A lot has been written about the virtues of a capital efficient business model during the past several years. Capital efficiency became a popular topic when exit valuations dropped significantly from levels that were achieved in the bubble. Despite the large amount of commentary on capital efficiency, both investors and entrepreneurs tend to focus on pre-money valuation during discussion of the merits of an investment and deal terms. A look at the math, however, shows that capital efficiency is often more important than pre-money valuation.
First, let me offer an explanation of capital efficiency for the purpose of this exercise. A capital efficient company is one that needs a relatively small amount of equity and debt in order to achieve attractive revenue and profitability, which in turn drive a good exit for investors.
So, let’s look at two possible scenarios for investors.
Scenario #1: An investor places $2 million in a Series A financing at a $10 million pre-money valuation.
Scenario #2: An investor places $5 million in a Series A financing at a $5 million pre-money valuation. The company performs well and the company raises an additional $5 million at a $20 million pre-money valuation in a Series B financing.
It would appear on the surface that scenario #2 is better than scenario #1 for a Series A investor if one focuses on pre-money valuation. The pre-money valuation for the Series A investor is much better in scenario #2, and the company is able to raise additional capital at a big valuation step up during the Series B financing. When one runs the math, however, the outcome actually favors the investor in scenario #1. Assuming customary Series A terms, the Series A investment in scenario #1 would achieve a 3.3x return at a $25 million exit and a 9.5x return at a $100 million exit. The Series A investment in scenario #2 would achieve a 2.3x return at a $25 million exit and a 7.8x return at a $100 million exit. (The Series B investment would perform even worse.) So, despite the much lower pre-money valuation, the Series A investment in scenario #2 is worse off because the capital needs of the company eat up returns and more than offset the lower valuation.
A capital inefficient company will also hurt founders and other common shareholders. Let’s compare a situation in which a founder raises $10 million at a $25 million pre-money valuation in a Series A financing to a situation in which a founder raises $2 million at a $5 million valuation. The $25 million pre-money valuation seems much better, but one would be surprised at the outcome. In both of these cases, the founder has given away 26% of the company, but the impact of capital intensity goes beyond that. After going through the the math using customary investment terms, one can see that the founder is left with $64 million at a $100 million exit and $16 million at a $25 million exit if the founder opts for the $2 million raise at a $5 million exit. Alternatively, the investor is left with $61 million at a $100 million exit and only $8 million at a $25 million exit if the investor opts for the $10 million raise at a $25 million pre-money valuation.
I am not saying that venture investors should accept high pre-money valuations. Rather, I am pointing out that capital inefficient businesses can be surprisingly unattractive to both investors and entrepreneurs. Both would do well to discuss and think through the capital needs of a company.
Alan
