Capital Allocation is A Startup CEO's Most Important Job
Capital allocation is a CEO’s most important job, all CEOs - from an early entrepreneur to Tim Cook at Apple.
What is capital allocation?
Capital allocation is the process of deciding how to deploy a company’s resources to earn the best return for shareholders. In his seminal book on capital allocation, The Outsiders, William Thorndike outlines that “CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity.” Thorndike, however, focuses solely on public company CEOs from Warren Buffett at Berkshire Hathaway to Katharine Graham at The Washington Post.
Why is capital allocation so important for startup CEOs?
Fortunately for most entrepreneurs and startups, the primary decision between those five essential choices for how to deploy capital is already made - they will almost solely be investing in existing operations. (Note: Acquisitions and stock repurchases may be used in rare and unique circumstances, but we’ll cover that another time.)
So, as long as a startup CEO deploys capital into existing operations, that makes them a good capital allocator? If only it were that easy.
Before I go any deeper, I am going to tweak the definition of “capital allocation in existing operations” as it relates to startups by breaking it down into three key pieces:
The literal allocation of money in people (hiring) and other operating expenses (budget allocation)
The allocation of resources (people) toward specific strategic and operational goals and tasks
The allocation of a CEOs time toward different activities (time management)
A typical VC-backed startup raises money every 18 to 24 months and between those funding rounds the company needs to use the capital to demonstrate meaningful progress. A SaaS company example:
From Pre-seed to Seed, will be expected to launch a product and get a few customers who like the product
From Seed to Series A, will be expected to achieve ~$1M in Annual Recurring Revenue (ARR) and demonstrate clear product market fit
From Series A to Series B, will be expected to reach $3-5M+ in ARR and prove out a cost effective sales marketing machine…
These milestones may not have to be achieved precisely, but failing to show this directional progress can significantly hinder fundraising prospects and put a company at risk of failing.
Why include resource and time allocation in “capital allocation”?
The old adage “time is money” is even more true for startups, which is why it is central to #2 and #3 above. Early on, the sole asset of a startup is its people and their ideas. To take an extreme example, if a solo founder allocates 50% of their time towards activities that don’t move their ideas forward, they’ve improperly allocated 50% of their capital. When a company is 4-5 people, if one person is heading in the wrong direction that is 20-25% of capital being wasted.
Common Mistakes to Avoid
Given that every company is unique and capital allocation strategies evolve as companies grow, we won’t share a capital allocation blueprint, but rather highlight some common mistakes to avoid. As Charlie Munger says:
“It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.”
Don’t be stupid. Avoid these mistakes and you will be well on your way to being a great capital allocator.
CEO’s Inconsistent Time Allocation
As a CEO decides where to spend her time, she has three key areas to balance between: capital allocation, fundraising / investor relations, and management of operations.
Over time, the mix between these activities will evolve; however, being balanced and maintaining some consistency in the mix between these activities is critical. Rather than ping ponging focus to one activity one quarter and one activity another quarter, CEOs should consistently make time for all three.
The earlier stage the company, the less complex the operation and therefore the least time needs to be spent there.
Investor relations and specifically fundraising early on, is a critical activity that no VC funded startup can survive without. A common mistake for startup CEOs is that they treat fundraising as an all out sprint. I’ve experienced this first hand at Full Harvest, where every 12-18 months my CEO and I would essentially drop everything and focus 110% of our time on fundraising. In one instance that fundraise took 3 months, in another instance it took 12 months, 12 months with the CFO and CEO largely away from the day-to-day of the business.
As I wrote in Demystifying Raising VC, building relationships with investors prior to fundraising will make your fundraising process much faster and easier - so you don’t have to dedicate 110% of your time on a fundraise every 12-18 months.
The CEO balancing their time effectively is also critical to company culture. Without the CEO’s consistent and material presence, the ship is essentially rudderless, will undoubtedly steer in the wrong direction and people will be lost.
Not Focusing Enough Time and Attention on Hiring
When it comes to hiring, the first key decision is around picking the right co-founders, getting that wrong loses you time, equity, and can be very difficult to unwind. Beyond co-founders, the first few hires are almost as critical as they will help establish the company culture and be in the trenches for that early product development and initial sales. Depending on how many hires need to be made, a CEO might be spending anywhere from 15-50% of their time on hiring - setting up a great process, finding candidates, interviewing and evaluating, closing candidates, and effectively onboarding.
Hiring is so critical that Google Co-Founder and longtime CEO Larry Page famously reviewed and approved every new hire for over a decade, even as the company eclipsed 50,000 people.
Investing in sales and marketing before having product market fit
One of the most classic mistakes startups make is building out a sales and marketing team before establishing product market fit (PMF). If you haven’t achieved PMF, your sales team will have to work much harder, sales cycles will be long, your close rate will be very low, and your customer acquisition cost (CAC) will be very high. The customers they do bring in will likely churn quickly - you will have a hole in the bottom of your bucket, your customer lifetime value (LTC) will be low, and you’ll have an upside down LTV/CAC ratio.
Your company culture and employee engagement will suffer too, the sales and marketing team will be frustrated and probably quit and your tech and product team will feel like they aren’t getting the necessary resources.
The vast majority of that money spent on sales and marketing should have been spent on further product development, customer discovery, and engineering to build the right product. Leveraging tools like Maze, can help the company get product feedback before the engineering team starts building.
That doesn’t mean you spend no time or money on sales and marketing, just keep it to a minimum and focus those efforts on getting a lot of customer feedback and determining what sales and marketing strategies could work when you reach PMF.
A provocative guidepost, from legendary CEO coach Matt Mochary, is that teams should not grow above 6 people until you have achieved product market fit and $1M in ARR. While this may be far too prescriptive for many startups, it’s a good thought exercise for any early stage CEO. If you are going to grow beyond 6 people before $1M in ARR, why?
A Key for Great Company Culture
In every situation where I have seen a weak or deteriorating company culture, improper allocation of capital and resources has been a top culprit. As outlined above, whether it is a CEO spending 110% of their time on fundraising and ignoring the day-to-day operations, hiring the wrong people, or a sales and marketing team getting frustrated trying to sell without product market fit, bad capital allocation is devastating to personal, team and company morale and significantly weakens trust and confidence in the leadership. On the flip side, if resources are being effectively allocated, individual employees and teams can see how their work ties to the company's success, and the team is recognized for its success - you’ll have a key underpinning for a great culture.
As the old saying goes, culture eats strategy for breakfast, and great capital and resource allocation will create a powerful flywheel effect where a company hires the right people, directs resources effectively, creates a strong company culture, and therefore retains and attracts top talent.