Starting in 2004, I spent a few years tracking the promising story of Freddy Adu. Freddy, then a “14” year old phenomenon, and widely tipped to be the next big thing in soccer, became the youngest athlete ever to sign a professional soccer contract. He was drafted by D.C. United. United made a bet that he would grow into a superstar and would either help the club win many trophies or would be traded for a handsome return. Freddy was a flop. There was a rumor that although he appeared small, he was actually “20 something” and was only better than his youth teammates because he was significantly older. Whatever the true story is, United made a massive error in evaluating Freddy’s potential.
I spent the last two weeks in the Bay Area with senior executives of the several businesses owned by our Limited Partner. Our objective was to explore the entrepreneurial ecosystem in the Valley (hence my inability to write in the last two weeks). We met with many young companies with aspirations of growth and domination. However, I observed a clear distinction between companies with demonstrable potential for growth and those without. When analyzing growth potential, I focus on three primary levers: Customer satisfaction; Unit economics and Distribution.
- Customer Satisfaction: Customer satisfaction is arguably the best way to prove scalability, due to the power of the virtuous cycle of referrals. Satisfied customers drive greater retention rates and spread positive news about the brand, which results in further customer acquisition and more revenue. Companies use several tools such as Net Promoter Score (NPS) to measure customer satisfaction. High-growth companies have high scores relative to their peers, possess a deep understanding for why and have clear strategy and resources to exploit their advantage.
- Gross Margin: Strong unit economics provide solid validation for sustainable profitability of a product beyond temporary factors such as hype or promotion. Additionally, there is a self-reinforcing loop between customer satisfaction and profitability. The more customers refer a product to peers, the lower a company’s customer acquisition costs and the higher its profit margins.
- Capacity / Distribution: This is a catchall for all the processes that culminate in an economic transaction. Distribution starts with the capability to source and produce enough inventory followed by the ability to place it in the hands of customers as quickly as possible and in a way that is most convenient to them. Certain constraints in this value chain could limit the ability of a business to scale. A great example I read recently used inventory constraints to explain why Uber is valued more than Airbnb. Whereas there are relatively fewer people willing to open their homes regularly to strangers, there are many car owners with excess capacity to transport others during their down time.
When assessing startups, investors and entrepreneurs must carefully assess scalability of key growth levers. For example, is observed revenue growth driven by discounts? Is the product scalable at full price? Are there potential bottlenecks to growth e.g., scarce raw materials, regulations around distribution etc.?
Freddy’s case reminds me a bit of myself. While in college and at 5’6 and 135lbs, I lost a meaningful sum of money investing in height enhancing supplements. I only stopped when I realized that instead of growing taller, I was developing love handles.
Feels good to get back to writing!
Recently, I attended a conference on investing in food and nutrition companies at the University Club. One of the panelists dropped the statement above. It was catchy so I dwelt on it for a while on the train ride back home. I wanted to share my notes.
Trade spend is a blanket term for all cash or equivalent outlay that companies devote to promote their products at a point of purchase. Examples include price reductions, free product/trial and coupons. Trade spend is supposed to stimulate trial and drive post-promotion volume growth at full profit margin. A simple way to measure ROI for trade spend is:
ROI = (Incremental Volume * Contribution Margin – Promotional Cost) / Promotional Cost
ROI for trade spend is particularly important for small food companies. Due to lack of concrete historical data, buyers often offer shelf space to young companies based on potential e.g., an exciting new super food, a charismatic founder’s story etc. However, buyers usually impose mandatory trade spend on these companies. Spending can be as high as 25% of revenue. Ecstatic entrepreneurs often forget that competitors on the same shelf are also required to invest in promotions. They also forget that promotions are merely a catalyst for future high volume growth at full profit. Numbers ruin a good story. As data accumulates, buyers quietly replace products that don’t meet volume thresholds with new products whose owners have fresh cash to spend on trade.
Before committing to promotions, young companies should focus on a few key things to better position themselves to win.
- Clear Value Proposition – Companies with a strong value proposition are better able to identify relevant customer segments for their products. They also have clearer frameworks for pricing and value. Additionally, they are better positioned to develop compelling marketing materials that resonate with customers and drive engagement. A strong value proposition also allows companies to test products on different potential customer segments, collect more data and improve their offering.
