Why Capital Efficiency is so Important

Pablo 0:00 As you go and you, you spend some time, like in the world of, in the world of startups, whether it&#39;s as a founder or or as a vc, I think very quickly the number, like the , the most important k p i that, that you start to focus on is revenue. By the way, it&#39;s really different. Like if you , if you talk to the owner of , um, of a coffee shop or like literally any like main street, you know, classic business, they really talk about revenue. They, they almost always talk about profit. Like what do you end up with in your pocket? So the fact that in the startup world we&#39;re , we&#39;re like, you know, addicted to, or, or just so focused on revenue is, is not really all that normal. But if you, if you&#39;re a founder like, like I was, or you&#39;re a vc, that&#39;s the only thing that you&#39;re thinking about. And, and that&#39;s what I thought about. I mean, at the end of the day, it&#39;s just like, how fast, what&#39;s your revenue? You know, how fast you&#39;re growing revenue. Those are the most important questions in , in terms of traction, right? Like in terms of how your business is performing, there&#39;s a bunch of other things that matter, but in terms of how your business is performing, that&#39;s the number one thing. And I think one thing that happened over the last couple of years, right? If you look at 20 21, 20 22 is just how far, like obviously there&#39;s something to that. At the end of the day, you do need to grow your revenue really fast to become the next like billion dollar company. But you know, when you start to optimize on just one thing, you can take it way too far. And in many cases, that&#39;s what we saw in the last couple of years. It became everybody was so focused on revenue and revenue growth that it was just all that mattered. And as long as your revenue was growing extremely fast, no one really looked below the line <laugh> . And so I&#39;ll tell you a story that I heard not too long ago. I&#39;m not gonna name the company &#39;cause it doesn&#39;t matter, but here was a company that grew to literally a hundred million dollars in a r r annual recurring revenue. And when the market shifted, it went bankrupt, like literally from unicorn to bankrupt overnight. And you know, this stuff was, was kind of public information. So I&#39;m just like, what happened here? And I spoke with someone who was really high up in the company and they told me it was pretty simple. Like at the end of the day, the company had two goals at the highest levels, right? It was revenue growth and it was customer satisfaction. And he told me, he&#39;s like, we were crushing both those metrics. I mean, we were tripling our revenue year over year, even at that level, even at like a hundred million dollars. And we had near perfect customer satisfaction. And at the time, that&#39;s what everybody aligned on from the management team to the VCs that were backing it. What happened is overnight kind of the market shifted. There was less liquidity, people started getting more focused on other parts of the business. And here was a money that, there was a business that was burning incredible amounts of money. It literally would die if it couldn&#39;t get another material round done. And that&#39;s what happened, couldn&#39;t get that round done. It died. And one of the things like when I&#39;m talking to Michael Hyatt, who&#39;s been a founder, sold multiple companies for nearly a billion dollars and now as an investor, he&#39;s, he&#39;s been through kind of three financial , uh, ups and downs, right? The dotcom crash, financial crash and , and the one we&#39;re going through right now. And what he told me when he was doing his, Getting a High Gross Margin Early Pablo 3:14 one of his first companies, BlueCat, which was sold for $700 million, he said to me, one of my key learnings was that if you can have a high gross margin early enough, he said, that&#39;s the key number I think that you need to worry about in your p and l. I think that&#39;s incredibly important, right? I think no matter what, if you&#39;re running a tech startup, you&#39;re not going to be profitable in the early days almost, you know, it&#39;s extremely rare. Yeah, once you get to a million, 2 million in revenue, you can get to profitability. But there&#39;s many companies that can&#39;t do that because of a variety of reasons. Especially like if you&#39;re a consumer company or if you are selling to SMBs and you&#39;re kind of payback periods as long, there&#39;s so many reasons . Even if you&#39;re growing really fast, like net margin is hard to be the thing that you worry about. Gross margin though, I think it&#39;s a critical , um, that&#39;s a critical number. And going back to that company I was talking about, that company that was, you know, tripling and getting to a hundred million dollars in revenue, they had negative gross margin. You&#39;ve gotta understand what that means. That means that you&#39;re selling a product that costs you a dollar to make, whether it&#39;s software, whether it&#39;s an actual item, like an actual thing or whether it&#39;s a service, right? That costs you a dollar to deliver and you&#39;re selling that service for 90 cents in the hopes that in the future scale