How do we assess capital efficiency at the early stage?
Capital efficiency is a key focus of ours at D2 (and increasingly all other venture investors). The metrics to assess it at the growth stage are well covered elsewhere, but there remains a challenge as to how to look at early stage startups. These companies typically don’t have the operating history to make burn multiple, cash conversion scores and other growth metrics relevant. Instead, when assessing the capital efficiency of an early stage company, we look at three lenses which mix quantitative output, with qualitative intent and potential. Let’s dig in
Lens 1: The Ratio
The first lens we apply, and the most simplistic, is outcome based. The ratio we use to benchmark capital efficiency is:
Total Equity Capital Raised to Date / Current ARR = Efficiency Ratio
The lower the ratio, the more efficient the business has been in getting revenue traction. Bootstrapped businesses carry a ratio of 0, which is the most efficient possible outcome. Any company with a ratio <2x is efficient and a ratio of <1x we deem as highly efficient. The ratio is most relevant once a business has gained meaningful revenue traction of >£500k, and its significance as a metric grows as the company scales.
Some admittedly obvious points are worth emphasising on the efficiency ratio. Firstly it makes no comment on the future potential of that business. Just because a company has been efficient to date, does not mean it will continue to be so. Equally, it does not automatically make a company a good investment.
We believe strongly that unless you’re sending a rocket into space or curing cancer, it’s possible to build your business in a capital efficient manner. Despite that, bootstrapping the early stages of a business can sometimes be the preserve of the privileged. Many founders do not have savings to draw down, a partner working in a role that can support them both, or their parents’ garage to save rent in. As a result, it’s often simply not practical to bootstrap, and an early raise is necessary to get things up and running. There is a big difference between that type of raise though, and the >$5M pre-seed round to get onto the front page of TechCrunch.
Lens 2: The Business
Business Model
Capital efficient tech companies have been built in every conceivable vertical with a wide variety of different business models (check out some of our case studies here). In general though, companies which have a recurring revenue model will find it easier to be capital efficient than those that sell one-off products. Compounding is a powerful force.
Within recurring revenue business models, some approaches are innately more efficient than others though. Ideally, companies are able to charge upfront for a full year of services — this creates a positive working capital cycle that allows the business to use revenue to fund product development and more sales/marketing, which creates more sales, and so on. Billing in arrears is unavoidable in some cases but can create a much larger funding requirement for early stage companies in growth mode.
If a company is servicing enterprise customers it’s likely there will be customisation work required — the most efficient startups are able to charge for this such that they at least cover time-writing costs. Un-funded customisation work is a slippery slope for any business.
Other pricing terms can have different implications depending on the business. For example, some businesses structure multi-year contracts and deeply embed their solution into their customers’ tech stack. This can help mitigate churn but can have some unintended downsides. Veeva famously only sells annual contracts to avoid having to offer preferential terms to any customer to secure longer contracts. The annual contract duration also gives them frequent opportunities to upsell existing customers onto new products each time their contract came up for renewal. Others can structure contracts for up to ten years, creating a certainty around baseline revenue that dramatically improves planning accuracy. Contract durations and upsell strategies can have nuanced impacts on different companies so there isn’t a single best approach here.
Services Component
The standard venture industry mantra is that professional services are a poor revenue model — they’re people intensive so they scale linearly with headcount meaning there is no operational leverage. Whilst that’s a valid concern, a services element to a business can be powerful. Some of the most efficient companies we have met and invested in started with a services/consulting business and then moved progressively towards a product based growth strategy. Many more companies start out with a ‘mechanical turk’ version of their product which is at its core a services offering with a tech wrapper that gives the illusion of a product. A services element allows you to bring in cash early on, build relationships with customers and validate your product build in realtime. This is especially valuable for ‘deeptech’ or more technical products that require the customer to be brought along on an education journey prior to purchase.
At scale, a services element can also be an advantage, especially when serving enterprise customers. Having an additional chargeable customer success function or services component that brings the best out of your product can be extremely powerful. It keeps startups close to their customers and provides a constant feedback loop. It also makes the product itself more sticky — it’s harder for any pure product competitor to come and displace you and it ensures your customers are always getting the most out of your product.
G2M Strategy
As important as the business model itself, is the target segment the startup is going after. Enterprise strategies can be highly lucrative but carry the risk that the startup ‘dies in the waiting room’ of a lengthy procurement process, or requires substantial investment to bridge that risk.
A common successful strategy is for companies to target mid market customers initially and then to progressively move up market as they build out their product feature set. Mid market accounts convert more rapidly than enterprise and typically require less features or customisation work. Purchasing decisions at mid market companies usually sit with the business unit manager or senior executive vs. the multi-stage process involving business unit, procurement teams and committee sign off that characterises enterprise sales.
