Unit economics – Because you gotta survive long enough to make the $

Last week, I attended the Expo West trade show in Anaheim with colleagues. This event is a great American show of entrepreneurial aspiration and competitiveness. Entrepreneurs showcase their product and contend for opportunities with buyers, vendors and investors. What struck me was that unlike middle school, not all of these great companies take home a trophy. Whereas winners are rewarded handsomely, the rest end up as stories of lost resources and lessons on failure. In my short investing career, I have observed two types of companies that usually win. I will call them the “Thrifty” and the “Lavish”. I prefer the Thrifty.

The Thrifty are often scrappy, live under their means and give themselves a chance to succeed by hanging around long enough until meaningful opportunity arises. A mentor once dubbed these companies “Cockroaches” because of their survivalist DNA (makes an interesting contrast to Unicorns). The Lavish often announce their arrival with a bang, splurge cash to “buy” market share and hope to carry the momentum until they win. On average, the expected dollar economic return for the Thrifty is higher because they require less investment in operations and hence they can wait relatively longer for high ROI opportunities.

What I was really searching for at the expo were Thrifties with stellar unit economics. Unit economics are a measure of viability for a business derived from calculating profitability for a single product or service. For example, if a water company receives $1 for a bottle sold and it cost $0.35 to produce – cap, label, container, liquid, freight – then the company keeps $0.65 per bottle.

A few reasons why I’m always pursuing high-margin Thrifties include:

  • A dollar today is worth more than a dollar tomorrow – In my water example above, for every bottle sold, the company immediately turns $0.35 investment into $0.65. An equally impressive exercise of instant value creation that comes to mind is Jesus turning water into wine
  • The option to be Lavish – A Thrifty with high margins can spend the extra cash on high-growth opportunities – aggressive promotions, new products, rock star hires – and completely crush the competition! If these opportunities are not available yet, the Thrifty can use the cash to extend its runway for a future take-off
  • Equity is expensive – At the time of transaction, unit economics are a zero-sum game. Any margin that the company doesn’t keep is forever lost and has to be funded through other means. For smaller companies, this usually means raising equity. Funding unit economics with equity will dilute existing shareholders. Soon, operators become demotivated because they now own a dwindling portion of a pie that is not growing. It sucks
  • Psychology matters – I have observed that most Thrifties would never enter into a business with low unit economics. They would negotiate aggressively with vendors or customers or move on. On the contrary, the Lavish are often comfortable with low unit economics “for now” because they rely on their expertise and someone’s deep pockets to “fix it later”

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s