Capital efficiency is about understanding the ratio of output to the amount of capital investment involved in sustaining a company's activity or a product line. This basic comparison can decide whether a particular operation should be continued as is, modified, or abandoned and resources transferred to other projects.
How Capital Efficiency Works
The fundamental method for measuring capital efficiency is to divide the average value of output by the rate of expenditure over the same period. Output divided by cost will help clarify if a venture, which is currently yielding a modest profit, is approaching that point where profitability is achievable once there is a cost reduction or no actual value in funding the business.
Although you ought to avoid the latter condition at all costs, the two potential states before it are unfavorable. Since many business projects begin with higher capital expenses, these businesses realize fewer profits in the early stages of activity. Some costs are expected to be resolved after the initial launch and will not be ongoing.
The incentive for profit grows as the rate of investment falls and the output or production rises. As a result, calculating a project's capital efficiency will provide investors with assurance that the project is on track.
Real-World Example of Capital Efficiency
Like all things that take discipline, capital efficiency requires planning and practice—like preparing for a marathon. If an organization can bootstrap through crucial growth stages, it will be well placed for capital efficiency when outside investors inject capital. The trick is to remember your bootstrapped days and act as though you don't have any capital.
One example is Marketo, which raised $105 million but only used $40 million until its IPO. As a best-of-breed marketing automation approach, it significantly aided the substantial demand for marketing technology as the marketing department increased its profile. Marketing has now become the major buyer of enterprise SaaS solutions.
Efficiently running a business entails avoiding distractions. Great companies concentrate on product development and marketing. Veeva Systems did a fantastic job with this. Veeva built its product on Salesforce's platform from the beginning to focus on its main business and zero in on replacement market opportunities.
Why is capital efficiency so important?
It depends on who you speak with. Many investors and entrepreneurs believe that capital efficiency is unimportant for new companies in their early stages.
It's not as if they don't have references to refer to. A spend-your-way-into-growth strategy has proven to be extremely useful for many big, successful businesses. Hubspot, Salesforce, and Box are only a few examples.
The problem is that numerous businesses have tried and failed to implement the plan. You don't hear as much about them as you do about the ones who flourished. Building capital efficiency into your startup from the beginning has many advantages. Here are a few benefits below:
It encourages good decision-making:
Capital productivity compels you to make better business decisions about where to spend your money. You tend to evaluate and refine pilot projects to ensure that they are efficient before increasing investments. The constraints of capital efficiency compel you to think beyond the box to find new ways to expand rapidly without wasting money.
When doing more for less becomes a requirement, motivations to improve your business practices tend to arise. You'll dip your toe into the water to make sure it's the correct temperature before diving in full force and then regretting it.
It allows you to have more influence over your business:
It's great to have the right partner invest in your company and help it expand. On the other hand, the more outside funding the startup receives, the less leverage you'll have. Businesses that are capital expensive would raise more money than companies that are capital efficient.
Consequently, there will be a reduction in your ownership, and you will have even less say in company operations. You can keep more control of your company in the long run by being careful with your money and giving yourself more options for operating, scaling, and exiting your business.
When it comes to a liquidity situation, this can make a world of difference. Let's be real—an entrepreneur who owns 50 percent of a $100 million company gets the very same reward as one who owns 5 percent of a $1 billion business—and the former is a far more achievable target.
It assists you in navigating the ups and downs of life:
When things are going well, it is much easier to spend freely. However, if anything unexpected occurs (such as a global pandemic) or the company hits a snag, being capital efficient makes it far easier to navigate issues.
If you've been wasting money, you may feel compelled to make drastic budget cuts, including layoffs and spending restrictions, to the point that it's impossible to expand at all. Your organization may not even know how to develop if you haven't practiced the discipline, and you'll be struggling to find it out.