Unit Economics

The old joke describes a lot of companies at the moment - “I’ll sell at a loss but make it up on volume.” Pilloried in the press, startups burn through vast sums of capital before spectacularly imploding.

Let’s go back to 2012-13. The world was finally emerging from a punishing financial crisis, and low returns across most asset classes mean that a glut of capital was looking for a return. Leading tech companies were outperforming the rest of the stock market, and venture funding started to flow more freely as investors tried to find the next big thing. Loss-making companies finally had the capital to spend aggressively after a lean decade following the dot-com boom and bust.

Uber took this to an extreme, weaponising cheap capital. It would expand aggressively into new cities, pay drivers cash incentives to sign up, and simultaneously subsidise the cost to riders. Every additional ride would lose Uber more and more money. This often continued for years in a given city. But it was part of a strategy - its business improved with scale and density - even if it took hundred of millions of dollars per city.

As Uber got to scale in a city driver utilisation would increase. As a result, it could stop subsidising rides so heavily and margins would improve. In time, the city became profitable. To compete with Uber, other companies needed to raise huge war chests and go head-to-head in the same game of deep subsidies. It became an incredibly expensive war of attrition. In markets where a competitor was present, prices stayed lower for longer. Consumers got cheap travel funded by the venture capital industry. Whoever could raise the most capital could survive the longest and take the market. And Uber was great at raising capital. Their strategy largely worked in US and European markets, building a multi-billion dollar company.

A new generation of entrepreneurs in 2014-2016 saw this playbook and drew the obvious conclusion. Growth to gain market-share mattered above all else. Negative unit economics could be fixed with scale. A generation of "on-demand” startups were launched; food delivery, laundry, home-cleaning, dog-walking, child-minding, hairdressing, massage. They heavily subsidised their service to acquire new users, believing that they’d turn things around once they got enough scale or density in a given city. Investors, following the “Uber playbook”, pumped in money.

Companies raised eye-watering amounts of money on the back of growth metrics; skyrocketing weekly-active-user numbers and impressive viral co-efficients. But they had lacklustre revenues and unsustainable cost structures. It was a bloodbath - most companies failed when they couldn’t improve margins and investors finally pulled the plug on ever-growing losses. Some, though, succeeded in turning their business around. Instacart - most recently valued at $4.2bn - is a shining example.

Now in 2018, what’s the lesson?

Inevitably, investors are paying serious attention to "unit economics” - how much do you earn (or lose) from each extra "unit” (normally a customer) per year? How much does it cost you to acquire the customer? What’s the payback period? What’s the customer lifetime value? Business fundamentals matter again.

Nevertheless, I think many new startups will continue to run successful negative-unit-economics strategies. I want to talk about a couple of examples where I think it makes sense.

Perhaps the business is a marketplace that needs critical mass to be effective. Think about a traditional village market. Without vendors, no customers are going to show up. But serious vendors are not going to bother pitching their stall if they aren’t sure the customers will be there. So what does the village council do? Run a massive, free funfair to attract thousands of visitors from all the nearby villages. Then the merchants are sure to pay to set up stall. Alternatively, guarantee each merchant a minimum revenue amount to pitch their stall. As most marketplace models needs some kind of critical mass, focussing on growth first makes sense.

Alternatively, companies can often dramatically reduce unit cost as they grow. Perhaps there are “economies of scale” - building an enormous factory will allow the company to produce products more cheaply than any competitor. Rather than trying to raise the money to build the factory up-front, companies will initially subsidise their product, selling below cost in order to stimulate demand and grow a massive customer base. They can then use this evidence of customer demand to raise capital to build a more efficient factory, eventually improving margin.

Or, more simply, a company may believe it can use its massive scale to renegotiate with suppliers, improving margin over time.

The advantage of these strategies is that you can figure out if there’s customer demand for your product without having to raise massive up-front investment. Customer demand is almost always the biggest problem for early-stage companies - a total lack of "product-market fit”.

The problem with these growth-first strategies is that they’re capital intensive and very, very risky. You could simply be wrong about the savings you can achieve at scale. You might burn more cash than anticipated getting there. Perhaps a competitor also raises a lot of capital, and pushes the cost of customer acquisition even higher. Or perhaps there’s another financial crisis, and capital becomes scarce.

But here’s the dilemma - if there two companies are competing for the same consumer market, the one that gets to scale first will generally win, provided it can continue to raise capital.

If you’re going to take this approach, you’d better get really, really good at fundraising.