Inflation. War. Pandemic.
There’s a lot to be worried about in the current economy. We’re on the brink of yet another recession, just a few years after the COVID-19 downturns and the Great Recession of 2008. In fact, the current period happens to be the 10th worst downturn since 1929.
As we’re all panicking and pondering our next steps, a question emerges: have we learned nothing over the past couple decades? The voices of reason were present back then, and they repeat the same message now:
The growth at all costs model falls flat at the slightest hint of a troubled economy.
Capital efficiency: the balance of growth with measured cash burn. This concept has time and again proven to be a way for companies to ensure long-term, sustainable growth.
Discover five capital efficiency metrics to measure the return on every dollar burned, and build a strategy to protect against future downturns.
What is capital efficiency?
Officially, capital efficiency is defined as the ratio of capital expenditure to revenue generated. In the SaaS context, however, capital efficiency refers to the ARR return on each investment dollar burned.
For SaaS companies, CapEx vs OpEx is a gray area. Expenditures such as IT infrastructure, which are technically capital expenditures, can be written as operational expenses for a more flexible expenditure model, albeit less predictable.
Regardless of the model you choose to follow, a capital efficiency mindset maps every dollar spent to ideally a multi-fold return on investment.
Why is capital efficiency important?
Capital efficiency plays an important role in sustainable, long-term revenue growth. It is more than a ratio, rather you adopt a mindset of prudent and strategic spending for maximized returns. There are several other reasons why it’s important to measure capital efficiency:
- Investment in activities with high return
- Growth at sustainable costs
- Attractive to investors and leads to higher valuations
- Better measure of product-market fit
- Optimal hiring decisions at each stage of the business
- Forces strategic thinking at every step
- Builds habitual operational efficiency
In summary, capital efficiency is a key to growth through well-paced, results-based expenditure. And one of the key ways to achieve it is through measuring and tracking capital efficiency metrics:
Burn Multiple answers one simple question: how much are you spending to obtain each incremental dollar of ARR? This metric is a two-fold measure of capital efficiency and revenue growth.
To calculate Burn Multiple, divide net cash burn by net new ARR for a given time period.
Burn Multiple helps capture several problematic aspects of the company’s financial health and red flags in the balance sheet:
- The risk incurred through each invested dollar
- Poor product-market fit and the resulting churn
- Ungainly and high customer acquisition cost
- Inefficient capital and operational expenditure
- Under-performing growth strategy
For a mature business, a Burn Multiple well below than 1X is ideal. Early stage and hyper-growth businesses may hover around the 1.5X to 2X mark.
A couple of honorable mentions to Hype Factor: net burn by total ARR and Bessemer Efficiency Score: net new ARR by net burn. These alternate versions of Burn Multiple are helpful in taking a results-based approach to expansion measurement.
Rule of 40
The Rule of 40 has an interesting backstory. It originated with a private equity investor only investing in companies with a combined revenue growth percentage + EBITDA margin percentage above 40%.
The Rule of 40 is a balance of growth and profitability that is correlated with higher valuation to revenue multiples, and 15% higher returns.
By measuring the Rule of 40, you learn three important things about the company:
- The proportion of growth to profitability
- How attractive your company is to investors
- The sustainability of your growth in the long term
For more mature businesses, it is more difficult to maintain high rates of growth over several years. This metric is more suitable for companies looking to balance hyper-growth with profitability.
Venture Capital Efficiency Ratio
The Venture Capital Efficiency Ratio is the ultimate measure of return on capital. This ratio compares a company’s exit valuation to its total capital raised.
Other capital efficiency metrics are great indicators of ongoing, efficient spending for steady growth. But the Venture Capital Efficiency Ratio takes a backward look at the return on capital investment at IPO.
Although this is a lagging metric, it can be highly useful to analyze past performance to find areas of improvement in the future. As well, for companies eyeing IPO, this metric helps study other players in the industry.
Return on Invested Capital
Return on Invested Capital, or ROIC pits profit against invested working capital for a deeper look at the profitability of a venture. More specifically, this metric divides the net operating profit after tax (NOPAT) by invested capital. In simple terms, you can calculate return on invested capital with this formula:
ROIC Formula: NOPAT / Invested Capital, or, (net income – dividends) / (debt + equity)
ROIC is essentially a measure of a company’s value creation. It assesses financial efficiency by comparing the cost of capital with the output or return on capital. By maintaining a high ROIC, companies can understand if the activities they invest in are worth the investment.
However, this ROI calculation is better suited for industries with high capital expenditures.
The CAC Ratio measures Sales and Marketing efficiency by dividing net new ARR by customer acquisition cost (CAC). But what exactly does this metric indicate?
- High CAC Ratio hints at poor product-market fit
- Inefficiencies in Sales and marketing spend to acquire growth
- Growth practices that fall flat during tough times
As you can see, rapid growth can obscure several inefficiencies in a company’s operations and expenditure. To ensure sustainable growth, it is important to track and strategically convert each dollar of CAC into multiplied revenue growth for the business.
As an aside, you can calculate revenue growth as the percentage increase in revenue in the current period (month, quarter, year, etc.) over the past period. Just make sure to balance revenue growth with the costs of investing in that growth.
The current economic climate is in many ways an opportunity to pause and reassess how companies approach growth. Adopting an efficient mindset builds protection against the worst effects of future downturns.