Capital Efficiency and Scaleup Efficiency

You may have heard a lot of talk recently about Capital efficiency. There is a better metric to focus on though, that we discovered by accident when doing some research a couple of years ago. This metric has come to be a focal point of a lot of our research as it is an excellent driver of success. To start with we should define capital efficiency.

Capital efficiency equals capital raised divided by TTM revenue

The theory is that the more capitally efficient a company is, the better the returns will be for shareholders. Looking at 160 software IPOs as an example, the issue of capital efficiency is highlighted. The average software company goes public with $341 million of revenue and an average growth rate of 58%. One thing that is amazing is that 92% of these companies were losing money in the year prior to their IPO. This habit of losing money means that their capital efficiency comes in at 218%. In the end though, their valuation at IPO is 15.4 times revenue.

Valuation equals Revenue multiple times revenue

What that means for shareholders though is that shareholder return, measured as valuation divided by capital is on average 9.8.

Shareholder return equals valuation divided by capital

The problem with capital efficiency as a ratio though as there is only a correlation of 0.21 between capital efficiency and shareholder return.  Growth is still more important as there is a correlation of 0.51 between a company’s growth rate and its revenue multiple. You can see the effect of growth on valuation in the following graph.

The statistics we have just looked at is an average of all IPOs. But what are the results were for the companies that were more profitable? After all, maybe being profitable is worth even more than a 15.4 times revenue multiple. As it turns out, the ones losing more had higher revenue multiples as on average, they were growing faster. (Proving that growth matters more than profitability.)

But losses accumulate and the more they accumulate the more capital a firm requires. One can compare the results for firms with low versus high capital efficiency (Capital divided by Revenue). As you are aware, VCs have been obsessing over capital efficiency for some time now. As it turns out, higher efficiency didn’t result in higher revenue multiples. In fact, just the reverse. Lower efficiency brought higher revenue multiples because of higher growth (this growth thing again).

But a good example of capital efficiency is Shopify in the year they IPOed. Capital to revenue of .92 (better than 81% of companies) and their growth rate of 109% (better than 92% of companies. What they had was a Valuation to Capital ratio of 13.12 times. This means that they returned $13 for every $1 of capital invested. The average is 9.8 times and Shopify was better than 81% of companies. What Shopify shows is that it doesn’t matter what your capital efficiency is, only what it is in relation to your growth rate.

As it turns out, if a firm can grow quickly and keep high capital efficiency, its revenue multiple and thus valuation doesn’t benefit but its shareholders do because not as much capital was used to get that valuation. This is Shopify and why they have been so successful. They deliver good growth rates with high capital efficiency making their shareholders wealthy in the process. The best part is that there is a valuation to growth efficiency of 0.64 which is much higher than the link between capital efficiency and return. You can see the effect in the following exhibit.

We have called this metric Scaleup Efficiency. It shows how efficient a firm is at scaling up. What it does is to divide a firm’s growth rate by its capital efficiency. The formula is as follows:

Scaleup Efficiency equals growth rate divided by capital efficiency

And why is this connected to success? The top quartile of firms as measured by Scaleup Efficiency deliver a Valuation to Capital ratio of 21.2 times and the next quartile only delivers 9.1 times. And that is what success is, delivering a high valuation to shareholders in relation to their investment.