will fix all of that. By the way, Uber, Lyft, DoorDash, all these companies, they did that early on. If you think about what Vouchering was doing right? You were getting like $40 off your, you know, $50 order. They were losing money on that order, not just like at the city level, not just at the , at the business level. Like every order costs money and it&#39;s a dangerous game. I&#39;m not saying it never works, right? Like Blitzscaling is a thing, it can work, but it is such a dangerous game, especially for the founders because by the way, the VCs that are backing those business models have like 20, 30, 40, 50 companies in their portfolios. Maybe a few are running that model. Maybe the market turns before the exit outcome and so they fail. But guess what? They&#39;ve got like 80% of other companies that will keep them afloat. You the founder that&#39;s running that playbook. You have just that company and you&#39;ve gotta realize if you&#39;re losing money on every single order and the market changes at all for any reason, whatcha gonna do you , you literally can&#39;t grow yourself out of that problem. And so I think gross margin is kind of one of those metrics that founders need to pay attention to in the very early days. It&#39;s just so much easier to become profitable and even just to, to fundraise and have a healthy business if you have healthy gross margin. Buying Revenue Pablo 5:47 The other thing that, that Michael spoke about this point, he has this line that he says, he&#39;s like, if you know, he&#39;s like, I see companies that are growing their revenue and their gross margin is decreasing as they do that. And if they do that, they&#39;re just buying revenue. That&#39;s an interesting thing as well, right? Like if you&#39;re growing your revenue but you&#39;re actually getting less gross margin as a result, you&#39;re probably doing some sort of discounting or something along those lines in order for demand to kind of speed up your revenues to go up. But at the end of the day, your cost of goods sold went up as well, more than your revenue actually. And so you ended up with less money. So you&#39;ve gotta think about that hybrid of thinking on the one hand, like almost this S M B owner who&#39;s addicted to, you know, bottom line, what they take home at the end of the day and the startup founder who&#39;s addicted to top line growth and getting as big as fast as possible. There&#39;s this in-between line and I think gross margin really speaks to that. Another thing that&#39;s, you know, obviously related to this is, is the concept of capital efficiency. Capital Efficiency is Key Pablo 6:47 And Michael&#39;s point on, on this is, if you think about BlueCat, I find it funny how much money people raise today because to get those exits, the exits of like 700 million and I think $400 million total, we raised that net total amount of $27 million. That&#39;s it. So we were very capital efficient and again, it was because of a huge gross , huge gross margin. It reminds me of, I was listening to Jeremy Levine who&#39;s a , a partner 20 plus years at Bessemer. He was the VC that backed Shopify, he backed Yelp , he backed Pinterest. So a lot of like big names, multi-billion dollar companies. And when he was asked, you know, what was one of the number one things that he looks for in companies and he said capital efficiency, he&#39;s like, I want companies that are so capital efficient, they don&#39;t even need my money. He tells a story about how Shopify raised about nine , raised about a hundred million dollars before they went public. And when they went public they had $97 million still on their balance sheet. So they&#39;d consumed a net total of $3 million. He&#39;s like, that&#39;s what I want. I want companies that don&#39;t even need my money. Which by the way is kind of opposite. Like I think in the early days and especially the last few years, it started to become this thing where like, the more money you need, the better you are for VCs. It&#39;s like VCs want these companies that actually can take in a lot of money. If you think about the soft bank playbook, the Tiger playbook, just trying to pump as much money into the system. And so these companies that had these , um, asset heavy , maybe they were lending out money or maybe they had this asset heavy component of their business, they&#39;re buying like fleets of something or warehouses or things like that. They were like darlings frankly for VCs because they could just suck so much money in and there was so much money to deploy. But Jeremy Levine, who&#39;s been through it like a long time, has the exact opposite idea, which is I want companies that literally don&#39;t need my money. By the way, from a founder perspective, there&#39;s no more powerful thing you can have than not needing VC money. If you run a company with a nice gross margin, right? And it&#39;s capital efficient, you&#39;re not burning too much money relative to your revenue rev relative to your gross margin. You always have an eye on how you could change things a little bit to become profitable. All of a sudden you&#39;re in a position of total strength because guess what? You don&#39;t need the VC money, you just don&#39;t need it. And that&#39;s just like negotiation one-on-one. So