By Georges van Hoegaerden

[This article is a further expansion on the subject of Capital Efficiency of our article from one year ago, named "The trap of Capital Efficiency"]

I cannot tell you how many times I still hear Venture Capitalists (VCs) mention how they look for and "create" capital efficient companies, and how masterfully they continue to sell that "strategy" to their Limited Partners (LPs) as a viable investment thesis.

Those LPs subsequently must believe that they are now investing in a unique class of companies only they have access to (otherwise why is the mention of the specific denomination relevant), and instead of clambering to the old world of capital-inefficient companies, now have the opportunity to prance around in the formation of new, and sexy capital-efficient companies.

Sounds good, doesn't it? Perhaps for those not seeing through the tactics of the spin-doctors.

Let's dissect "capital efficiency" as deployed by most VCs:

First, putting less money into companies, or selecting innovation that supposedly needs less money is a strategy deployed in the last 10 years that has proven not to work. 790 VC firm investors who make - say - two investments per year on average (low ball), produced no more than a handful of IPOs and no more than 10% IRR over the last ten years, is no testament that an attachment to the "capital efficiency" category carries any special value. With our economy now also in dire straits, the chances of capital efficiency bearing fruit has diminished even further.

Second, with a fully loaded commitment from LPs the last ten years, VCs who look for capital efficient deals are dramatically fragmenting investment commitments by having to invest in more companies (to put the full capacity of the fund to work), and conversely increase the investment risk at a time when performance of the sector is already shaky. So the supposed capital efficiency of a startup, with uncalibrated VC fund sizing is actually capital inefficient to LPs.

Third, the cost of acquiring a customer on the Internet has not dramatically changed over the years (if not increased), and so to lower the input into early stage technology companies disproportionate to the dynamics of their output does not only make no economical sense, it again increases the risk of success, opposite of what capital efficiency attempts to promise.

Fourth, Internet technology companies deploy the same rudimentary economics to their customers as old-school companies, they are just using a low threshold (often immature) and a more immediate distribution channel (the Internet). But that immediacy combined with a little bit of money needed to enter into distribution significantly increases competition that in the end favors only those companies that provide relevant social economic value to its customers. And so not the lowest cost-to-entry defines the value of the company, but the quality of service it delivers to its customers. And quality of service is adversely affected by the improper implementation of capital efficiency and thus the reason why the current implementation of capital efficiency in venture capital is incompatible with building real value and public market trust (and therefor reliable IPOs).

Fifth, capital efficiency as deployed by many VCs today, forces startup companies to build technology first. Yet the gating technology proposition offers no indication that the company will ever achieve macro-economic value that has the potential to outshine competition for the next seven years or more. For example, building winner-takes-all marketplaces (such as iTunes, eBay etc.) requires a minimal investment incompatible with the capital efficient VC model, and as such we have not seen any since the popularity of the flawed implementation of that model.

Sixth, technology development is not the risk of a technology company, the application of the appropriate technology to a marketplace is. So, while it may have become slightly cheaper to develop a single line of code these days (I would argue that too), the amount of code needed to make a difference in a highly competitive market, forces companies to make more meaningful and robust products, which requires the deployment of a larger workforce with a cost that hasn't seen any significant reduction. So, just like in any production business, the people-cost is the most predominant factor of the success of the company, not the expense of technology it deploys.

So, yes, capital efficiency the way it is deployed by the demi-cartel of VCs is a big fat lie, that has not and will not deliver.

The ultimate subprime VC lie

Don't get me wrong, capital efficiency is a prudent way to build any company. But the way most VCs confuse capital efficiency lies in the difference between inexpensive and cheap. The way most VCs implement capital efficiency is cheap and lowers a company's ability to grow up, and makes it more difficult for the company to move from the left side of the chasm (Geoffrey Moore) to the right side, where massive user adoption awaits.

The currently popular deployment of capital efficiency spoon-feeds money to startups, which in most cases means the company cannot hire the much needed specialized expertise to turn it from a technology play into a real company early. Many startups can simply not hire a visionary CEO who protects their macro-economic agenda (and returns), and ensures the company remains owner-run (also favored by Warren Buffet) rather than investor-run. That means technology developers without sufficient business experience now run the asylum as inmates of the "investor prison", doomed to make the early mistakes that dilutes founding ownership and therefor - again - increases risk.

So, capital efficiency deployed by subprime VCs is a foolish prophecy. Any VC who uses the phrase capital efficiency as a sector differentiation has no clue what he is talking about. For me, having seen all sides of the venture equation, capital efficiency is the ultimate VC bullshit detector; it communicates they understand nothing about economics, investment risk, innovation, the workings of the technology sector, and business in general.

Capital efficiency today is implemented as downside protection by subprime VCs who look at venture investing as a commodity, and signals how they themselves therefor have become a commodity (and do not belong to operate in Venture Capital).

Capital efficiency should drive upside

Real capital efficiency in venture capital is defined by the cost to produce upside, as opposed to the cost to protect downside. Most companies become extremely capital efficient once they establish beforehand what the operating plan of the business looks like in detail, and as such plausibly define how they need to be "lubed up" to run as efficiently as possible to achieve upside early.

Contrary to popular Silicon Valley belief, technology does not create markets but has - at best - proven to support macro-economic and marketplace behavior that existed for many years. And real capital efficiency is easily achieved by identifying the behaviors that can be more efficiently supported or displaced with the help of technology as content and the internet as distribution. The selection of which marketplace (that is in timely need of efficiency) you pick as an investor determines how capital efficient an individual investment can be.

Capital efficiency, therefor is not a sector strategy, but a way of picking individual companies that have the potential to create extreme and timely upside.

So, from now on dear LP and entrepreneur, when you hear a VC mention capital efficiency, run the other way.

Tags: Subprime, Private Equity, Venture, Limited Partners, Entrepreneurs, VC, Fundraising, Funds