Thursday, December 11, 2008

Do capital efficient businesses exist anymore?

We keep hearing from both investors and entrepreneurs that building a capital efficient business is the key to survival in this economy. We heard that plenty of times, but do capital efficient businesses exist? I would submit that capital efficiency exists only in relative terms, if exists at all.

I put some number around what I call "capital efficiency index" that measures the value created by a firm divided by the total capital going into the business. As used in VC methods used in some academic literature, the time horizon is chopped at the time of venture exit.

So what exactly is a capital efficient business? There are many dimensions to measuring it, including,
  • low burn rate, better resource utilization
  • high revenue with small Capex
  • self-sustainable business model
  • repeatable source of revenue with same platform
  • etc.
In summary, high value is created with as little capital as possible. Simple enough.

There are reasons to believe that capital efficiency is easier now and should be done. Cost of hardware keeps going down the curve, some technologies get commoditized, SaaS makes it cheaper and easier to consume traditionally expensive technology products, etc.

After putting some numbers around, capital efficient businesses don't seem to exist at all. At least, macroeconomic factors and craze created by the market may be the only way to make a capital efficient business.

Look at the following chart. Listed are some of the most successful ventures in the "old" and "new" age. To be fair to the value associated with the companies, let's stick with consumer services companies.

What the chart is essentially saying is that much more capital is required to create the same "value multiple" in the new age of startups in the internet space. A single digit value multiple is everywhere in the new age group. The old age group took much less capital and created much more value. Yes, they are at different phase of life, but the absolute size of investments went up significantly even when the companies are much younger.

It seems that the potential size of successful startup is proportional to the $$ going into the company. Let me know if anyone has a business plan to match eBay's value multiple, I'd rather put my money into triple digit value multiple company than Facebook's meager 31.

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