The myth of capital efficiency

Jon Soberg is a managing director at Blumberg Capital.

True or False?  The cost to build a product has dramatically decreased in the past 10 years.

True.

True of False?  The cost to build a company has dramatically decreased in the past 10 years.

False.

Costs to build an initial product are continuing to decrease

I’m making a significant distinction between building a product and a company here, and when I say building a company, I’m talking about one that fits a venture return profile. Others have eloquently articulated how the cloud, open source software, outsourced design and coding, and many other advances over the past 10 years have cut the costs to initially build a product by upwards of 80%. I really think Mark Suster’s analysis based on his personal experience is one of the best blogs about this, and I agree with him wholeheartedly. In this context, “capital efficiency” should be talking about the fact that the capital can be allocated directly to the product rather than to infrastructure, and other non-core costs.  Steve Blank’s Lean Startup methodology to me is the foremost approach to using resources efficiently, and he fully embraces the low cost capabilities that we have today.  As these services continue to improve and drive costs down, companies will be able to focus their resources and capital on their core product and business. This makes capital much more efficient, but isn’t the full story.

Scaling a company is not cheap

Now let’s talk about scaling. I’m sure I wasn’t the only one who noticed when Greylock announced its new $1 billion fund, that Reid Hoffman made the statement that it is getting MORE expensive to build software companies. He is absolutely correct. Even though platforms like Facebook, LinkedIn, Google, and others have made it easier to reach masses of potential customers, they have made it easier for everyone. Not to mention that easier doesn’t mean less expensive. The noise level in the market is continuing to increase, and in some industries, there are players who are driving up the costs. This makes it more difficult to find your target customer, differentiate your value proposition, and scale your business.

Example from Hootsuite

Let’s look at the example of Hootsuite, where Blumberg Capital is an investor. They have been held up as an example of how a company can scale without taking substantial capital, but my view is a little broader. They scaled early without a lot of capital, but have raised a substantial amount of capital later to go after a dominant enterprise position. The trend I see is the shift in the capital needs of a company. It used to be that the startup costs just to build the initial prototype were so expensive that only well-resourced companies could get a product to market. Now, getting a product out is relatively cheap. But, adding the resources to scale isn’t cheap.

Hootsuite took only a modest amount of capital early, and its timing to the market was excellent. It built an excellent product and moved quickly in a mode of continual improvement. People signed on and the adoption curve was impressive. Early on, the company offered only a free product to the market and scaled dramatically. When it turned on the paywall and added premium services, it got strong response, and the revenues grew quickly as well. Normally this would be the time to pour on the gas, and Hootsuite took some additional capital then to drive growth.  It took less than normal because it benefited from three key factors that many companies don’t:

1. Ryan and his team built a brand early and focused on social media channels to drive that (it didn’t hurt that they were specifically managing social media communications)
2. Being in Vancouver, Hootsuite’s cost structure was lower than most of its competitors — it had access to great talent at lower prices than its Silicon Valley-based peers
3. The Canadian government has some generous programs that gave Hootsuite access to grant capital that gave it a lot more resources than just the equity the company raised. It made a big difference early.

Hootsuite is an exceptional company in many ways. It built a brand faster than most, and it turned profitable very early based on its strong product. This enabled the company to push out the timeline for raising substantial capital. But, even with all of the impressive performance, as the company began to scale in the enterprise, it  took on additional capital, and the recent huge raise is a perfect example of why Greylock says it is more expensive to build a software company than it used to be.

There are countless other examples of taking substantial capital to scale a business. On the enterprise side, you need to build a substantial organization, and to do it right, you build ahead of the revenue ramp. On the consumer side, it is a similar concept, where there needs to be investment in acquisition and in product that will retain customers ahead of the adoption curve.

The reality of the situation is that it has not become less expensive to build a company, at least not if you want to scale it to achieve venture-style returns. (I will completely acknowledge that there are exceptions, and I’m in awe of the companies that have scaled with very little capital).

In general, it has become less expensive to turn an idea into a product, and even to prove that some customers will adopt the product. Achieving scale is not cheap, so when I hear “capital efficient” meaning that the company will need less overall capital, I assume a little too much optimism. The term “capital efficient” should refer to companies that raise capital at a time and scale that aligns with their growth curve. It isn’t about being cheaper.

Jon Soberg is a managing director at Blumberg Capital and has been a serial entrepreneur, an executive at large corporations, a consultant, a financial analyst, and a robotics geek.