I wrote an article about capital efficiency for The Business Journals years ago and the topic seems as relevant as ever. I wanted to take a deeper dive here on the Norwest blog.
Since I first published the article, the financial landscape has been upturned. After years of sky-high valuations and free-flowing capital, investors are tightening their belts. In the first half of 2022, investments in US tech startups dropped to $62.3 billion, the lowest total value since 2019.
Though times feel tough for startups right now, in some ways, this more frugal mindset fits my advice around capital efficiency. Why? Because I consistently advise young companies to raise money cautiously. Raising too much, too fast can make it difficult to find capital further down the line. I’ve always said that startups should first create capital efficiency.
What is Capital Efficiency?
At a high level, capital efficiency is the financial return on capital deployed. It encompasses the ratio of how much capital a company spends versus how much it brings back in. Your capital efficiency ratio measures how efficiently your company spends cash to operate and grow.
It’s important for startups to establish this ratio early on and maintain it at scale. For one, it helps develop engaged, thoughtful leadership. In capital efficient companies, leaders need to be very deliberate about how they allocate resources. This leads to more informed decision-making, enabling executives to hone thei rapproach to business.
A startup that holds the line on its capital efficiency ratio through angel funding rounds demonstrates a track record of sound money management. Institutional investors are much more likely to throw their money behind a startup that has used its angel funding judiciously than behind a devil-may-care spender.
This is more relevant in the current market as investors withcapital to spendare looking for safer bets than ever.
With this in mind, below are some of my best practices for maintaining capital efficiency.
1. Don’t splurge on sales and marketing
Inefficient sales and marketing spending is one of the most common ways startups waste capital. A Gartner study has found that the average marketing budget for startups is 11 percent of their overall revenue.
I’ve seen many startups hire large sales and marketing teams, then launch huge campaigns, before they fully understand their business model. This is a setup for failure. In a company’s early days, the founding team should be making most sales.
I’ve seen many startups hire large sales and marketing teams, then launch huge campaigns, before they fully understand their business model. This is a setup for failure.
When your company is small, it’s not efficient to hire a sales manager. Your CEO, who has a much stronger understanding of the industry problem your company is trying to solve than anyone else, should be your number-one salesperson. Customers take a huge risk when they bet on the product of an early-stage company. They want to see the whites of the CEO’s eyes to know he’s committed to their success.
The founders of WageWorks, where I was VP of sales and partner development, did a great job on this front. They were tax policy experts, not salespeople, but WageWorks’ commuter benefits services were in such high demand that despite having no prior sales experience, they were able to sell to major clients, such as Ernst & Young, Pitney Bowes, and Bank of America within the first two years. Such customers gave WageWorks credibility when the company began marketing to Fortune 500 companies. By 2003, when WageWorks hired its first professional salesforce, 50 of the Fortune 500 were customers.
Likewise, when life sciences software maker Veeva Systems launched, it focused primarily on selling to just the top 20 companies in the pharmaceutical industry. When it went public in 2013, Veeva was a $4 billion public company few had heard of. Its leaders had targeted customers personally, building meaningful, long-term relationships, and felt no need to pound their chests in Silicon Valley. Then, with a meaningful base of customers and product validation, the company benefited from word of mouth and became the industry standard for pharma CRM despite spending very little on marketing.
To improve capital efficiency, startups need to carefully consider their expenditures and ensure they are getting the most bang for their buck. Every dollar wasted could have been used to fund a more crucial part of the business, such as improving product development. By being mindful of their spending and ensuring that every dollar is well-spent, startups can give themselves the best chance at success.
2. Hire the most eager talent, not the most senior
In a company’s early days, you need employees who want to execute, not delegate. Capital-efficient startups tell me they turn down a lot of applications from seasoned engineers who haven’t coded in at least five years and are used to delegating. They realize they need employees across all functions who will roll up their sleeves.
Aaron Dinin, a lecturing fellow for innovation and entrepreneurship at Duke University and founder of multiple venture-backed startups, advises young entrepreneurs to spend less time talking and get more things done.
Startup teams work best when a group of people with diverse and complementary skill sets divide the work among themselves, do their jobs as best they can, and trust that their co-founders are doing the same thing.
A startup I know churned through three senior sales leaders in two years before realizing that it should promote its top sales representative. He had been helping the company define product-market fit and had been speaking with lots of customers; he had more credibility to lead the team than any outsider.
In these early days, you want people who will be motivated more by equity or potential bonus than guaranteed wage. They’ll have more conviction in what you’re doing and will want to do more to increase the value of your company than an executive who’s in it for an unnecessarily high wage. They’ll set the company culture and grow into bigger roles over time.
3. Solve an industry pain point
If your startup is not meeting a specific market need, customers will be hard to come by. CB Insights reported that 42 percent of startups they surveyed fizzled out because they did not solve a major industry problem.
To improve capital efficiency and achieve major business growth, a startup should focus its resources and attention on one product that solves an important pain point. Customers tend to pay for products that solve their top one or two problems; many startups waste money trying to build a portfolio of products, each with a thin layer of functionality. These companies don’t produce the top product in any area.
It’s better to have small successes than try to win the entire market at once. Develop other products over time
So take a methodical approach to your product plans. It’s better to have small successes than try to win the entire market at once. Develop other products over time.
It’s better to have small successes than try to win the entire market at once. Develop other products over time.
Cornerstone OnDemand, where I was VP of channel management, developed and launched its employee learning software before turning its attention to other cloud-based talent management products. Building a single best-of-breed product gave Cornerstone the credibility to later sell its customers recruiting, performance, onboarding solutions, and other products.
Likewise at WageWorks, we first focused on a commuter benefits product. Our success in this realm gave us enough credibility to later develop and sell health savings account products, among others. In the early years, we focused on one area where we knew we could provide the best product, and we became the top company. Customers had such a great experience that they trusted us when we began to offer more.
Bonus Tip: Keep money in the bank
Many entrepreneurs who raise a lot of money early believe attracting investors will always be easy. This isn’t so. Investors want to see that you’ve been successful with what you already have.
They want to see that you have channeled money you’ve saved on marketing and recruiting into developing the best product in the marketplace. They want to see that you are spending prudently.
And of course, cash flow is an excellent signal of your startup’s capital efficiency. The amount of money coming in and out of your organization, the channels, and the sources of these funds are critical information on a company’s financial health.
Capital Efficiency: An Investor Magnet
When investors are judging which startups to finance, a track record of capital efficiency can be very attractive. It’s a positive signal of founder discipline and leadership. Capital efficient companies typically have a clear destination and have set a three-to-five-year window to get there.
Capital efficiency indicates that founders have a mindset built on cautious and calculated spending for maximized returns. This cultivates a sense of confidence among stakeholders, making any startup extremely attractive to investors.
Super short takeaways: 10 ways startups can establish and maintain capital efficiency
- Develop the best product addressing one key problem to start.
- Ensure that the problem is a top pain point for many stakeholders.
- Hire talent that wants to execute, not delegate.
- Promote from within.
- Have your CEO lead sales efforts to secure the first 10 customers.
- Ensure that those first 10 customers are not your friends or family.
- Establish your sales model before expanding go-to-market efforts.
- Quantify the return on investment before spending anything on marketing.
- Test your marketing messages with small audiences before running major campaigns.
- Don’t spend everything you raise.
