By Sean Cantwell & Pete Keenan
In the classic novel A Tale of Two Cities, Dickens describes the era of pre and post-revolutionary France as both an age of wisdom and foolishness. Building and growing a successful business obviously requires wise decisions to overshadow bad ones along the way. This is especially true for how companies manage external capital on a path to exit.
There is more to capital efficiency than meets the eye. Large equity rounds that look ripe for reckless spending are justified when that capital can be deployed to fuel responsible customer-focused growth. Venture capital firms often take a reductive view of capital efficient businesses as those that take limited amounts of external funding — usually less than $10-15 million.
However, funding alone does not determine capital efficiency: it’s how those dollars are deployed and the growth, recurring revenue, and valuation that they generate.
The most capital efficient company isn’t always the company that has raised the least capital. For example, if company A has raised $3 million with $10 million in recurring revenue, everyone would say that they are remarkably capital efficient. But if company B has raised $25 million with $85 million in recurring revenue, few would point to their capital efficiency though they are, in fact, slightly more capital efficient.
As check sizes have grown over the last decade, VC and growth equity firms need to reconsider what it means to be capital efficient. Let’s dig a little deeper and examine three very different companies that have all gone public. Veeva, Domo, and Chewy.com.
The ARR Efficiency Ratio
To figure out the valuation of companies in between rounds of financing, many SaaS investors look at annual recurring revenue (ARR). This is where the ARR Efficiency Ratio comes in. The ARR Efficiency Ratio takes Cash Burned over, where Cash Burned equals Capital Raised – Cash on Hand – Founder Liquidity:
ARR
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Cash Burned
Think of this as a real-time snapshot of capital efficiency rather than the final picture. The reason Cashed Burned is used is because many companies still have significant amounts of capital on their balance sheets even as they head towards IPO. For instance, Slack raised $1.39 billion of outside capital but had $849 million of unspent cash at IPO.