Part 3: Unit economics – Because you gotta survive long enough to make the $

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
  • Pricing
    • Manufacturing – Price per widget
    • Infrastructure – Average size of contract or ticket
    • Internet – Revenue over lifetime of a single user
  • Cost
    • 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.

Part 2: Unit economics – Because you gotta survive long enough to make the $

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.

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”

If it doesn’t make sense it doesn’t make $ – In support of spreadsheets

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.

CDs and Sunglasses – Not all $ are created equal

One afternoon, a long time ago, I was taking a stroll on Times Square and made a snap decision to buy a digital camera to bring as a gift to my parents on my next visit. I walked into one of the touristy electronic stores.

The owner, some enthusiastic chap, thought it worthwhile to rehearse his cross-selling skills on me. He offered some CDs at a discount, which I refused, then tried to hustle me into buying sunglasses, which I needed since my “future was so bright”. I laughed. I walked out when he began peddling a suitcase to use on the trip.

Fast forward a few years, I was looking at a business that had high revenue growth, good gross margin and a clearly defined path to profitability. I asked the owner to send product samples to my office. His response raised a red flag – the company had about 500 SKUs. I backtracked and asked him for the revenue breakdown of his products. Suddenly, the growth rates for most were no longer as impressive. I dug a bit deeper and the gross margin didn’t look so fat after untangling all the “adjustments”. The entrepreneur had an explanation. The company had started off selling fried plantains and when those didn’t seem to stick, it launched popped potato chips, but then decided to just extend the product range to air-dried and then freeze-dried fruit and eventually… candy, to fully attack the snacking category. I took the opportunity to share the CD and Sunglasses lesson.

For companies that are having difficulty cracking a desired core market or finding product-market fit, the path of least resistance is to start selling something else, kind of related, but fundamentally different. All products above are snacks, but plantains and potatoes are sourced from different places. And, though they sound very similar, air-drying and freeze-drying are totally different manufacturing processes.

For entrepreneurs with a mission to build a brand, launching multiple products is often poor strategy because of the inefficiencies and high cost of working with small batches. Also, an eclectic product mix makes it challenging to build a coherent story that justifies putting everything under one brand umbrella. Brand building requires patience and rigorous testing in order to establish a match between product and market. Rather than launch a new product, investigate who likes / hates your product and why. Rather than add a new feature, consult your customers on adjustments that could improve the utility of existing functions.

As an investor, I spend time identifying the core revenue of a business and analyzing its: Characteristics – distribution methods, elasticity, psychographics etc.; Scalability; and Economic expected value. I avoid assigning credit to CDs and Sunglasses.

I will cut my entrepreneur friend in New York some slack. He probably wasn’t trying to build the next biggest brand in electronic products. He was just an opportunistic middle-man in retail, searching everywhere for a decent mark-up to cover his hefty New York rent.

The fundamental unit – Lesson from a botched interview

When I was in business school, a close friend made a referral for a potentially prestigious role with one of the leading private equity firms investing in Africa. This was an opportunity I was desperate for. One of the partners at the firm invited me for a coffee chat in San Francisco.

When we met, I was relieved to see that he hadn’t brought a computer with him. I had purposefully left mine at home to avoid being ambushed with an on-site modeling exercise. After we ordered our drinks, we had a small chat and I was doing really well showing off my knowledge on different industries and business models.

The partner then pulled out a piece of paper and sketched out a short five-year financial summary for a “hypothetical” company. He then asked me to model a “quick” leveraged buyout analysis by hand. I got all the mechanics right, double checked my mental math and handed it back to him with that “nailed it!” grin. The exchange that followed was one of the most important lessons of my life and one of the reasons I decided to write this blog.

In my cash flow statement, I assumed no changes in working capital; no investment in capital expenditure and made silly assumptions on other fundamentals that were meant to make the arithmetic easier to perform. After reviewing the model and obviously in a state of total flux, the partner asked what type of company I was presenting and in what industry it was? I briefly tried to get the focus back to my mechanical prowess, but he became so infuriated that I ended up apologizing for wasting his time. 

The partner told me that he gives the same test to everyone who applies for a job at his firm (Analyst to Principal) because the fundamental unit of investing and entrepreneurship is the same. However, the depth of analysis and debate that is expected changes dramatically for every role. As a Senior Associate candidate, I was expected to ask relevant questions and make credible assumptions about all operational aspects of the business – Growth stage of company; Unit economics; Capital structure; Working capital requirements, Investment in capital expenditure. I was also expected to debate other investment considerations – Effect of investment cycle; Exit considerations and multiples etc. The work I had submitted was only good enough for a summer analyst.