When I started K9 Ventures, I did so based on a specific investment thesis which had a clear set of investment criteria. One of those criteria was ‘Capital Efficiency.’ We hear that term lobbied around often these days. It comes up most commonly in cases when investors talk about how “it’s gotten cheaper to start a company these days” (particularly in the Web space), and therefore these companies don’t require a lot of capital. That was my thesis as well.
In fact, when starting K9 I used my own startups as an example such capital efficiency. In my first company, SneakerLabs, the total capital raised was $1.15M. I started the company in December 1996, we sold the company in March 2000 (3+ years). We had just under 20 people prior to the acquisition at over $100M — that’s a pretty capital efficient company by any definition. My second startup (iMeet/Netspoke) raised a combined funding of around $2M — not a lot of capital for a company that grew to 60+ people before it was acquired. So I argued that I want to try and find companies which can follow a similar model. Raise a modest amount of capital and then have a great return. Sounds plausible right? Well, today I’m going to explain why I now believe that this thinking is flawed (for Silicon Valley at least, not sure about other geographies).
While the reasoning above is mostly sound, it doesn’t take into account one very critical variable: maturity of the funding ecosystem. I’ve since realized that the reason why my startups were so darn capital efficient was not because they didn’t need that much capital. In fact, our Valley-based competitors (eGain, Kana, WebEx, Placeware etc.) had raised a lot more capital than we had. The real reason was that we simply didn’t have access to capital. This was partly due to us being located in Pittsburgh, where there are only a handful on local venture capital firms (neither of which funded either of my startups). The other part was because I was still learning how the system worked and in hindsight didn’t do a good enough job of attracting venture capital from firms in the Valley or the east coast.
So, we were capital efficient, but only because we had no other choice. I now claim that:
“There is no such thing as a capital efficient company (at least in Silicon Valley). There are only two types of companies — those that attract capital, and those that don’t. And you obviously want to be the former.”
Let’s dissect that a bit. If you look at most of the recent (<5 years) Silicon Valley tech companies that we consider “successful” today, most of them have raised a lot of capital. They certainly don’t meet the simple definition of capital efficient without additional qualifiers. Why is that? Because when a startup starts to do well, VCs all sit up and take notice. That starts a feeding frenzy that then results in VCs calling up the company and literally offering money on a platter. The entrepreneurs look at that and appropriately think — “if I had more money, I could do X or Y.” And more importantly, “things are good now, but what if they’re not in the future? Wouldn’t it be nice to have a cushion in the bank for the rainy days?” And so the company takes on more capital. (Sometimes companies take on more capital than they should which results in indigestion for the company, or what I otherwise refer to as the curse of over-capitalization, but that’s a topic for its own blog post sometime.)
By contrast, even if you’re a company that’s doing well, if the VCs don’t take notice, you’re going to have a tough time raising the capital you need. You’re not attractive enough for the $$s. So what’s your option? You either become more attractive for the $$ or you become capital efficient!
As an investor realizing this has been a critical bit of learning for me. It has caused me to change my criteria to not look for just “Capital Efficient” companies, but instead to look for companies which are “Capital Appropriate.” i.e. the amount of capital the company needs is commensurate to the size of the opportunity or to the size of the potential exit that company can have. If you’re going to be a multi-billion dollar company, then raising $50M or more isn’t a big deal. But if the opportunity is only that of a $100M company, then raising $50M to get there would not be a good path.
Yes, it is cheaper to start a company (at least certain kinds of companies), but if your objective is to go big, then chances are you will take on more capital than you originally planned. And in some cases it won’t be because you need it, but because it’s offered to you, or because you can.
Food for thought and fodder for discussion. And of course, you still want to be the company that attracts capital!