Denice R. Preston
Venture funding has grown by more than 120% over the past five years in the US. Both startup founders as well as investors are now comfortable with low-margin business models. The success of Amazon and the Facebook of the world can mask failures in other sectors where the “build-it-and-they will come model” doesn’t work.
Toby Clarence Smith, Toptal Finance expert, focuses on the importance of studying the long-term sustainability of a business. He focuses, in particular, on unit economics as one of the key building blocks for profitability and breakeven analyses.
The hype soon wore off, and many well-funded companies shut down. The New York Times declared it to be the “end” of the “on-demand dream,” while Pandodaily documented it as the coming “food apocalypse.” Quartz quipped in a May 2017 piece, “We ,have been living a golden era for years of VC-subsidized meal.” While startups flooded the food delivery market, they offered customers coupons and promotions made possible by generous investor financing …[But] In the end, people seemed to be more excited about getting their meals delivered at absurdly low prices. “In that sense, the last three-plus years were less about innovation and more about a massive wealth transfer from the VCs who funded the startups to the consumers who received a free meal along the way.”
What happened? Poor unit economics. Startups that deliver food on demand were not profitable, and their business models failed to work at scale.
The fate of the food-delivery market in Silicon Valley should serve as an important reminder that even today, profit margins are still important. Bill Gurley himself stated this in an ominous 2015 interview: “One thing happens in Silicon Valley – and this has been highly cycled – the more we reach peak [valuations] terrain, the more optimistic people get about lower-margin business models.”
It makes no sense to invest in or scale unprofitable companies. If a company loses money with every sale, growing it will only make the loss bigger. Yet, I am continually surprised at the number of entrepreneurs who do not internalize this. After having founded and sold an eCommerce company and moved to the investment side, I have seen time and again how founders of startups adopt the mentality of “scale it first and make it profitable later” without ever thinking about whether or not their business will be profitable.
This article is meant to bring attention to unit economics, which is one of the best ways to think about how profitable a startup business can be. By addressing some of the most important issues that I have encountered, I want to share some valuable information. Not only will this help founders improve their chances of raising money, but it will also allow them to make an informed decision about whether or not they should invest years of their lives at great personal and financial expense into businesses that may never make any profit.
What are unit economics, and why are they important?
Simply put, unit economics is a measure of the profitability of selling/producing/offering one unit of your product or service. Consider it unit profitability. Positive unit economics indicate that you have a viable business. If you are a company that sells widgets, unit economics is a relationship between all of the costs and revenue associated with the sale. Uber is an example of a company that offers a service. The unit economics would be the relationship between income (e.g., one taxi ride) and the costs involved in providing the service to the customer.
Unit economics’ purpose is to estimate the amount of profit that a company makes before its fixed costs so they can calculate how much product a firm needs to sell to cover their fixed costs. Unit economics is a key part of breakeven analysis.
This type of analysis is essential for startups in the growth phase. This analysis outlines a route that a company can take to reduce its reliance on external equity financing. This is shown graphically in Figure 2. Profits before fixed costs (called “contribution” on the chart) will move up and to the right as volumes increase. They will eventually cross paths with the fixed cost lines. This point is called the breakeven point.
If you want to go deeper, the way that one approaches the calculation of unit economy is important. The key difference is the definition of a unit. When a unit is defined as one sold item, the unit economics calculation becomes what’s known as the Contribution Margin. The contribution margin is the revenue generated from a single sale after all variable costs are removed. This amount then goes towards paying fixed costs.
If, instead, one defines a unit as a single customer, then the metrics that are commonly calculated are Customer lifetime value (CLV), along with its relationship to Customer acquisition costs (CAC). These are essentially the same as the contribution margin in that they represent the profitability of a customer against the cost to acquire said customer. The difference between them is that they do not have a fixed time. CLV is a measure of the total profits generated by customers throughout their relationship with a company. This is because startups are forced to make investments in order to acquire customers. Often, they do so at a loss. If the customer continues to do business with the company, it will eventually be able to recover its initial investment.
This article does not provide a detailed tutorial or explanation of unit economics. For those new to the unit economy and how to calculate it, here’s a good introduction to contribution percentage. And here are two more on CLV. These are geared more towards eCommerce, but they still apply to any business. The web is full of tutorials that explain how to calculate the metrics. Suppose you want to get into unit economics in depth. In that case, I highly recommend reading Peter Fader, who is widely considered the expert on the topic (and, incidentally, was my former business school professor).
Common Mistakes Founders Make with Unit Economics
Most founders have some basic knowledge of unit economics, and they often include it in their discussions with investors. In fact, many startups base their entire value proposition on improving the unit economics in their vertical. A common example is the direct-to-consumer startups that we covered with a fascinating article about the mattress industry.
What has surprised me most is how superficially many founders approach this subject. They only do it because they have to. But they don’t understand what unit economics are and why they’re important. I have encountered three sets of common mistakes made by founders, which I will address in more detail in this article. (n.b. : a surprising number of investors also do not understand these principles.
