Capital Efficiency — Part II

A deeper dive into how operating executives can make changes in their processes and functions to improve capital efficiency.

In Part 1 of my thoughts on capital efficiency published earlier this week, I discussed how the pendulum is slowly shifting from growth at all costs to growth balanced with efficiency. And I walked through the different ways the private investment community has measured efficiency. I recommended measuring efficiency based on the ratio of cumulative cash consumed to annual gross profit, using data published by Shin Kim the basis for my recommendation.

However, this high-level metric (the ratio of cumulative cash invested to annual gross profit) doesn’t help operators identify what to modify in their day-to-day processes to improve efficiency. So in part 2 of my post, I am going to dig a little deeper.

My Favored Efficiency Metrics:

1. CAC (Customer Acquisition Cost) Payback: I am a huge fan of this metric. I focus on the number of months of gross profit required to payback CAC. When CAC payback is quick, it allows you to reinvest those cash receipts into acquiring new customers without needing to raise as much outside capital. For companies targeting multiple user segments, CAC Payback analysis should be done by segment. Tom Tunguz has a good recent post on this metric. The overlap with the most efficient companies in terms of total capital raised to ARR is striking.
2. Net Dollar Retention: Measured ideally by cohort (meaning all customers acquired by specific period, often in three-month increments.) This analysis applies to both B2B and B2C companies. I look to see how cohort retention metrics are changing over time — are they improving or not?
3. Customer Pull: This helps me understand how much potential customers want/need your product. And when customers are proactively looking for you and buying your product, the efficiency will be high. Metrics that relate to customer pull are Inbound Lead % (ideally form fills requests a call with a salesperson in B2B) or Resting Growth Rate (for consumer start-ups when they stop paid marketing). I like this post by Kent Bennett and Connor Watumull on consumer businesses where episode 5 focuses on resting growth rate and describes its importance.

Building Capital Efficient Businesses

“Efficiency is doing things right; effectiveness is doing the right things.”
- Peter Drucker

As business owners and operators, we always want to build capital-efficient businesses. And it is not easy. Here are some thoughts I would offer to business leaders on specific tactics to consider. Clearly, as leaders, you know your businesses and challenges and so ought to both add to this list and prioritize from this list on the items that would have the greatest impact on both future profitable growth and customer satisfaction. In striving for improved efficiency, we always need to first focus on the most important things.

1. Product:
   (i) Design for product-led growth, if at all possible. Have an offering with freemium or a limited free trial that encourages virality.
   (ii) Ensure the product proactively reminds users/customers of its value through automated messaging and updates which drive engagement.
2. Sales & Marketing:
   (i) Marketing: Be careful about how you use paid marketing — it’s rarely defensible and a drug that can be addictive (hard to turn off when you fear growth will slow down without paid spend). That is not to say paid marketing isn’t necessary, but focus first and foremost on your owned and earned marketing channels.
   (ii) Sales: Focus on conversion optimization further down the sales funnel (small improvements there will mean much less need for an increased number of raw leads at the top of the funnel); and, use product marketing content to help improve conversation in the middle and bottom of the sales funnel.
   (iii) Understand the components of your Gross Margin Payback in Months: Break down your total gross margin payback by months into each part of the sales cycle. For a B2B business that might include the following components: (i) the Marketing team costs; (ii) all marketing spend on all channels; (iii) any costs associated with free trials; (iv) the SDR team cost; (vi) the sales team costs; (vii) the sales overhead costs (management, sales operations, etc.) This understanding will allow you to focus on areas for improvement which are material to overall CAC payback months.
3. Customer Success and Account Management:
   (i) Focus on retention early in the life of the business. Solving the leaky bucket problem early on will save a lot of money.
   (ii) Make onboarding easy — lengthy onboarding with delayed time to value really hurts the customer experience. If the onboarding is necessarily complex (as it will be with some enterprise-focused offerings), build in another feature to your offering that can be accessed relatively immediately (see my post on “the value of community” as an example of one such possible feature).
   (iii) Invest in the customer success function; ensure they do regular calls with clients and provide feedback to the product team on real-life customer experiences.
4. Invoicing: Payment Frequency and Terms
   (i) Optimize payment frequency and terms: Each customer win is a mini-fundraising event.
   (a) If you have a subscription business model, make your default payment frequency an annual in advance payment; then, offer payment plans that allow for quarterly or monthly payments but at a higher price point to reflect your cost of funds.
   (b) Insist on credit card payments for lower value subscribers (especially smaller monthly payments) to offset the time and hassle of billing even though it will cost you 2–3% of the invoiced amount.
   (ii) Ensure payment terms are no more than the net 30 days; the sooner you collect the cash the sooner you can invest in additional growth efforts.
5. Other Operating Expenses:
   (i) Hire slowly; know what the roles required to hit milestones to enable a successful next financing round.
   (ii) Scale the revenue organization slowly: It is preferable to see most or all sales people beat quota and get paid their accelerators while potentially leaving some deals unclosed. The alternative, hiring extra reps too rapidly which leads to low sales efficiency (even if slightly higher total sales) is much higher drain on cash.
   (iii) Be cheap on office space: Squeeze people in until it is obvious you need more space. More often than not you will grow headcount slower than you have budgeted. Sign short term leases, taking advantage of the change WeWork has brought to the office lease.
6. Pricing and Compensation Plans: Make Land & Expand Easy
   (i) Tie pricing to something: (a) directly related to the user experience of value; (b) easy to measure; and, © which leads to upsells. Products that generate value for all users allow for per seat models which lends themselves to upgrades over time. So do products that are directly tied to revenue or revenue bands. People understand paying more when more users access a product or paying more when revenues grow.
   (ii) Ensure compensation plans allow for sales people to get paid something for land and expand over time so that they have the incentive to close smaller deals in the near term to and collaborate with customer success and account management to get a company live with your product and help with future upsells.
7. Keep the Business Model Simple
   (i) In the early days, keep the business model and product offering as simple as possible.
   (ii) Over time a business that grows will create multiple different products (fundamentally different offerings and not just pricing editions) and sell to multiple different customers. However, delay that urge for added complexity as long as you can. In the short term, business complexity seems appealing. But in the medium term, the added complexity will cloud focus, slow down execution and increase costs.

Capital efficiency will not get you in the business press as frequently as there will be fewer fundraising rounds to tout. However, capital efficiency will increase the likelihood that all shareholders — employees and investors — are rewarded well upon an exit.

The Capital