Start-up Entrepreneurs' Blog

Why Capital Efficiency Is an Annoying Buzzword

January 6, 2011

Entrepreneurs hear a lot of buzzwords around the start-up community. Capital efficiency is one such word. It brings to mind a vision of vagueness with no real tangible meaning. Like trying to see an object through a dense fog, you stare at the fuzzy object intently, barely able make out its shape and you strain in hopes of filling in the details. Investors want to tout their portfolio companies as being capital efficient, and start-up wanting to please their investors, tell them they are capital efficient. Does anyone really know what capital efficiency means to a start-up?

To the entrepreneur, it means …

To an entrepreneur, it means operating a lean and frugal company – no wasted expenses.  This is a myth. At some point, everyone spends money and gets little or nothing for it.  One start-up told me it hired 3 public relation firms before it found the right one. How many times have you hired an employee and got nothing from them because they were just the wrong person? The issue is every set of founders has a core skill set and once they need work performed outside their expertise, it’s easy to hire the wrong service or buy the wrong product. 

To the investor, it means …

To an investor, it means building a company and realizing a better return for less money in shorter time. I’ve heard venture capitalist talk about how the new one million dollar investment is yesterday’s ten million. I’ve even heard venture capitalists say everything is free today – tools and people. If you every worked for a volunteer organization of any kind, you’d realize quickly that free labor is very non-productive.  The solution for investors has been to simply move seed stage capital to others and not fund pre-revenue start-ups.  Thereby investing that first one million at a later stage in the start-ups life, and hence capturing a return with  less risk.

To the analyst, it means …

To an analyst, it means calculating the ratio of output to capital expenditures. In an established business, it’s easy to measure the amount of additional revenue realized for every extra one dollar of expense. This is result of analyzing marginal cost and marginal revenue.  But as Clayton Christensen of Harvard points out, this is not the best approach for innovation since “this biases companies to leverage what they have put in place to succeed in the past, instead of guiding them to create the capabilities they’ll need in the future. If the future would be exactly the same as the past, this approach would be fine.”

To others it means …

There are those that believe that capital efficiency is not relevant unless a company has revenue. Since pre-revenue start-ups aren’t likely to be funded, then funded start-ups are those ready to scale and often simple economies of scale drive efficiency as a byproduct of growth.

There are those that believe that venture capitalists have coined and popularized the term to provide spin factor for their limited partners. VCs are feeling the need to restore trust and confidence in start-ups which in recent years have not been returning much to their funds. 

Capital efficiency seems to be a trendy buzzword, intended to evoke an emotional response of goodness rather than any tangible, working definition or methodology of what it exactly means to start-ups. Perhaps it just means that start-ups are not engaging in drunk and disorderly spending as they had been in the dot-com era, where too much available capital caused start-ups to put home-theaters in their facilities or had company logo dog collars made for employees pets (No, I’m not kidding, both of these are true events).  Remember when companies were “right-sizing” and partnership displayed “synergy”? In tough economic times, wisely using cash and assets optimally just sounds good and in the end, perhaps that’s all it’s meant to be.

Filed under: Management

Tags: capital efficiency, capital efficient, investor funding, limited partners, start ups, venture capital