everything gets better from there. Your terms get better. You have, you&#39;re in a position that you can choose the capital partners that, that you want, you probably end up with more control. And so there&#39;s just all these benefits that come from being capital efficient and I don&#39;t think there&#39;s a true trade off . You&#39;re seeing it now like with Uber, Uber&#39;s profitable now. They&#39;re still growing, right? And Dara has this quote, Dara&#39;s an amazing, he&#39;s a c e o of Uber, was a c e o of Expedia. And he talks about how it&#39;s a false dichotomy. It&#39;s not about growth or leanness, it&#39;s not about growth or capital efficiency. Hugh as a founder have the hard task, very, very hard, but non impossible task of figuring out how you can do both. Again, talking about a very similar, we&#39;re we&#39;re tagging a similar problem , but in a bunch of different ways. And I&#39;m just feeding off of what some of the things that, that Michael Hyde was, was talking about. You Can Raise Too Much Money Pablo 9:59 He , he has this quote, he says, I&#39;ve never heard a founder say I raised too much money, but that&#39;s because I think what happens is they raise that money and then they find a home for it, which is probably the mistake. So let&#39;s talk about that for a second. When I started off, I remember , uh, one, let&#39;s call &#39;em like advisor type, which there&#39;s so many of these in, in startup world, and he told me never leave money on the table. And there&#39;s some truth to that, you know, because fundraising is, is not that easy. Markets can turn things outside of control can change and you&#39;ll regret in many cases having had the opportunity to raise a bit more money but not taking it because you thought you didn&#39;t need it because the terms were weren&#39;t perfect or whatever. And , and I&#39;m not like disagreeing with that. There is some truth to that, but there&#39;s a counterpoint as, as there is most things I think in startup land that are just, they&#39;re just not that linear. I can tell you about a company like many companies, frankly, that are actually decent companies. So let&#39;s talk about, again, not naming names, but a company that maybe is at five, seven, $10 million of top line revenue that&#39;s not growing that fast though. They&#39;re growing like 20%, 30% year over year . Now, if you&#39;re the founder of that company and you&#39;ve built a company that&#39;s clearly beyond product market fit, maybe your tam&#39;s not that big or maybe, you know, the , the product market fit you have is just with a , you know, it&#39;s a small segment of that market. But if you&#39;ve got five, six, 7 million in top line revenue and you&#39;re selling software which is, you know, usually 70, 80% gross margins and you are still growing like 20% or so year over year , that&#39;s not a bad , that&#39;s probably not a bad outcome for you. I mean obviously you&#39;re earning salary, but beyond that, like you could probably sell that business at some point depending on the market, you know, between three and eight times revenue. And if you own 20 30% of that, that&#39;s a multi-million dollar day for , for the founder. Unless of course you&#39;ve raised too much money. And that&#39;s what many of these companies that I see and find themselves in, right? They&#39;ve raised 20, 30, $40 million and yet they&#39;re, they&#39;ve never been able to use that money to actually fuel growth. And by the way, this was a preventable, avoidable mistake because when I charted through what happened here, here&#39;s a company that was growing relatively well, did not have the dials for growth, did not know, oh I&#39;m gonna do this thing like I&#39;m gonna hire more salespeople or I&#39;m gonna invest in this marketing channel or whatever. And I&#39;ve already proven that doing that speeds up my growth. But they kind of got to a place a hundred K, 200 K in monthly revenues and they&#39;re like, okay, it&#39;s time to raise a series A. So they go out and they raise like a 10, $15 million series A and like Michael said, I mean it would be ideal and some founders, they had reselect, few founders will raise that 10, 15 million, stick it in the bank and act like they don&#39;t have it until they figure out levers for growth. If you can do that, perfect, because you didn&#39;t leave money on the table, you still got it in the bank. If you don&#39;t find ways to grow, it doesn&#39;t matter. You still have it in the bank, which just increases your enterprise value. &#39;cause people will obviously pay one X for whatever cash you have on the balance sheet. So if you can do that, great, but most of the time what happens is they raise that money and then they, they use it. They&#39;re like, well, and by the way, it&#39;s not like you have these power dynamics, like the VCs that invest that money expect you to use it. So they&#39;re kind of pushing you to use it. It&#39;s easy for you to use it. There&#39;s no friction to spend money, so easy to spend money. So that&#39;s what typically happens. You start spending that money, you hire more people, you spend more on marketing, you polish a bunch of things and if it doesn&#39;t translate into growth, all you&#39;ve done is you&#39;ve added this pref stack on