Capital Efficiency Matters
In a previous post, I mentioned that it is the job of the CEO, the board, and the executive team in driving corporate value to grow EBITDA, while also managing debt, assets, and capital raised and consumed. Capital efficiency refers to the corporate value created relative to the amount of capital consumed, and it is the ultimate measure of how well the critical job is performed.
Being capitally efficient impacts a company, its growth, and its stakeholders in the following ways:
They need to raise less external capital. Therefore, there is less dilution of founders and all investors.
They are able to re-invest free cash flow in new products and markets, improvements to the company, and further growth. They actually scale faster over time. This can be especially important when addressing out-scaling competition.
The rigor and attention to measurement and profitability is a company-wide discipline that not only positively affects unit gross margin, but also customer value delivered, churn, customer acquisition cost, as well as product development and general and administrative costs.
The ability to further raise capital is far less in question.
The company has greater strategic options in both organic and inorganic growth as well as market positioning.
The current executive team and possibly board members are more likely to remain in their roles.
The employees, customers, users, and community involved with the company experience less disruption.
In the event market conditions shift and further capital raises become difficult, the company is able to survive by tuning down growth rather than force itself through restructuring and possible liquidation.
Capital efficiency is a universally positive attribute for a company; but achieving it requires discipline, forethought, planning, and investment. Further, there are differences in both availability of capital as well as barriers to entry for the company's industry and niche that can dictate different perspectives on the degree of waste and risk that is appropriate. For that reason, the pursuit of capital efficiency is viewed differently within different investor models and investors and the specific company’s growth story.
In venture backed companies, the early stage focus is entirely on establishing revenue and then enough profitability as the company progresses through the its maturation stages. The fundamental advantages of achieving and sustaining capital efficiency are equally true in venture backed companies, however, there are three factors that tend to elevate revenue over profitability.
The first is that revenue alone is the key metric of corporate value and progress in the earliest stages of a venture backed companies; this philosophy can be sticky.
The second is that early-stage companies have limited resources and can be vulnerable to counter-disruption where an incumbent or another new entrant introduces a counter strategy product and is able to disrupt the development of market presence sufficiently to threaten growth. Growth tends to create its own virtuous cycle; both in terms of prospect and customer perspective as well as talent perspective. For these reasons, too early and too committed of a transition to profitability can create impediments; however, having to interrupt scaling to transition to sustainable scaling can also create impediments.
The third reason is that there are industry and operating model differences in the ease with which a company may become capitally efficient. Industries and operating models, as one factor, with fewer barriers to this transition tend to attract venture investors. Further, as venture is about industry disruption; venture investors follow the disruption and may tend to shift their industry and model focus over time. That shift can lead to misconceptions about the relative ease of making the transition and/or the downstream cost of inefficiency and that can lead to investor or board pressure to focus too much on growth or too much on profitability.
An example can help illustrate the implications. A venture-backed company is shown below; with 3 separate corporate development scenarios involving institutional investor involvement with a Series-A in 12-18 months post-founding and subsequent rounds as appropriate to the scenario. Three scenarios are shown:
• In the first scenario (capitally inefficient), the company is run in pursuit of revenue, with revenue growing to $23M by the seventh year with reasonable focus on reducing customer churn and customer acquisition cost. The company requires four (4) rounds of investment for a total of $22.5M.
• In the second scenario (Capitally Efficient in GM Alone / No Reinvestment), the company is run with the same attention to revenue growth, but also strong attention to raising unit gross margin to its full potential and good attention is also paid to reducing churn and customer acquisition cost. The company requires three (3) rounds of investment for a total of $15M.
• In the third scenario (Full Capital Efficiency / Modest Reinvestment, the company is run with precisely the same operating improvements as in the second scenario, but the additional cash produced from early operating improvements is reinvested in organic growth. The company is funded with the same three (3) rounds of investment for a total of $14M.
The revenue growth curve for the 3 scenarios is as shown below. Note the revenue curve for the first 2 scenarios is identical, while for the third scenario, revenue grows much more rapidly in the 3 years prior to exit.