- Customer Knowledge – Grocery aisles are chaotic. Products are similar and are perpetually on promotion. Brands that can occupy customers’ mind share prior to a store visit have a higher chance of winning. Data gathering is the driver for customer knowledge. Here’s an example: a tart cherry juice company in our portfolio was initially positioned as a recovery product for high-intensity athletes. However, as we gathered more data, we discovered that baby boomers seeking relief from joint pain were also a major customer segment. We adjusted our strategy accordingly.
- Tracking and Adjusting – Companies must also develop tactical mechanisms and processes to test, track and measure ROI for different types of trade promotion. Promotions have to match preferences and habits of the customer segment, geography etc. After testing, promotions that don’t generate positive ROI must be dropped.
My initial takeaway from the panelist was that brands that don’t satisfy buyers’ volume thresholds will lose shelf space. A profounder takeaway was that companies without robust strategic and competitive processes to maximize return on trade spend will fail.
Back in the day when analysts were still getting paid in investment banking, a friend decided to “invest” in a $80,000 Porsche. His reason was to “use this baby to woo and close on a wife asap then hopefully afford car payments on a dual income.” Those who know me well also know how I sometimes believe that everyone is entitled to my opinion. So, I offered my friend a lesson on operating leverage that I will revisit today.
Operating leverage is the degree to which a business has fixed costs. Let’s consider two companies with $500 of fixed production overhead. Assuming that pricing and contribution margin are held constant, the business with lower revenue will have higher operating leverage. The table below illustrates the concept. As units sold increase, fixed and total cost per unit drop, but dollar savings progressively become smaller.
There is a catch. Companies still need to work diligently in order to unlock operating leverage, e.g., through:
- Revenue growth – My friend’s ultimate goal/revenue was to find a wife so I urged him to go, with his car, to as many dates as possible to maximize the number of potential candidates/units reached/sold (not as comparable really). We also discussed possibly renting out the car during downtime or Ubering on the way to dates. Companies with high fixed costs have to quickly cover them by growing revenue e.g., through finding new customers, applications and/or related revenue streams.
- Margin expansion – We also considered using non-premium gas for the car and having some dates at cheap restaurants. Companies can increase price and/or decrease cost. However, as we have learned, increasing contribution margin ain’t easy.
- Capacity utilization – I also suggested that my friend drive his car to as many dates as possible even for candidates that didn’t satisfy his marriage profile, but potentially provided other value e.g., great conversation. Companies call this private label. Unfortunately, private label is often low-margin and might require additional investment in order to meet different customers’ specifications. Furthermore, companies need to unlock additional capacity to accommodate private label orders that are usually lumpy and unplanned.
My friend succeeded in his mission, but in reality, the car turned out to be serious overkill. Most dates decided on an encore based on substance of the discussion and experience. By the time the car was retrieved from six blocks away, they were too tired to notice. If he hadn’t succeeded quickly enough, his car and rent payments would have sunk him and he would have been forever a sad bachelor.
Some entrepreneurs I speak to tout several benefits of in-house manufacturing, which include; independence from contract manufacturers, flexible production and inventory planning, ability to customize and produce different Skus e.g., seasonal products, branding reasons e.g., supply chain control. In my view, when put into perspective, these benefits often aren’t “must-haves” for smaller companies. Fixed costs hog cash, increase pressure to “grow now”, reduce nimbleness and can generate negative retained earnings. I encourage companies to avoid piling up fixed costs before investigating cheaper (maybe not as convenient) alternatives.
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.
I received feedback from some of my readers that my latest post wasn’t easy to understand. So I spent the remainder of last week brainstorming ways to explain the concept better. The light switch moment occurred on Sunday while I was running the New York half marathon. I spent most of the race sketching out parallels between my racing adventure and the philosophy behind the post. I will attempt to put it all together below. For those who didn’t read the post, you can find it here.
