VC:VC Capital Efficiency

Capital efficiency is the notion that an organization uses capital wisely, frugally - that the capital is used to best effect. The ultimate measure is the amount of returns to investors as a multiple (we hope) of the capital invested, adjusted by the length of the investment. Obviously doubling your investment in a year is better than waiting 10 years for the same result. A rather esoteric calculation called IRR (internal rate of return) is used by Venture Capitalists to measure time-adjusted returns to investors.

It is conventional wisdom to note that a software company is more capital efficient than a hardware company. If that were always true in an absolute sense then no hardware companies would ever get VC investment. However, in this case we tend to mean that you need more capital to get from stage to stage. Each "spin" (or revision) of a semiconductor product, for example, costs far more than a new version of even a fairly complex software program. What we mean, therefore, regarding capital efficiency, is that the company will advance to less risky stages using smaller amounts of capital. The bets we place on software companies are generally smaller, and the company gets to delivering a product with less capital.

As a venture cyclist, how do I think about capital efficiency? Certainly, once I have bought the bike (and the bling) I have very little follow-on financing to do. However, this means that almost all the investment was made before the risks were worked out: would I make it as a cyclist, or would the bike just languish unused in the garage? I guess a bike is just like other hardware!

As a venture cyclist I also think about Hazon and other non-profit organizations... and, of course they are capital efficient (the small ones I am involved with, at any rate). They don't have enough capital to be inefficient. Of course, "returns" are a bit fuzzy in this regard, but Good to Great and the Social Sector helps there.


Asad Quraishi said...
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Asad Quraishi said...

My interest is in capital efficiency as it relates to IT investment. Thanks for the brief, understandable definition - which I linked to from my blog post