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Why Founders Should Focus More on Capital Efficiency

In today’s fast-paced venture capital market, tech startups are often granted billion-dollar valuations that are nearly impossible to match in actual revenue. Not everyone in Silicon Valley has signed onto this new normal, however. Jodi Sherman Jahic and Susan Mason, Managing Partners of Aligned Partners, advocate for a different approach. They emphasize “capital efficiency” — a high level of financial return on capital funds — as an essential component of smart leadership and good money management.

We recently spoke with Jodi and Susan about the importance of capital efficiency, why it needs to be more top-of-mind to founders and investors and how startups can maintain this fiscal ethos as they expand and mature.

Why should capital efficiency be important to an entrepreneur?

Jodi: There’s a narrative in Silicon Valley that having more cash in the bank leads to less risk. That doesn’t correlate: If you raise more money, you’ll spend more money. If you’re a founder and raise only a modest amount of capital, you can achieve a lot more exit value, own more of your company and keep a greater percentage of your company. In our view, companies that carefully determine their go-to-market strategy with capital efficiency in mind can go through all their paces and broaden their exit opportunities.

How has Silicon Valley’s view on capital efficiency changed over the years?

Susan: When cloud computing came to market a decade ago, the business-delivery model for enterprise technology companies shifted, which meant they could utilize very little cash to achieve market penetration and adoption. Back in the ‘90s, it would cost $15 to $20 million to start a company and get it to proof-of-concept and validation. In today’s environment, startup costs may only be $400,000 to $800,000. Cloud and open-source software brought about a fundamental shift in Silicon Valley and made it easier to manage capital efficiency.

Jodi: Technology startups tend to focus on seed-stage investments, but there’s a big gap between seed-stage funding and venture funding. Anyone who wants to progress beyond seed funding must go to venture capital firms, which typically have a starting investment level of $25 to $50 million. Aligned Partners exists to fill that gap: We invest in companies that are go-to-market ready and efficient. They may have no need for that $50 million; they may only need to raise $10 million over their lifetime.

How should company founders determine how much capital to raise?

Susan: What you’re really looking for in any round of funding is matching the amount of cash raised to the stage of the company where you’re ready to achieve the next major milestone — that’s your inflection point. In Series A funding, we focus on optimizing the company’s go-to-market strategy and validating the sales process. When you start ramping up sales and employee headcount — your most expensive cost point — you can often make serious mistakes. We focus our companies in that stage on fully understanding their sales process and learning how to ramp up without using excess cash. Most of those companies will raise Series A and B funding but not go beyond that point because they have a break-even cash flow and are profitable by then.

Jodi: Think of the freedom this question affords. Instead of considering, “How do we raise more money so we don’t die?” you’re thinking, “Do we raise more money so we can shoot the moon?” So many companies come to us and talk about how fast their customer adoption rate is, but when we ask how much those customers are paying, the reply is often, “Oh, they’re not paying us.” Call us old school, but they’re not customers if they’re not paying you. Solid companies are not momentum-style companies. They have real business models, they sell products and services, they actually get cash from customers and they have profits. The world is their oyster.

And how should founders determine where specifically to allot their funding?

Jodi: The first thing we ask our companies to do is focus on a limited problem that can be fully solved — something that’s contrary to the Valley’s general narrative of building a platform first. Startups are told by VCs that the platform yields the product. But you can’t sell a platform to an early customer, only the complete solution to a painful problem. A platform alone requires too much heavy lifting for the customer; the startup must do the heavy lifting. Solve one problem completely, then build the platform under it.

Susan: Focus spending on things that yield actual revenue results. A fancy office in Palo Alto should not be on the agenda. Our companies work with customers to identify clearly the problem they need to solve so the customer realizes the value. You spend dollars on things that line up that value, like a return-on-investment-based sales process. But you don’t hire 10 salespeople at the start; you hire one or two to figure out the sales process, then you expand. You don’t do tons of marketing or broad advertising; you find the key early adopters first.

What suggestions do you have for a founder to establish — and maintain — capital efficiency in the company as it grows?

Jodi: The only way to survive economic downturns is to eliminate the need for more capital. You always have control of your destiny if you don’t need more cash. To a young investor, it feels awesome to raise $100 million and be valued at $500 million, but the punishment is pretty strong if you don’t hit those numbers. Founders and employees do better when they start out small.

Susan: The outcome of starting small and focusing on capital efficiency ensures founders can lay claim to a significant part of their companies so they’re owners, not employees. The mindset between those two roles becomes dramatically different when growing a company. The beauty is that, in being aligned with entrepreneurs, we give more value and less risk when it comes to funding. We take pride in the fact that we have a proven, reputable model that works and delivers value to founders and their staff and rewards investors for the risk they’re taking.

The information is presented as is.

© 2018 First Republic Bank

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