In the article, I suggested that start-up companies should manage resources carefully in order to survive long enough and deploy cash in future high-return opportunities. My general thesis is that though critical for survival, early activities, which include set up, staffing, creation and launch of product, don’t generate a high return. One of the reasons is because valuation for high-growth companies is often calculated as a multiple of revenue. An article I read recently by one of my heroes John Maeda, although focused on leadership, captures my evolutionary philosophy rather precisely. The lesson from this article (and my race!) is that before a company can aspire, it must first survive and build the ability to compete effectively. A company should only splurge once there is indisputable proof that the investment will directly impact the primary value driver. The higher the correlation the better.
- Survive – For marathon prep, I had to overcome a few mechanical issues and injuries before commencing training and building the cardiovascular capacity required to survive the race. For companies, this preparation means translating the idea into a strategic plan and a product that serves a demonstrable market. Nailing these fundamentals allows a company access to investors, who provide the cardiovascular capacity a.k.a. cash to execute. High unit economics are a powerful survival tool because they reduce a company’s dependence on outside capital while simultaneously increasing the company’s appeal to investors
- Compete – During training, I took long runs on weekends, which served as proxy for the real race. I also started training for pace and other competitive tricks e.g., managing hydration. In business, this translates to arriving at a product that is sold to real customers and is profitable at the unit level. This process is called finding product-market fit. Peter Reinhart, CEO of Segment has an excellent article explaining this concept. Using the marathon comparison (again), a product that hasn’t demonstrated the ability to “complete the race” somehow – from production through to profitable sales – won’t succeed.
- Aspire – Aspiration is a privilege. After I became confident that I could finish the race at a 10 minute/mile pace, I then started to aspire to finish in under two hours. For companies that have mastered competition, pumping cash into the system can maximize growth, profits and returns. In aspiration mode, companies have the license to dream, go big and crush the competition!
In part 3, I will elaborate on the technical aspects that make unit economics a powerful driver of return on investment.
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”
Outside of investing, I occasionally enjoy listening to hip hop music. A shared trait between the two trades is a maniacal focus on “the things that matter”. In hip hop it’s almost always cash and in investing it’s return on investment. Hip hop artists and investors alike casually drop catchy phrases to reinforce this philosophy. Two of my favorite lines are “If it don’t make dollars it don’t make sense” and “No one ever made money doing spreadsheets.” The first line is from a famous 90s diss track “Dollaz & Sense” by DJ Quick. The second is from a mentor from one of my old jobs. From these two lines, you could logically (maybe with a leap) conclude that spreadsheets don’t make dollars so they don’t make sense. Not so fast.
I was reviewing a model of a chocolate company where revenue growth was driven by tons of chocolate sold. The model predicted that during its first year of operation, the company would sell 50 tons of chocolate at Whole Foods stores in the US. In this case, assuming average size of 85g for a chocolate bar, this would translate to ~600,000 units. Whole Foods has ~430 stores, which implies a velocity – number of units sold per store per week – of ~26. This plan doesn’t make sense for a few reasons: The average velocity for chocolate bars in natural grocery is meaningfully lower than 26; Acquiring shelf space with a major retailer could be a long and arduous process; It is unrealistic to expect a new brand to “go from 0 – 100 real quick” and achieve full national distribution in just one year…Maybe DJ Quick had it upside down and really meant to say, “If it don’t make sense it “won’t” make dollars.”
My example provides a rational rebuttal to DJ Quick, but one could argue that this exercise is so simple and can be performed on the back of a napkin instead. A few more comprehensive ways I have used spreadsheets include:
- Forming of perspective for an entrepreneur’s understanding of the industry and that particular opportunity by systematically testing the facts behind her/his assumptions. Assuming a 100% penetration and outlier sell-through rates in a short time demonstrates a lack of appreciation for industry complexities. However, if an entrepreneur produces a spreadsheet with purchase orders from each buyer that slightly improves credibility.
- Building of scenarios to assess the difficulty (or ease) of our fund to achieve its economic hurdle rate, usually by comparing management’s assumptions with industry benchmarks and assessing cost of the strategic plan under different economic realities.
- Learning and measurement of new market opportunities, especially where an entrepreneur is proposing an innovative approach to business fundamentals – sourcing, manufacturing, distribution, pricing etc. – that potentially increases expected return on investment.
In general, it might be true that nobody makes money doing spreadsheets, but I would posit that some investors and entrepreneurs who didn’t do their spreadsheets lost money and time from investing in schemes that didn’t make sense.