Capital Efficiency

The idea in one minute#

Three ratios get quoted whenever somebody senior asks whether the company is being run well: the magic number, the burn multiple, and the Rule of 40. They are not interchangeable. Each one tests a different thing, each is gameable in a different direction, and knowing which is being quoted tells you what the person asking is worried about. For a product manager the practical value is that two of the three are movable by product work, and knowing which lets you say so in terms the room accepts rather than claiming a general improvement nobody can price.

A picture#

flowchart LR
  Q[":i-circle-help: <b>Is this being run well?</b>"] --> M1[":i-megaphone: <b>Magic number</b><br/><small>is sales spend working?</small>"]
  Q --> M2[":i-piggy-bank: <b>Burn multiple</b><br/><small>how much cash per new revenue?</small>"]
  Q --> M3[":i-scale: <b>Rule of 40</b><br/><small>growth plus margin</small>"]
  M1 --> P[(":i-target: <b>Where product helps</b>")]
  M2 --> P
  M3 --> P
  M3 -.->|"gamed by cutting growth"| G[":i-triangle-alert: <b>Looks better, is worse</b>"]
  class Q neutral
  class M1,M2 compute
  class M3 queue
  class P memory
  class G warn

Three answers to one question. Each is a different worry wearing a formula.

How it really works#

The three ratios#

These are rules of thumb circulated in venture benchmarking rather than sourced measurements, and this course does not treat them as benchmarks. They are useful as a common vocabulary, which is most of their value.

What each one is really worried about#

The magic number worries that sales is spending more than it returns, which is a question about the go to market motion rather than the product. Product affects it indirectly, by improving conversion and by making the product easier to prove in an evaluation.

The burn multiple worries about the whole company, because it includes every cost rather than just sales. It is the broadest of the three and the hardest to game, which is why investors increasingly prefer it.

The Rule of 40 worries about balance, and it is the most gameable, because growth and margin are substitutable in the formula but not in reality. A company can improve its Rule of 40 by cutting growth investment, which raises margin and looks like discipline for about a year.

Which ones product can move#

Burn multiple, directly, from two sides. More net new revenue through better conversion, retention and expansion. And less cash consumed per dollar of it, primarily through cost of revenue, which is where the inference argument lands.

Rule of 40, directly, through the margin half. Reducing cost of revenue raises margin points one for one, and a product manager who can name the margin effect of their work is making a Rule of 40 argument whether or not they use the phrase.

Magic number, indirectly. Claiming otherwise without naming the mechanism is the kind of claim that gets a proposal discounted.

Why retention sits underneath all three#

All three ratios improve when customers stay longer, and none of them has retention in the formula. Net new revenue is net of churn, so reducing churn raises it without winning a single new customer. This is the most reliable route a product manager has into any of these numbers, and it is invisible if you only look at the formulas.

When to use them#

In a proposal, pick the one the person deciding already quotes. Finance tends toward burn multiple, boards toward Rule of 40, sales leadership toward magic number. Translating your work into their ratio is a presentation decision, not an analytical one, and it changes how proposals land more than the underlying argument does.

Run the numbers#

The same company, two quarters, measured three ways, including a scenario that improves one ratio by making the business worse.

// efficiency.go: three ratios, and one of them can be gamed.
package main

import "fmt"

type quarter struct {
	name                    string
	newARR, churnedARR      float64
	salesMarketing, netBurn float64
	growthPct, profitPct    float64
}

func (q quarter) netNew() float64 { return q.newARR - q.churnedARR }
func (q quarter) magic(prevSM float64) float64 {
	if prevSM == 0 {
		return 0
	}
	return q.netNew() / prevSM
}
func (q quarter) burnMultiple() float64 { return q.netBurn / q.netNew() }
func (q quarter) rule40() float64       { return q.growthPct + q.profitPct }

func main() {
	qs := []quarter{
		{"baseline", 2_400_000, 900_000, 1_900_000, 2_100_000, 38, -14},
		{"churn halved", 2_400_000, 450_000, 1_900_000, 2_100_000, 44, -12},
		{"growth cut to save cash", 1_300_000, 900_000, 900_000, 600_000, 17, 9},
	}
	prevSM := 1_900_000.0
	fmt.Printf("%-26s %12s %10s %10s %10s\n", "scenario", "net new ARR", "magic", "burn mult", "rule of 40")
	for _, q := range qs {
		fmt.Printf("%-26s %12.0f %10.2f %10.2f %10.0f\n",
			q.name, q.netNew(), q.magic(prevSM), q.burnMultiple(), q.rule40())
	}
	fmt.Println("\nHalving churn improves all three without winning one new customer.")
	fmt.Println("Cutting growth improves the Rule of 40 and makes the burn multiple worse.")
}

The second row is the product argument and the third row is the warning. Halving churn moves every ratio in the right direction while winning nothing new, which is why retention work is the most reliable financial contribution a product team makes and why it is consistently underweighted against features that are easier to describe.

The third row is the gaming case. Cutting growth investment raises the profit half of the Rule of 40 and the headline improves, while the burn multiple gets worse because far less new revenue was produced for the cash spent. Any time somebody celebrates a Rule of 40 improvement, the burn multiple is the number to check alongside it.

Sector lens#

Remember this#

• Three ratios, three different worries. Magic number is about sales, burn multiple about the whole company, Rule of 40 about balance.
• Product moves burn multiple and Rule of 40 directly, magic number only indirectly.
• Retention improves all three and appears in none of the formulas.
• The Rule of 40 is gameable by cutting growth. Check the burn multiple alongside it.
• Use the ratio the decision maker already quotes. It is a presentation decision.

Try it#

1. Run efficiency.go with your company’s figures. Which ratio does your work move most?
2. Compute what halving churn would do to each of the three. Compare that to your largest planned feature.
3. Find out which of the three your leadership quotes most. Use that one in your next proposal.

Check yourself#

1. Why do all three ratios improve when retention improves, despite none containing retention?
2. How can a company improve its Rule of 40 while becoming less efficient, and which number exposes it?
3. Why is the burn multiple harder to game than the other two?