Figure 1: Revenue vs. Years from Founding for High to Poor Capital Efficiency (Venture Backed Company)
While there is a notable difference in revenue post year 3, the real difference is in valuation between the three scenarios. At an exit valuation based on 10x EBITDA plus assets less debt, the financial performance of these three scenarios are extremely different:
Figure 2: Summary Investor Returns for High to Poor Capital Efficiency (Venture Backed Company)
In the first and second scenario, it is shown clearly that the difference in exit valuation is over four times higher, but more so, the internal rate of return of the investment has been improved from a loss at -13% to a reasonable gain of 27%. However, reinvesting the free cash flow generated from early improvements and focusing improvement efforts on gross margin, churn, and cost of customer acquisition, the exit valuation can be turned upward to approximately $325M and the IRR raised to 57%. Note that cash: cash return, for the investor, is improved from losing 50% of the investment to a 2.9x return improved further to a 11.6x return for the optimized return. These factors are from the perspective of the external investor. The founders also share in the substantially increased exit valuation and are diluted nearly 15% less, and so retain a much larger share of the value they have created.
What is worth noting, additionally, is that these projections assume continued investment and dilution under circumstances where the ability to raise capital would come into question. In the first scenario; it is more likely that the company would simply fail and be liquidated or the external investors would successfully drive a change in leadership to make the needed changes.
Private Equity backed companies are an entirely different model, the sole focus is value creation through capital efficiency in the form of leveraged acquisitions and a variety of high-disciplined EBITDA growth levers. From initial investment thesis to platform acquisition to subsequent add-on acquisitions, the plan and its elemental steps are explicitly focused on growing corporate value in the most efficient way possible. This different perspective drives an entirely different perspective on risk, EBITDA growth, and a rich range of value creation levers. Further, the mandate for capital efficiency and performance to plan is stronger due to deeper General Partner (or proxy Operating Partner) involvement and the PE control governance structure.
The following example shows a PE buyout projection for a five year hold, leveraged buyout model. In this case, the plan is to take on a low-growth / low-EBITDA (3.6% of revenue) platform and use technology to enhance its core product offering to enable growth and higher pricing, while also streamlining key areas of the operation. The debt leverage used is based on 5.5:1 Debt:EBITDA ratio resulting in 51% of the transaction funded through PE Equity financing of around $10.1M. Because of the changes made to improve the value of the company, the highly efficient model yields a 5.9 cash:cash return in a 5 year hold period for an Internal Rate of Return of 56%.
Figure 3: Transaction and 5 Year Hold for Well-Managed PE Backed Company (High Efficiency)
This project far exceeds Private Equity return expectations, but also takes slightly more risk than a typical PE investment, relying on a doubling of Compound Annual Growth Rate (CAGR) over the period using product value enhancements to enhance pricing and growth and execution of multiple cost reduction and value enhancing activities and the company is run quite lean.
Other scenarios could reduce those positive impacts, examples of which are shown below. The moderate case shows achieving approximately half of the CAGR improvements and about half of the operational improvements. The cash:cash return is reduced to 2.7 for an IRR of 29% for modest reductions in CAGR and operational process efficiencies in the moderate scenario, but note that the company requires an additional $1M in operating cash. Finally, in the final and worst scenario, cost containment is not enforced, working capital discipline is not enforced and the company needs an additional $7M in cash to reach year 5. The cash:cash return is reduced to 0.5 for an IRR of -16%. No Private Equity firm would allow this scenario to play out.
Figure 4: Comparison of Investor Returns for High to Poor Capital Efficiency (PE Backed Company)
In summary, capital efficiency matters. As a CEO, it’s important to build and deliver products and services that customers love and that make a difference in people’s lives so that you and your team love doing the work. It’s important to grow and reach public milestones and remain competitive. Doing all of those things without capital efficiency means you won’t achieve the goal of creating wealth for you, your team and your investors; and for that reason it also means you may not be able to do it for very long. As an investor, investing in companies that don’t move to build and sustain their capital efficiency as soon as possible means you’re giving up on potential return on investment, increasing the risk profile of your investment, and increasing the likelihood of downstream dilution.
Please contact us if you would like to discuss how to assess and improve your capital efficiency.