We also look closely at the contract value vs. customer size. A common trap we see startups falling into is the ‘small ACV / large customer’ chasm. Pilots are one thing, but if a startup is selling a small ACV into a very large account, it will be incredibly challenging to scale the business efficiently. There’s been some helpful work done by Mosaic on matching sales process with contract value here.
From a metrics standpoint, it’s often too early to assess Net Dollar Retention (NDR) and Customer Acquisition Cost (CAC) payback, but we look for early positive signals. These can include customers expanding their deals during their contract, or, where there is volume based pricing, moving into higher paying tiers. A common hallmark of an efficient business is that they seek to stay incredibly close to their existing customers and their needs, possibly at the near term expense of new logos. We assess this qualitatively with reference calls but wherever possible quantitatively (e.g. NPS).
Across the board we pay close attention to the sales efficiency of young businesses. In the early days founder led sales and other sales activities that ‘don’t scale’ are necessary. However, thoughtful companies will still be actively thinking through the ACV of each potential customer segment and will adjust their G2M strategy accordingly.
How much is enough?
A key facet of efficient businesses is that they seek to get to revenue quickly. In some cases that may necessitate a ‘mechanical turk’ approach as described above. Universally though we find that efficient businesses have mastered the old adage that ‘perfect is the enemy of good’; their early revenue generating products are often a long way short of where they could be but they consciously chose to get to market quickly and iterate with customers rather than create a flawless product without the constant feedback loop of the market.
Closely related to the speed of MVP production, is the strategic decision on what parts of the value chain a startup needs to own, and where it can partner with or leverage existing products. Veeva’s $2bn revenue a year business was initially built entirely on top of the salesforce ecosystem and adjusted for the life sciences industry. ‘Owning your tech’ is common start-up gospel, but every company should think deeply about what it is in the business of doing — do that well, and partner with the best in class elsewhere in the value chain to help deliver it. In the early stages, it is also radically cheaper and faster to use and adjust existing tech wherever possible vs. building everything in-house from scratch. That in turn lowers the capital required to get to market and accelerates feedback loops.
Timing
Sectors ebb and flow in their popularity. Rewind a few years ago and legaltech was hot, now it’s not. Fintech has lost its crown and now all investors are crushing towards AI. Being in a hot or cold sector from a VC trends standpoint is meaningless to a founder’s ability to build an efficient business, but they do create different challenges. Hot sectors will test a founder’s resolve to stay efficient. When every other company in their sector is raising mega rounds and the threat of competition appears to loom large, only the strongest founders are able to stay focused on their business and resist the temptation to follow the herd. Conversely companies in cold sectors have the advantage that the noise disappears from their space, allowing them to get their heads down, ship and sell. Here though self doubt and envy can creep in — it’s hard to build in a space that nobody seemingly cares about or dropped in favour of the next hype cycle. The best founders that have a deep calling to their sector will power through both environments.
Lens 3: The Founders
The third lens we apply, and arguably the most important, is on the founders themselves. The type of company the founder(s) wants to build sets the tone for the entire business.
We actively avoid ‘dinner party founders’ — the founders for whom building a venture backed startup is a social calling card. These individuals tend to measure their success by the paper value of their business and by the quantum of VC dollars they have raised. Many set out to create ‘a venture backed startup’ at the outset rather than solve a problem or build a business. Rarely in our opinion does this ethos lead to a sustainable and durable company down the track.
We are drawn to founders who obsess about their customers rather than their investors; people who want to create a real business and for whom external funding is a means to get to self-sufficiency versus a springboard to a quick exit. Key to that mindset is the desire to earn revenue as fast as possible and a fanatical level of resourcefulness.
The ideal founder has a keen understanding over all aspects of their business; they think carefully about the possible return on investment of every dollar deployed. They understand the cost of capital and seek to raise what they need to hit the next milestone, rather than what they can get away with or what the market feels they should take. This depth of thought and maturity are traits more common among second time founders but can be found at any age and in individuals of any background.
For early stage opportunities, we index towards companies where the founders have the ability to create at least a minimum viable product themselves and/or who can then lead the sales efforts to distribute it. We’ve backed teams of two in the past who are able to get to high six figures of revenue before they need a single other team member.
Building an efficient tech startup is a choice, but it’s not for the faint hearted. Raising lots of venture early on is a comfort blanket — it gives founders societal and industry validation, and in many cases sustains the salaries they were earning in their prior lives. Taking the efficient path means less social clout early on and much leaner times. It’s why we argue that efficient founders are the most ambitious folks in the startup ecosystem. They capture the resourcefulness and grit that are the true spirit of entrepreneurship.
At D2 we invest in and actively support efficient founders building truly enduring businesses. If the above has resonated with you, we’d love to hear from you.
