Unicorns vs. Donkeys: Your Handy Guide to Distinguishing Who’s Who
No surprise, a lot of unicorns are actually donkeys.
I’ve been having this conversation a lot lately:
Friend: “Did you see [startup] just raised at a $1B valuation?”
Friend: “They’re apparently killing it on [metric that is meaningless without the bigger picture].”
Me: “Yeah, but their [metric that also matters] is struggling.”
I am by no means the unicorn prophet, but here’s how I think about which companies have earned their unicorn status vs. which ones are playing a dangerous game of massive capital needs, sky high valuations, impossible expectations, and deferred judgement days. Hopefully, by the end of this post, you’ll have an intuitive feel for which startups actually have a shot at being unicorns and which ones are probably just donkeys.
The Fundamental Law of Growth
Like Newton’s laws of gravity or momentum, most tech startups (see exceptions below*) who sell directly to their customers — both enterprises and consumers — must eventually obey the Fundamental Law of Growth: LTV/CAC > 3. There’s a lot of nuance as to why — a discussion that is better suited for a semester-long class than a blog post — but suffice to say that the LTV/CAC ratio speaks to a startup’s revenue trajectory, capital needs, and in turn, how much “irrational exuberance” is demanded of its investors. The lower the LTV/CAC ratio, the less efficient a company is at deploying capital and the more money it needs to fuel growth; conversely, the higher the LTV/CAC ratio, the more efficient the company is and thus the more value it creates for the same amount of capital. Though this can be derived, many before me have empirically observed that 3x is roughly the threshold needed to build big, sustainable businesses.
Assessing a company’s valuation is a discipline on its own and growth is only one factor in that calculation. However, for simplicity’s sake, one can assume that tech companies who don’t obey the Fundamental Law of Growth will eventually lose access to capital, drastically slow their growth, and watch their valuations plummet — those fabled unicorns will eventually emerge as donkeys. So with that, let’s dig into some examples…
*Companies whose value is not predicated on revenue (e.g., disruptive technologies, monopolies, social networks, intellectual property) as well as companies where revenue is achieved indirectly (e.g., ad-tech networks, certain marketplaces, certain viral growth startups) or discontinuously (e.g., government contractors) typically do not follow this rule
For each example, I’ll make assumptions about the various components of the LTV/CAC ratio (see below); some assumptions are based on publicly available data and others are just gut feels. If it’s the latter, I’ve generally erred on being generous to the startups.
Case Example #1: HelloFresh, Subscriptions Meals
- Customer Lifetime — in my household, we usually try each meal subscription company for a few weeks then switch it up, but let’s assume the average across all customers is 3 months or 0.25 years
- ARPU — average revenue is probably 2 people, 3 meals per week, 3 weeks per month, so $60/week x 3 = $180/month or $2160/year
- Margin % — we know from Mahesh’s excellent IPO filing teardown that their margin is 52% (sign of a strong operating team; that’s higher than I expected for this type of business!)
- CAC — given the numerous other meal subscription companies, brick and mortar competitors, etc., it feels like the CAC is probably in the hundreds, say $400
LTV/CAC = 0.25 years x $2160/year x 52% / $400 = 0.70x
Under these assumptions, HelloFresh is an incredibly capital intensive company because of the (presumed) low customer lifetime/high churn. We know from the IPO filing that HelloFresh grew its revenue from $77M in 2014 to $290M in 2015 (276% growth), so you can understand why someone would say, “They’re killing it on revenue!”. We also know that the company didn’t report cohort retention data, but as per Mahesh, “they do mention that they achieve 2.8x LTV/CAC after two years.” Hold up, come again? Reporting LTV/CAC for only a subset of customers is disconcerting, and even then, it’s just under 3x; substituting 2 years into the LTV/CAC ratio suggests that the true CAC may be much higher ($800). Other food subscription and even some on-demand meal companies — Blue Apron, Plated, Instacart, Munchery, Sprig, etc. — may similarly have short customer lifetimes/high churn and thus low LTV/CAC ratios, thereby also violating the Fundamental Law of Growth.
Verdict: Donkey Watch
Case Example #2: Evernote, Productivity Software
- Customer Lifetime — I use Evernote constantly, so I expect if anyone is going to have an extended lifetime, it’s them. But as a rule of thumb, lifetimes >3 years should only be considered in exceptional circumstances
- ARPU — in most freemium products, paid customers make up only a tiny fraction (<5%). Nevertheless, let’s assume 25% are premium users at $50/year, so a blended ARPU of .25 x $50 = $12.50
- Margin % — pure SaaS company with no customer service costs should probably achieve 70–90% margins, so let’s go with 90%
- CAC — freemium models typically land in the $1–$100 CAC range, so let’s assume $20
LTV/CAC = 3 years x $12.50/year x 90% / $20 = 1.69x
Evernote has great customer lifetimes, margins, and low CACs; however, because their pricing is low, their overall LTV is limited and thus results in a low LTV/CAC ratio, again violating the Fundamental Law of Growth. Evernote could compensate by increasing pricing, but with other readily available substitutes (Google Docs, Microsoft OneNote), increased pricing likely increases churn too, so the pressure is on Evernote to then increase ARPU by increasing value (additional products, collaboration tools, AI insights, etc.).
