Capital Efficient Business Models

Yesterday I participated on a panel at the Mid Atlantic Venture Conference on the current venture capital market and how to raise capital. While this was a plain-vanilla panel about venture investing, there was one theme that was echoed by a number of my fellow panelists from Rho Ventures, New Venture Partners, Edison Ventures, and Cross Atlantic-today's world requires software companies to have a capital-efficient business model. What is a capital-efficient business model and why does it make sense? From my perspective, a capital-efficicent model is one that allows a company to use as little cash as possible to generate significant growth and become self-sustaining and profitable. Growth at all costs without profitability does not get you there and neither does profitability with no growth. Finding the right balance is important. Given this backdrop, the real question is how does today's VC generate a 10x return? Yes, that is easier said than done, but let me walk you through why it is imperative for VC investors today. During the bubble years, a $500mm to $1b exit for a software company was not uncommon. A bad deal for a VC was a $100mm sale. However, many of the software companies during the bubble years required $50mm or more to create meaningful exit value, and in many cases the companies were still not profitable. Today and into the future, I believe we will return to a sense of normalcy where a great exit for a venture investor will mean $100-200mm of value. If it takes $50mm or more to get there you are talking about a 2-4x multiple for a GREAT deal. That is not terribly exciting. A capital efficient software model should only require $20-25mm to get to profitability. With those numbers a VC could earn 4-10x their investment, even at today's reduced values. Given my perspective on what ultimate exit values will be, it will serve the entrepreneur and venture investor well to do as much as they can with as little capital. This is doable-looking at history, Peoplesoft only raised $10mm of venture funding, Documentum raised $13.5, and Veritas raised $6mm. This does not mean skimping on growth, but it requires companies to:

1. Focus on getting product into the hands of its customers earlier rather than later-do not build the perfect product (see an earlier post);
2. Grow carefully-do not ramp personnel too far in advance of revenue;
3. Leverage offshore resources where appropriate;
4. Leverage reseller and OEM relationships (direct sales is way too expensive).

Each bullet point above deserves its own lengthy discussion, and I hope to address some of these in future postings. The impact this will have on the industry will mean that venture capitalists will need less capital for each company resulting in smaller funds and a better ability to generate multiples of invested cash for its investors. For today's entrepreneurs, it will mean that they rethink their go-to-market strategy and remember to balance growth with getting to profitability sooner.

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