top, right? So now you&#39;ve got this business that, like I was talking about, is doing $5 million in revenue, but it&#39;s raised 20, $30 million. Well guess what? If that business sells for $30 million tomorrow, that first 30 million goes right back to the VCs. &#39;cause they have, they&#39;re on top of the pref stack . They have a one x liquidation preference, which means they get paid first. Now you the founder went from owning 20 to 30% of some outcome, right? That same business had to stayed lean, not spend all that money would still be worth $30 million. You could take your 20%, that&#39;s like 6 million bucks. That&#39;s what you gave up, $6 million and you gave up the optionality of selling that business in that way. You&#39;ve now got no choice back against the wall. You need to figure out how to grow a hundred percent year over year , otherwise you&#39;re never gonna get out of the press stack you&#39;ve created. So watch out for that, right? Like watch out for raising too much money. And it happens, by the way, in the early days as well, if you look, and I&#39;ve done, I&#39;ve done episodes with the founder of Clio , which is a billion dollar company, done episodes with Howling , the founder of wapa, which sold for over half a billion dollars. And look at the , the early days they bootstrapped, they actually didn&#39;t raise those early rounds and to the extent that they did, it was like a few hundred thousand dollars. And I asked them specifically, did that help you? Did it help you to bootstrap? And they&#39;re like, yes, it helped because it kept the team really small, it kept everybody super focused on what matter which was customer value. I&#39;ve seen companies on the flip side that have raised like $4 million pre-seed rounds before they have forget product market fit even like before they&#39;re delivering true value before they have customers. And guess what, all of a sudden you hire way too many people, you over polish everything, everything kind of gets bloated and you, your lead is stray from what really matters, which is delivering true value. So watch out for that. Like those are the two things. Those are just observations. On the one hand, not leaving money on the table is sound advice. And there are times when you might regret not having taken that. Having said that, raising too much money is something I&#39;ve seen many founders do. And especially because they tend to spend that money, it often becomes a massive mistake. Here&#39;s Conferences are a Vacation Pablo 15:27 another fun one that he mentions. He&#39;s like talks a bit about , um, about conferences and he&#39;s like, we party here and there&#39;s these conferences and they&#39;re on stage and they take a photo of so-and-so on stage and they&#39;re at this and they&#39;re meeting and they&#39;re networking. I think 90% of that, 99% of that is a waste of time. I think you should work on your product and sell your product to a company land and expand every rooftop party. You&#39;re going to just count it as vacation, it doesn&#39;t matter. That&#39;s Michael High&#39;s thought on conferences and events. I&#39;ll tell you this, I feel a similar way and you know, again, when you start off and you&#39;re founder, there&#39;s just like, there&#39;s just so much fun. There&#39;s so much excitement, there&#39;s so many events that are going on and they do like, they can&#39;t fuel you with energy and , and , and here&#39;s what depends , like type of person you are, the type of business that you have. You know, some of this stuff can be true BD if you think about it. Smart. I&#39;ve seen founders who can really leverage these conferences into something, but, but making no , make no mistake, like they&#39;re not the most efficient use of time. They can easily be huge. Time sucks and I see a lot of founders. I think the problem is like, and and it happened to me as well, is like you get caught up in it and all of a sudden you feel like going to the events and going to conferences is being startup founder is like work. And and again, unless you&#39;re very targeted about it and you&#39;re like selling to lawyers and you go to some lawyer conference, it&#39;s often not work. It&#39;s often just the fun and game side of it. And , and you can do it, you know, for enjoyment. Like he says, like treat it like a vacation. But the reality is you&#39;re probably not getting much closer to product market fit by doing it. You&#39;re probably spending time on things that aren&#39;t getting you closer to product market fit. You&#39;re feeling like you&#39;re spending all this time being a founder. But just remember being a founder is fundamentally about building an amazing product that delivers clear r o i clear value to some part of the market and figuring out what product that is and what market that is and getting to product market fit. That&#39;s what it&#39;s all about. So whenever you&#39;re doing stuff that isn&#39;t clearly related to it, you&#39;ve, you&#39;ve got a question, why is you even doing it? I&#39;ve got one final point here that I wanna talk on. So Michael Hyatt went through, like I said, the.com bust. So he went through the financial crash and, and unfortunately he had to kind of go through layoffs and really cut back in order to make