A few weeks ago, Instacart, the grocery delivery service provider, announced that 40% of its business had achieved profitability…at the unit economic level. According to the Bloomberg article, Instacart has raised $275mm in equity since its founding in 2012. This story is the perfect case study to conclude our unit economics discussion.
Unit economics and profitability
Last week we defined unit economics as a measure of viability of a business based on a single unit. The idea is that profitability at the unit level is scalable e.g., through broader distribution. When evaluating a business opportunity, entrepreneurs need to understand the unit of sale, its pricing, cost and the pattern of scalability beyond Unit 1. I will illustrate differences among the first three parameters using businesses I frequently analyze.
- Unit of sale
- Manufacturing (food / beverage) – Widget e.g., water bottle
- Infrastructure (digital media / restaurants) – Digital: Sponsorship contract. Restaurants: Single location
- Internet (marketplaces) – Single subscriber / customer
- Manufacturing – Price per widget
- Infrastructure – Average size of contract or ticket
- Internet – Revenue over lifetime of a single user
- Manufacturing – Direct variable cost: Ingredients, labor, packaging
- Infrastructure – Fixed plus variable: Digital: Production equipment, Studio space, talent etc. Restaurants: Mark-up, Occupancy, Labor etc.
- Internet – Acquisition plus servicing cost per user
Margin improves through adjustments to price or cost. Instacart’s challenge was that “…it costs much more to deliver an order than the $5.99 it charges shoppers, but customers are unwilling to pay more.” With the price lever unavailable, Instacart resorted to changing its entire revenue model (basically a new business) and reducing labor costs (potential issues with quality and productivity).
My takeaway is that companies generating losses at the unit level will face difficulty achieving profitability unless there is a very easy path. Failure could be a simple result of customers refusing to pay more.
Unit economics and valuation
The fundamental value of a business is dependent on its ability to generate future positive net cash flows (there are no exceptions). Because of uncertainty, future cash flows are discounted to today’s value by some factor. Under the discount model, a business like Instacart will face critical challenges:
- The longer the business loses money at the unit level, the more funding (negative cash flows) it needs upfront and the more future positive cash flows required to become net positive. Factoring in discount rates, the nominal value of these future cash flows could be astronomical
- A business that is not profitable at the unit level will likely attract investors with high internal hurdle rates. High hurdle rates position investors to claim a high proportion of future positive cash flows in high-risk businesses, often at the operators’ expense
- Negative unit economics can drive temporary high revenue growth. However, as prospects of translating the revenue into positive net cash flows dwindle, investors will pull the plug
The takeaway is that negative unit economics can severely cripple a business’ ability to generate meaningful returns for its shareholders.