For many startup software companies (and their founders), an early capital-efficient approach to growth can make a huge difference in the long run. It can be the difference between having 6 months of runway versus an endless runway. It can make the difference between needing to make deep cuts when the business climate gets rocky versus making slight adjustments. Your ability to be capital efficient can even dictate when, how, and why you take on institutional funding.
When I was a bootstrapped SaaS founder, my company was inherently capital-efficient, even though that wasn’t a term I would have used to describe it. I just knew I needed to make money (be profitable) to stay in business, and it was as simple as that.
Today, I have a more nuanced perspective of capital efficiency and how it can be important to a startup’s growth path. So, let’s review what capital efficiency is and why it matters to founders.
1. What Is Capital Efficiency?
In the simplest terms, capital efficiency means growing profitably, without overinvesting to land customers and drive revenue.
Capital efficiency is the ratio between spend and growth. For example, a 1:1 capital efficiency ratio means you’re earning one dollar for every dollar you invest into company growth. If you’re earning three dollars for every one dollar spent on growth, that’s a capital efficiency ratio of 3:1. Another term for this is “return on capital employed,” or ROCE.
As you can imagine, spending less to make more is a sound concept, especially if you are bootstrapped or have raised a small amount of money that you want to last a long time. You can use the efficiency to fuel more growth because you can confidently know if you spend X, you will get Y.
2. Ways to Think About Capital Efficiency
Understanding capital efficiency is one thing, but what does that actually mean for running the business day-to-day? There are a few ways I think about it.
The Rule of 40 (or, actually,70!)
Spend enough time talking about SaaS finances, and the “rule of 40” will probably come up. The rule of 40 states that at scale, a company’s revenue growth rate plus its profit margin should be at least 40.
Many capital investors view that as evidence of capital efficiency and a strong return on equity but the rule of 40 was a concept originally designed to benchmark large, publicly-traded SaaS companies with over $100,000,000 in revenue. It doesn’t really apply to startups. It is totally reasonable for a high-growth, efficient company to be hitting a rule of 70 to 100+. Yes, it’s the marker of an elite company, but it is totally attainable.
Revenue per Employee
Revenue per employee, the company’s total revenue divided by the number of employees, is another great indicator of capital efficiency. When I was a bootstrapped founder, I may not have known about the rule of 40, but I monitored my revenue per employee maniacally. It was one of my critical measurements of how efficiently we were scaling.
Ideally, as a company scales, headcount doesn’t scale exactly in tandem. It is difficult for a SaaS company to operate profitably if revenue per employee is $100,000 of annual recurring revenue (ARR). Companies generating significant profitability while growing will generate $200,000 (or more) per employee.
Ah…you know there can’t be a B2B software article that doesn’t mention churn, right? Yes, a third way to evaluate capital efficiency is churn rate.
In the long-run, it’s almost impossible to be a capital-efficient company if your gross retention rate is less than 85%. Startup founders who rely on recurring revenue learn quickly (and painfully) that it’s far too expensive and difficult to scale a business if the company is losing 20%–30% of their customers every year. Even if you bring in plenty of new customers, you’re really just replacing the lost ones. That’s a revenue treadmill.
What churn rate indicates your company is pretty efficient? Consider 90% gross retention and 120% net retention as the gold standard. It’s rare to be much higher than 90% for gross retention, but your net retention might even be as high as 150%. Getting existing customers to stay & spend more is a much easier path to growth than replacing lost customers.
3. Capital Efficiency Today Impacts Financial Outcomes Tomorrow
To be candid, if you are burning lots of money because you aren’t capital efficient, you will need to raise money, perhaps even many rounds of it. Every time there is another investment, it dilutes the previous investors’ shares (including the founders and employee grants). It doesn’t take many rounds for a founder’s ownership to shrink substantially. Soon, they have much less influence over the control of the company and a much smaller piece of the pie.
If a founder can grow their company without needing too many rounds of investment, they’ll protect their ownership position. The more value you can create with your company with as little dilution of your ownership as possible, the more lucrative your piece of the pie will be when and if there is a liquidity event.
This can profoundly impact the trajectory of the business and make it easier for the founding team to have a financially meaningful exit.
I’ll give a specific example because I think it really helps illustrate the point. If a company raises many tens (or hundreds) of millions of dollars in outside investments, it can mean they have to exit at a high value or multiple (think billion-dollar exit) in order to make a solid return for the founding team. That kind of exit is rare and hard to pull off—it’s unicorn-level stuff.
However, if a company is more efficient with their capital from the start, they will need to raise less, and the team keeps a higher percentage of the company. In this case, a smaller (and much more likely) exit event—such as a $100 or $200 million acquisition, can net a fantastic financial outcome for everyone.
Even when emphasizing capital efficiency, you might want to take on significant external funding. However, the difference is that you would be doing that because you want to, not because you need to. And in this case, capital efficiency will help increase the company’s value upon funding, opening the door to more favorable options.
4. Blockers to Capital Efficiency
As helpful as capital efficiency is, sometimes it just isn’t possible. Why can some companies nail it while others can’t? Well, there are many variables in play, but four that we see having the most impact are the product, the market, the culture of GTM accountability and customer payment terms.
If you don’t have product-market fit or some form of product-led growth strategy, it will be hard to be really capital efficient because you will need to make heavier investments in sales & marketing.
How strong is the market opportunity? How much work does it take to acquire customers? If you solve a real pain for a sizeable audience at a good price point, you’ll usually have a lower CAC, faster sales cycle, and a more efficient growth machine.
Payment terms can make or break a capital efficient, high-growth startup. Wherever possible, establish annual customer contracts that include pre-payment. Even better—work on closing some multi-year, pre-paid deals. And, of course, watch your accounts-receivable like a hawk. Billing customers isn’t enough—it takes active A/R management to ensure customers pay on time.
If your go-to-market culture is simply “spend,” it’s going to be hard to be efficient. An efficient go-to-market includes rigorous attention on sales & marketing measurements so you know exactly what’s working and what isn’t.
5. The Other Side of Capital Efficiency
So, now for the less rosy reality. Just because a company is capital efficient, it doesn’t mean it’s rolling in the dough with tons of extra cash laying around.
I’ve always run a capital-efficient company as a strategy. Still, there have been plenty of times I was sweating payroll or wasn’t able to take advantage of a great opportunity because it would take my cash balance too low.
Once a bootstrapped business has gotten off the ground (let’s say $1 million–$5 million of ARR), it may only have ~$200,000 or so on the balance sheet. When cash is that low, a founder can find themselves really stressing about payroll, the big upcoming trade show payment, and the perfect-fit, expensive sales leader they want to hire. Low cash reserves don’t provide much wiggle room to operate the business. Even just a handful of late customer payments can really derail you and leave you on a razor’s edge.
That’s a lot of pressure and sleepless nights. And it’s why taking on some primary (and even secondary) capital can give some breathing room for you to operate your business without the cash management demon constantly on your back. Just having a cushion to protect against a late payment from a large customer or take advantage of a great growth opportunity can dramatically change most founders’ mental state. It’s peace of mind and stability so you can run your business.
Capital Efficiency as a Path to Flexibility and Optionality
Being as efficient as possible with your capital is essential for the founders of almost any software startup. It gives you greater control and makes it easier to get a meaningful return on the investment of time, energy, blood, sweat, and tears that it takes to build a successful company. Capital efficiency just gives founding teams more flexibility in running and growing their business, and that’s a good thing for the company, the customers, and the team.