it through and survive. Do Not Delay Company Layoffs Pablo 17:41 And he said to me, he said, another mistake I think founders make, he&#39;s like, you know, they&#39;ll tell me if I cut too hard, it&#39;ll change the feng shui of my company and the vibe. And so , you know, what he is getting at there is , and I&#39;ve heard this too, it&#39;s, and , and I made this mistake. Here&#39;s the reality, right? Like you are a founder, you go out and you finally like, you hire people and every single hire is actually so hard. Like each independent hire is such a big win. You go through so many candidates, so many interviews. Once you find some that are actually solid, then you&#39;ve gotta convince them to actually join. And then you do that over time and, and more and more and more and more and more. And you build a team, a team that you love, a culture where people are happy, where they like coming into work, people are vibing. Then you find yourself your place when you have to cut. Maybe it&#39;s because your burden is too high, the market&#39;s changed, whatever. Maybe it&#39;s due to performance reasons. It does kind of doesn&#39;t really matter. You find yourself in a position where you&#39;re seriously considering some sort of workforce reduction. And, and I&#39;ve been there and I can tell you that the, the normal thing to do is to try and fight it, right? Like you try and fight it, you try and delay it, you try and delay it. And I get it because again, like you spend so much time hiring these people, the last thing you wanna do is let them go. That&#39;s what it was for me. Like it was the last thing I want to do. Just find a way to not have to, to do that, right? And, and even like, you&#39;re getting all these things accomplished because you have all these people. How are you gonna keep getting things accomplished? What&#39;s gonna happen to the people that are left over ? How are they gonna feel? Et cetera, et cetera. But I can tell you that if you&#39;re seriously considering layoffs, like if you&#39;re at that point, it&#39;s because realistically you&#39;re not profitable. You don&#39;t have a path to profitability and you probably have way less than 24 months of runway. &#39;cause if you had any of those three things, you probably wouldn&#39;t be considering layoffs in the first place. And so if you find yourself in that situation where you&#39;re considering it, you&#39;re probably gonna have to do it. And delaying and trying to avoid it is one of the biggest mistakes you can make because all it&#39;s gonna do is mean that the layoffs that you, you do when you do them are gonna have to be bigger. I&#39;ll tell you when I did it at Gym Track , we did it the worst possible way. We started off, we kind of had to reduce. So we said, okay, let&#39;s find kind of the weakest, the people that we find are the weakest, let&#39;s get rid of those at least and make it a performance thing. And we got that was like a 10% reduction. So we did that. Obviously it wasn&#39;t meaningful enough. So guess what? Two months later we&#39;re like, okay, you know what, that wasn&#39;t meaningful enough. We need to do bit a bigger reduction, so we need another, I don&#39;t know , 20, 30%. And that wasn&#39;t big enough because we&#39;d waited and now we have to do a third of one. And so it&#39;s death by a thousand cuts at that point. You have no credibility anymore when you tell people, but worry , you&#39;re safe now. They don&#39;t believe you and now you&#39;ve really broken your culture. The right way to do it is just understand like the people you&#39;ve hired as much as you like them, they&#39;re not your family, they&#39;re not your friends. What you&#39;ve built is a team and you&#39;re, you&#39;re the only one in a position to make sure that that team survives, right? That the ship survives. That&#39;s your number one objective. And if that means, if you&#39;ve, if you for whatever reason have gone into a place where you might need to do a , a reduction, it means You just have to do it. And, and you have to do it once and do it right. That&#39;s the keys . Do it once and do it right. You know, pay the right severance, give ample time, be transparent. All those things are incredibly important. But don&#39;t push it, don&#39;t delay it, don&#39;t avoid it. And it doesn&#39;t have to break your culture. It really doesn&#39;t. If you do it the right way, you do it decisively and fast, then yeah, of course the people that get laid off get affected are going to be upset, they&#39;re gonna be angry and that that&#39;s totally legitimate because it&#39;s not fair to them. But like Michael says, it ultimately is about the people who stay and the people who stay will come to understand it because they&#39;ll now understand that, you know, we are in a situation where the c e O has saved the ship . If you&#39;re transparent with them and they understand kind of the new plan , the go forward plan and the position that you&#39;ve now put the company in, it&#39;s a stronger position. So yeah, maybe before you made some sort of mistake in terms of over hiring , but now you&#39;ve corrected that mistake. And that&#39;s really what what leaders do is they act decisively, they&#39;re transparent and they own up to the mistakes that, that they make.