to one location. How do you scale your team globally and ensure they are performant?
3. Reduction in fixed costs. Fixed recurring costs are the killer of capital. If you have them, you know you need to identify exactly what they are now and what they will be in the mid-term and implement plans to reduce them. These are tough and necessary decisions, but where do you start?
4. Increase iterative capability. You need to do all of the above while becoming even better at iterating on product ideas relative to core value proposition and their translation into tangible engineering deliverables. How do you improve on your product-engineering delivery process?

The world has fundamentally changed and it’s important not to allow ego to bias decisions moving ahead. There will be major changes in valuations, down rounds, reduction in exits, offers of bad term sheets, and increased rate of failure. These are realities we all need to contend with. Sticking to the facts and keeping a keen eye on the key metrics that point to success and a finger on the pulse of the human component to your business will be critical to those that succeed.

Read more by Zach: zachsherry.net