The Impact of Capital Efficiency on Valuation at Exit

Every day we meet with businesses that have raised various amounts of external funding, primarily from angel and venture capital sources. Many software businesses raise capital to further accelerate growth by investing in product development, sales & marketing, and talent. Since 2016, capital deployed through venture capital software investments has nearly tripled while the level of deal activity has slightly decreased. (Figure 1)

While venture capital investments in the software industry have become increasingly concentrated, it’s important for founders and owners to remember that raising capital impacts the future financial outcomes of businesses. This blog post introduces and explores the concept of capital efficiency.

Figure 1: Historical VC Activity

Overview of Capital Efficiency

Capital efficiency describes the relationship between how much a business raises in external funding and the amount of revenue earned as a result. In our definition of capital efficiency, a business with a 1:1 capital efficiency ratio generates a dollar of revenue for every dollar raised. Capital efficiency is a consideration for many software businesses as it informs future decision-making frameworks, affects remaining cash runway, and determines future capital requirements.

There are many ways that a software business can think about capital efficiency. In addition to capital efficiency ratios, founders and owners can look to the Rule of 40, revenue per headcount, and revenue retention rates to better understand whether they are growing profitably without overinvesting. For the purposes of this blog post and the following analysis, we have measured capital efficiency as a multiple of total capital raised to trailing twelve months revenue earned (Capital Raised / Revenue).

The Impact of Capital Efficiency on Valuation

To analyze the impact of capital efficiency on the valuation of software businesses at the time of exit, we looked at all merger & acquisition transactions involving formerly venture capital, accelerator, and angel-backed software businesses since 2015. We then calculated the capital raised to revenue multiple of the acquired business in each transaction to create three distinct buckets of capital efficiency (< 1.0x, 1.0x – 3.0x, 3.0x – 5.0x Capital Raised / Revenue). (Figure 2)

The median Implied Enterprise Value / Revenue multiple for the set of transactions in each bucket of capital efficiency shows that software businesses in the 1.0x – 3.0x capital raised to revenue range tend to receive the highest valuations at the time of exit. The bell-shaped graph below offers a few useful insights for founders and owners of software businesses. First, it suggests that even the most capital efficient software businesses (< 1.0x Capital Raised / Revenue) can sometimes struggle to achieve the scale and growth that results in high valuations.  Second, it shows that software businesses that grow into the capital they raise by successfully executing product-market fit and go-to-market strategy are often rewarded with more attractive valuations upon exit (1.0x – 3.0x Capital Raised / Revenue). Lastly, those businesses that raise capital that doesn’t translate into revenue growth (3.0x – 5.0x Capital Raised / Revenue) exit for a considerably lower valuation than the optimal “middle bucket”.

Figure 2: Median Implied EV / Revenue Multiple by Capital Efficiency Ratio

Final Thoughts

While there is no one-size-fits-all approach to capital efficiency, it is important to remember that raising capital is a decision that has lasting impacts. Generally, software businesses that maintain a good degree of capital efficiency enjoy more flexibility and control during day-to-day operations and can expect a more favourable financial outcome from a future exit. 

Written by Trent Pora of Sampford Advisors.

About Sampford Advisors

Sampford Advisors is a boutique investment bank exclusively focused on mid-market mergers and acquisitions (M&A) for technology, media and telecom (TMT) companies. We have offices in Toronto, ON, Ottawa, ON, and Austin, TX and have done more Canadian mid-market tech M&A transactions than any other adviser.

Photo by Micheile on Unsplash. Link: https://unsplash.com/photos/ZVprbBmT8QA