17 Apr Why CEOs can’t afford to be blind to capital efficiency
After a CEO finds product-market fit, the inevitable question he or she asks is, “How fast do I grow to raise my next round?” It isn’t a simple question. Unfortunately, the venture community creates oversimplified benchmarks around minimum revenue growth rates of 2x, 3x or, for some, even 10x. A blind focus on growth hurts CEOs, team members, and startup outcomes.
During the 2021 funding frenzy, CEOs could raise funds based on future growth rates and comparisons to overvalued SPACs (that relied on 2025 revenue forecasts). In the end, too many startups missed their numbers. They were set up to fail. The temptation to accelerate growth left them with an impossible plan, bloated teams, and an aggressive cash burn. These companies now must grow into their valuation in this challenging new macroclimate, but they don’t have the capital to do so.
The focus on big exits sounds appealing for CEOs and founding teams, but the likelihoods are minuscule. The high expectations remove the most reasonable exit opportunities. A capital efficient approach creates lean, sustainable startups with a greater likelihood of a positive outcome, regardless of macroclimate. Remember that even a small acquisition with less capital raised could have been life-changing for the founding team.
Why chasing large rounds is overrated
Understandably, a large round alongside a high valuation is a temptation for CEOs. It feels like success and gives further opportunities to expand. Founding teams can hire faster, get more media attention, and sell their stocks in secondary transactions. A fundraising event now looks more like a liquidity event.
In actuality, these companies are in a vicious cycle, chasing unnaturally fast growth rates. They may ruin their unit economics and the fundamentals of their business. The team loses sight of important metrics like customer acquisition costs, and instead, as marketing spending increases, the quality of deals closed, and retention rates all go downhill. A company in this vicious cycle looks much weaker at its core.
A positive exit looks less likely, nearly impossible. The CEO’s ownership stake is diluted, and they own very little of the company. The company now needs a colossal exit to please common and preferred stockholders. If the company had taken a capital efficient path to grow with less capital and sell for a lower amount, the founding team would have seen better returns.
Why some investors focus on growth at all costs
It may appear straightforward that capital efficient growth is the most sensible approach, yet some investors push founders to chase large exit outcomes because of their fund economics. An exit with 100x returns will more than compensate for the remaining portfolio showing zero returns. Beyond that, because of the way preferred stock works, investors get paid back first.
The misalignment of incentives is made worse in bull markets. For example, between 2017-2022, funding and exits became more plentiful, and VCs encouraged CEOs to raise more to grow even faster. The reason was that the investors had to deploy bigger cheques, given their inflated fund sizes. A larger cheque generally means a higher valuation (to hold dilution constant), which was then justified with higher multiples. For example, SaaS startups traded at 20-50x revenue (at Series A) because of an assumed extreme hockey stick growth rate.
To show the different outcomes, let’s use a simple example where a CEO has a choice between two termsheets: (1) a fund that invests $30M into a startup at a $150M post-money (CEO owns 80%), and (2) a fund that invests $10M at $100M post-money (CEO owns 90%). Let’s assume a standard liquidation preference of 1x and a vanilla termsheet. Here are the outcomes for the CEO and investor at different raises and exits, assuming the IPO isn’t realistic with the smaller raise:
|Exit outcome:||Larger raise
($30M @ $150M)
($10M @ $100M)
|Better outcome for CEO:|
|Acquihire @ $15M||Investor recovers $15M (100% of total) and CEO makes nothing (0% of total)||Investor recovers $10M (67% of total) and CEO makes $5M (33% of total)||Smaller raise|
|Small acquisition @ $50M||Investor takes $30M (60% of total) and CEO takes $20M (40% of total)||Investor takes $10M (20% of total) and CEO takes $40M (80% of total)||Smaller raise|
|Large acquisition @ $200M||Investor takes $40M (20% of total) and CEO takes $160M (80% of total)||Investor takes $20M (10% of total) and CEO takes $180M (90% of total)||Both strong outcomes|
|IPO @ $2BN||Investor takes $400M (20% of total) and CEO takes $1.6BN (80% of total)||Let’s assume unlikely||More likely with larger raise|
This simplified example doesn’t consider dilution from further rounds or team vesting, but from the CEO’s perspective, taking less capital and growing slower is generally preferable. Investors have downside protection until they recover their capital. With a small exit, the fund recovers capital, and a large exit may return the fund and improves a VC’s brand reputation. Unfortunately, CEOs only receive a fair split in a sizable acquisition or IPO. Given that more than 90% of exits are acquihires or small acquisitions, it’s clear the smaller raise is preferable for CEOs.
Following a framework for capital efficient growth
Raising a smaller round only works if CEOs focus on running their business with a more restrained cash burn. To achieve capital efficient growth, CEOs should focus on three types of efficiency and track using metrics as they grow their business and burn capital. They are the efficiency in building, growing, and supporting your business. We’ll explore these in the next blog post. In the meantime, here’s a glimpse of what’s to come.
|Type of efficiency||Details||Example metrics|
|The efficiency of building||Capital is needed to turn technology into a product and find revenue opportunities that validate the concept. Tech teams should quickly focus on building a minimum viable product and then iterate as needed. Efficient startups use lighthouse clients to help them monetise quickly and build and shape the solution with pilots for early clients.||
|The efficiency of growing||Growth efficiency is concerned with sales and marketing momentum. Expanding a client and customer base means startups maximise distribution channels until all are saturated. However, if they push too hard, they may deviate from your ideal customer profile (ICP) and move towards subsidising customers.||
|The efficiency of supporting||As the closed deal pipeline and customer roster grows, operations need to scale to provide the quality of service expected. To ensure service level agreements and net promoter score targets are met, startups must overpay for an ever-expanding and sometimes overqualified team, over-complex technology stack, and expensive partner support.||
More about Conductive Ventures
Conductive Ventures is a $450M AUM VC fund focused on capital efficient, post-product expansion stage companies focusing on software, hardware, and technology-enabled services. We believe in the mantra of capital efficiency and that it provides the best outcomes for CEOs, creates sustainable companies that add value to the world, and stands the test of macroclimates.
If you are an early-stage startup CEO or an investor that shares our belief that portcos should treat venture dollars as fickle and never unlimited, please reach out to me at arif (at) conductive (dot) vc