Five Years Too Late

February 5, 2009

Is Capital Efficiency the Enemy of Innovation?

Filed under: venture capital — Tags: , , , , , , — fiveyearstoolate @ 2:17 pm
Eric Wiesen

Eric Wiesen

I’ve been thinking about two themes that have generated a lot of discussion lately. The first is a growing sense that we are in a period of weak innovation; that Silicon Valley (and the rest of the US tech ecosystem) is broken, and that most of what’s being invented today is incremental, with no real innovation taking place. The second is strong focus on capital efficiency within the technology startup world.

At this point, given both the trends in web development and the macro economy, it’s practically a race between the entrepreneur pitching and the investor being pitched as to who will bring up how capital efficient the business is. The large majority of companies we see these days make a point of how capital efficient their models are, and the majority of investors (VCs and angels alike) are quick to dismiss companies that are viewed as capital inefficient.

Let’s step back for a moment and talk about what capital efficient means, and then we can get to the heart of the question. Capital efficient, in its simplest form, means you can accomplish a lot with a small amount of capital. And of course if you stop there, it sounds like an unadulterated good thing. More for less, right? And as a first-order question, I think the answer is yes. Doing more with less is a good thing.

But the second theme contextualizes the first for purposes of our question. We are in a period where much of the technology innovation taking place is in “soft technology”, be it software, web services, technology-enabled services or data businesses. And while it’s certainly an enabling environment that so many of the tools required to create these businesses have become commodity and free, there is an increasing concern that people are simply using free, easy tools to create slightly better versions of things that already exist.

Because how many of the really innovative technology companies throughout history were actually capital efficient? Whether we’re thinking about Edison Electric or Google, Amgen or Intel, Nvidia or Nucor, we often find that companies that really transformed industries with new technology or approaches took a large amount of capital and significant time to achieve it. And while these are clearly cherry-picked data points, I think that even on the web most of the really significant, innovative companies have taken in quite a bit of resources along the way.

I was recently on a panel with a friend of mine who’s an angel investor. And what shocked me was when he said that his group was looking primarily to invest in businesses that could, from a dead start, achieve profitability on significantly less than a million dollars of capital. And while, on its face, this sounds amazing – who wouldn’t want to invest in businesses like that? – another part of me really had to wonder, can you build anything interesting or important if that’s the hurdle you establish at the outset? Would any of the companies who have significantly raised the innovation bar have fit that screen, back then or now?

So I don’t think there’s a clear answer – we at RRE Ventures are clearly going to continue to seek businesses that can accomplish their goals with as little capital as possible, because it’s essentially obvious to do so. But I also agree with the criticism that “Web 2.0” has been at least in part an exercise in excessive capital efficiency, and that people were building incremental products and services with no real innovation in the hope of a quick flip or tuck-in acquisition. In the back of my head, I’m still going to be thinking about opportunities to create something really transformative, even if the road is a little longer and tougher.

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  1. PayPal started off as a way to “beam” money between PowerPoints. Without the capital afforded to fail, they never would have taken off. To this day, capital efficiency strikes me as the reason why no one has been able to take them on. To do so will require expensive trial and error to make a truly better experience. Yahoo Wallet failed back when, as did c2it. Google Checkout is a loss leader for AdWords and Amazon Payments is a support structure for AWS. I can think of many others; this is but one example of an industry where the desire for capital efficiency is killing innovation.

    Comment by Sachin Agarwal — February 5, 2009 @ 2:29 pm

  2. Between Palm Pilots. The PP thing foils me again. Argh!

    I should also note that the need for capital efficiency has dramatically changed our ambitions for Dawdle – we had a plan to expand and enable all sorts of online commerce; now, with the capital markets dried up, we’re focusing on gaming only as we reach towards short-term profitability.

    Comment by Sachin Agarwal — February 5, 2009 @ 2:31 pm

  3. You know which companies are horrible capital inefficient? Cleantech companies. Billions of dollars are flowing into technology outfits that are trying to find new, clean ways to generate energy. This is where most of the real venture-funded groundbreaking work is being done right now and the amount of capital each company is raising is staggering. When you hear numbers like $500m for Nanosolar, Solyndra bringing in $220M in a single round, one can’t help but think what it would take for a traditional tech company to raise that kind of money. To me it just seems that the venture world isn’t interested in investing huge amounts of capital in a company that makes an iPhone app that counts your calories and sells for $2.99 a unit.

    Comment by Jeremy — February 5, 2009 @ 3:02 pm

  4. It would be beneficial to see how one defines innovation as transformative vs incremental. Couldn’t it be argued that at the outset Google created a better mousetrap by making search results more relevant and with a clean UI? If so they would fall in the incremental bucket.

    In my mind a transformative technology enables people / businesses to do the previously impossible. These people / businesses must learn a new behavior and a new set of rules. This learning process takes time and thus requires the company creating the technology to burn through tons of cash while adoption takes hold.

    Comment by Andres Moran — February 5, 2009 @ 3:43 pm

  5. To expand on my Google reference above, once they implemented AdWords they became transformative. AdWords enabled small and medium-sized businesses to advertise online, which was virtually impossible for them to do before.

    Comment by Andres Moran — February 5, 2009 @ 3:51 pm

  6. I wondered how long it would take you to write this post.

    I agree that investing in companies that can reach b/e on $x00,000 fundamentally changes the types of business that get capital. As a result there are a lot of very good innovative businesses out there that we would have funded 9 months ago but wont any more. That being said there are a lot of very good startups that do fit the model. Are they innovative, yes. Are they transformatitive, probably not.

