Credit: Shutterstock photoYou have probably heard that there is a growing problem in Silicon Valley. Startups are being valued too high, stay private for too long and have soaring burn rates. But one thing continues to be overlooked; unit economics. It is a basic concept that looks at the direct revenues and costs associated with a particular business model. This is expressed on a per unit basis and has meaning to businesses of all sizes, large and small.
Startups, now more than ever, struggle to explain how their unit economics will ever make sense. Essentially they are losing money on an ongoing basis with no sign of ever turning a profit. A change in mentality to improve this will help manage the perceived tech bubble, but also increase the cost of raising capital.
Basics of Unit Economics
All businesses, regardless of what stage, work around a financial model that is tailored to key assumptions and predetermined goals of its leaders. For most great companies, unit economics is the fundamental building block, even if the company was unprofitable in the beginning. If a company can identify its unit economics, then it can effectively determine break even points and margins, both of which define success.
Building the model first requires you to choose a unit. In a consumer facing business the best unit is often a single customer. The investment at the customer level is defined by customer acquisition costs (CAC), which is the total sales and marketing expenses of acquiring a single customer. Once that is determined, you can derive the amount of value each unit generates. This is often referred to as lifetime value (LTV). Mathematically it is a representation of gross margin, monthly churn percentage and monthly revenue per customer.
Now that you have the two most important building blocks, you can make an effective assessment of the state of your business. Expressing LTV and CAC as a ratio of each other determines return on investment. Ideally this ratio should be 3 to 1, meaning your customers are contributing three times more value than the cost of acquiring them. The faster a company can optimize this ratio; more cash will start to pile up.
What it Means to Startups
Lately basic unit economic are ignored in favor of vanity metrics like revenue growth. It’s become commonplace that venture-backed companies run double digit sales growth while continually taking a loss. In fact, many of the same companies have financial statements claiming they will never make a profit. They then turn to the capital market to raise huge amounts of funding and sustain operations. Unfortunately, spending more money instead of addressing the problem just creates more issues.
This starts a bad trend of high burn rates and when coupled with a scaling business, can become scary. Tesla (TSLA) has suffered from this very problem. The electric car company continues to lose money while making more cars. Recently it issued $2 billion in shares to meet the increasing demand for the Model 3. Assuming the Model 3 is just as unprofitable, its financial outlook a year from now might be bleak.
What Does It Mean for Funding?
Unfortunately, Silicon Valley investors have become far too concerned with missing the next Uber than making sound investments. Since 2014, startups have raised capital on the best terms in the past 15 years. Inexpensive equity funding enables startups to raise huge amounts of capital and disrupt the incumbent players. More funding with less dilution works in favor of entrepreneurs.
If investors were to shift their focus to unit economics, startups would be in for a rude awakening. Raising money would become harder than it is today, increasing the risk of early stage startups going under. The sooner investors use unit economics to identify viable businesses, valuations will come down, capital markets will stabilize, and the inflating tech bubble will start to shrink.
Final Take
Regardless of size, it is important to consider unit economics as a company scales. Essentially you can’t know whether your business works until a basic unit analysis is modeled. This is particularly important if you are considering raising capital in the near future.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