Verdict: Donkey Watch
Case Example #3: Oscar, Health Insurance
- Customer Lifetime — once you join an insurer, you typically stay with them until you switch jobs/get a job. <1.5 years is probably the average, but let’s use 2 conservatively
- ARPU — $5000; saw this in an Oscar press release and it’s fairly typical of this market
- Margin % — healthcare insurers have gross margins in the 5–10% range with a max of 15% as mandated by Obamacare, so let’s go with 15%
- CAC — this is an expensive product for consumers to purchase and probably requires a light-touch inside sales team, so let’s assume CAC is $800
LTV/CAC = 2 years x $5000/year x 15% / $800 = 1.88x
Similar to HelloFresh, Oscar is posting massive revenue ($200M) and growth rates (135%), so you can again understand the hype around them; however, Oscar fails the Fundamental Law of Growth due to its low gross margins. If the Oscar team can achieve a CAC near $500 — perhaps because they’re the hip/fresh insurer on the block with best-in-class marketing — then maybe the company can still grow a horn, but that’s asking a lot given the inherent complexity and cost of the product. Recently, a number of other companies— Jet.com, Instacart, etc.— have built fast-growing businesses that operate on low margins, but they too are at risk of breaching the Fundamental Law of Growth.
Verdict: Donkey Watch
Case Example #4: ZocDoc, Online Physician Reservations
- Customer Lifetime—I’ve heard that physicians typically churn after a year once they’ve established a sizable patient base, but let’s assume 2 years
- ARPU — $3000 (publicly available)
- Margin % — SaaS company with light-touch customer service should probably achieve 60–80% margins, so let’s assume 80%
- CAC — Selling to physician practices must be challenging, so like any high-touch inside sales operation, ZocDoc’s CAC is probably in the $1–10K range; let’s assume $3K
LTV/CAC = 2 years x $3000/year x 80% / $3000 = 1.60x
ZocDoc has a good LTV overall, but their CAC is likely a show-stopper. Unfortunately, there’s no getting around that — selling to physicians is tough stuff, just ask Pfizer. Also, as competition increases, customer lifetimes and pricing erode too, further driving down the LTV/CAC ratio. I suspect this is why ZocDoc is shifting sales to hospital system customers (1000x higher LTV and only 20x higher CAC), but hard to know what fraction of their business this constitutes. Although I am not familiar enough with the unit economics of fantasy sports startups, I suspect that FanDuel and DraftKings may similarly be spending heavily on customer acquisition without the supporting customer lifetimes or ARPU needed to satisfy the Fundamental Law of Growth.
Verdict: Donkey Watch
I hope this framework gives you a better sense of how to evaluate today’s unicorn landscape. The companies above all have impressive, press grabbing growth metrics, but they also fail the Fundamental Law of Growth for different reasons — short customer lifetime, low pricing, low margin, and high CAC — so must be viewed with some skepticism.
The most obvious next question is: if the Fundamental Law of Growth is so simple, why did investors grant $B valuations to these companies and others in the first place? I believe the answer is a combination of downside protections, upside overoptimism, and what can only be described as FOMO.
Downside protections are being prominently discussed now in light of Square’s down round IPO (albeit still in unicorn territory); to put it simply, late stage investors have (smartly) insulated themselves from losses, so they’re willing to give more on valuations. With regards to upside overoptimism, I imagine that when these rounds were executed, both investors and entrepreneurs believed that things would look up — customer lifetimes would extend, ARPU would increase, margins would expand, and CACs would decline. Alas, it doesn’t always pan out that way, which is why we encourage our portfolio companies to stay conservative on valuations: big up rounds can be appealing in the short-term, but when companies stumble (which they often do), the subsequent down rounds can be outright devastating. Zenefits, for example, is likely to feel that pain shortly given their recently exposed stumbles.
Personally, I’m looking forward to a private market correction. I feel my colleagues and I have done a good job building a portfolio of companies with sound fundamentals and well-earned valuations; a return to sanity would be a welcomed change, as it would unlock quality talent that we can then direct to our companies and others who are playing the prudent, long game.