    I like to think about the market opportunity for a company as a function of the economic value they create (or redistribute). The share they can take is a function of, among other things, their competitive position. When you think about it this way then there are a lot of companies with large market opportunities that can initially reach break even and prove their economic model… then grow.

    Traditionally Angel investing, as an industry, has been a feeder for venture. It also hasn’t been paid for the risk taken (neither has venture as an industry for that matter but that is another topic). I would not be surprised to see a separation of the two investment classes over the next couple years. There are several reasons for this, one smaller m&a exits became more common and two, this model affords us the opportunity to invest in ‘buy or build’ businesses that can still reach out exit multiples but can’t justify a later round. However, if this downturn is prolonged, I wouldn’t be surprised to see more venture firms providing growth capital to companies that have reached b/e. Reaching break even can justify the tick up in valuation we are looking for between rounds.

    All this being said, the b/e requirement is temporary. Once we have confidence that our portfolio companies can raise another round after ours you will start to see this requirement dissipate. Unlike the larger guys we cant fund a company for 2 years of burn so in order to avoid the financing risk we are forced to look at companies that can reach break even.

    Comment by Bronson — February 5, 2009 @ 6:45 pm

  7. You make an interesting point but I believe that Capital Efficiency is not the issue, the issue is how you differentiate real entrepreneurs from techies with great ideas but no clue about what business is about.

    I see in Silicon Valley a lot of CEO of startups who are engineers with a great technology and they are looking for a real customer problem to solve.
    Typically the selection process is that investors will find the great ideas and fund the one they like and they trust could turn into a success. And it is a lottery game for the funded, and a numbers game for the investors. They know that statistically they will invest in 10 companies, and 1 will be a hit and pay for the others, 3 will make it so-so and the rest will be goners.

    Now this selection process leaves out a lot of good entrepreneurs that have great businesses but do not fit the profile, and therefore would not make the numbers work for their investors. Which is clearly not good for Innovation by the way.
    But this is how it works, and with the press clamoring the big successes (Yahoo, Google and co) everybody keep believing in the dream.
    When recession hits, the numbers do not work as well, and a lot of investors get nervous, start becoming more cautious about the great ideas, and start looking more into also making sure the companies are capital efficient.

    So now instead of investing in great ideas, how about focusing on great entrepreneurs? Not evangelists with great ideas but people who combine vision with business accumen (including the ability to actually go and get customers). And how about changing the selection process from what it is today (competitive model) to a collaborative model that will actually foster innovation?
    Entrepreneur Commons ( is about doing just this, maybe you will find the concept interesting…

    Comment by Marc Dangeard — February 5, 2009 @ 7:47 pm

  8. I think we are trying to optimize an economic transfer function. Its outputs are probably IRR, cash-on-cash, and “how does this help me raise my next fund from LPs.”

    Capital efficiency is just one of the inputs—an imprecisely defined input.

    We are probably better off focusing on outputs and how the relevant inputs influence the outputs. The thinking tools in Don Reinertsen’s upcoming book will be quite helpful.

    Thanks for a post that got me thinking!

    Comment by Nivi — February 5, 2009 @ 8:23 pm

  9. Stuart,
    This is a great discussion to have…you tend to see the same cycles where, as entities get bigger (whether companies or VCs), greater amounts of capital need to be deployed to make a difference to bottom lines. This leads to certain, established selection criteria performed by mid-level managers to reduce risk of failure and emphasizes the operator’s requirement to execute successfully what they know they can do vs. heading into the chaos of the unknown.

    In the meanwhile, bigger amounts of capital need to be deployed, which means that currently small opportunities with unclear upside (lots of uncertain outcomes and unfamiliarity on the part of investor) will be put aside for the better opportunities with known outcomes. In the VC space, the kicker is that it has to have 10X return potential…which is much easier at the creation of a $100M company than a $1B company, but of course there isn’t enough bandwidth to invest at a level that would yield 10 companies at $100M.

    New markets either require time or the capital to break through early and buy scale (for example, is a two headed marketplace for healthcare appointments…neither of which has already been pre-assembled so local scale needs to be reached on each side). The quick-to-profit companies gain immediate scale by leveraging that which someone else has already built…by definition they must be incremental and fit nicely into someone else’s “slotting” space with an existing value chain.

    Thus, in the internet space, we’ve seen tremendous syndication of content and processes in new, lego-like configurations, but very little actual interest in building new infrastructure or building new value chains in unfamiliar markets. Until capital starts investing in solving “pain” by creating novel value chains and infrastucture/assets (which is expensive and risky), I don’t think we’ll see dramatic breakthrough companies coming via the VC channel.

    In taking a new job with the X PRIZE Foundation (I’m working at developing a $10M+ healthcare prize), however, I have seen a new way to deploy capital that allocates risk in very different ways. The prize model is much different, where leverage comes from the number of competitors looking to crack a market, rather than investors looking to guarantee the outsized success of one entity. The result is that smaller competitors can take radically different approaches to solving a single problem…the resulting attention and “traction” from the formation of a new market at scale (due to interest around the contest and participation by multiple stakeholders and competitors) highlights a very different approach to investment and use of capital to drive innovation.

    Comment by Vijay Goel, M.D. — February 9, 2009 @ 1:36 am

  10. […] and arguing that it does not deliver.  Eric Wiesen, a partner at RRE Ventures, argues in his article that capital efficiency leads to building incremental products with no real […]

    Pingback by Are True Early Stage Investors an Endangered Species? | VC Deal Lawyer — June 15, 2010 @ 2:12 am

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