Unit Economics Matter — Get It Right Before Investing Heavily in Growth

At venture-backed startups, the focus is predominantly on growth and growth rates. For SaaS businesses, the metrics tracked are bookings and bookings growth. For most other venture-backed businesses, the critical metrics are typically revenue and revenue growth. CEOs usually lead their “All Hands” presentations with these numbers. And recruiters highlight the strength of the business to prospective candidates with a % growth figure.

I have heard CEOs and Board members at start-ups I’ve worked highlight revenue growth as the number one priority. Many CEOs even refer to all other key metrics, whether retention or efficiency (both customer acquisition and operating), as “tomorrow’s” or “next year’s” problem.

Why simplify down to one metric — growth rate? Because a high growth rate is strongly correlated with a high valuation. The logic is that a high growth rate is indicative of product-market fit (customers demanding the product) and will over time lead to large scale (i.e. large total revenues). As a business gets larger the conventional wisdom is that efficiencies of scale will kick in leading to operating expenses growing slower than revenue. This will lead to profits which will grow over time. And, thus with growing profits and cash flows a high valuation is assured. A high valuation is the measure of business success.

The importance of growth is echoed by leading minds in the venture and technology community. Sam Altman, currently Chairman of Y Combinator, was quoted as saying, “Growth solves (nearly) all problems.” And Eric Schmidt, when CEO of Google said, “Revenue solves all problems.” A study published by Catalyst Investors shows the importance of future growth on valuation multiples.

Undoubtedly growth matters. The shortcoming of the arguments above is that all parties are looking at a cohort of successful business, publicly traded usually. The survivorship bias in the data analyzed overstates the importance of growth. High growth is tightly correlated with a high valuation when the unit economics of a business work (more on unit economics in a moment). Unfortunately many CEOs of earlier stage business (not yet public) who are raising or have raised money to scale don’t focus enough on unit economics or forget to update their unit economics data regularly enough and thus presume last year’s data is still valid today.

In the last quarter of 2019, the public markets sent a strong signal that they disagree with this singular focus on growth. The feedback to private company investors and operators is that growth alone is not sufficient for tech-enabled businesses to sustain a high valuation.

WeWork, which filed to go public in Q2 2019 and then had to cancel the planned public offering at the end of September 2019, is the quintessential example of the public market feedback that growth alone is not enough to tempt investors into buying equity at a high multiple of revenue.

WeWork is not the only rapidly growing “tech” company to struggle. For example, Lyft’s stock price has dropped ~35% from the late March 2019 IPO price even while the NASDAQ is up over 20% in the same time frame. And Uber, which listed after Lyft, is down over 20% from its IPO price even as the NASDAQ is up close to 20% since Uber started trading. Even Slack is now down back below its direct listing reference price of $26/share after the significant initial upward spike in the stock price on the day of the IPO. All this has happened while the market indices have continued strongly upwards. So the struggles of some “tech” company stock prices are not related to overall market weakness.

A number of venture capitalists have responded on Twitter that the valuation correction for these companies is warranted. They argue that valuations based on high multiples of revenue are reserved for software companies and not deserved by all tech-enabled business. Fred Wilson has written that it is the combination of high revenue growth, high gross margins, and a moat (by which he means a business that is hard to copy) that leads to these high revenue multiples. Bill Gurley has a more extensive piece from mid-2011 detailing nine (9) factors beyond revenue growth that determine high revenue multiples.

While the points made by these two venture capitalists are valid, much of the recent debate strikes me as incomplete. The reality is that almost every venture-backed software business has made a presentation to prospective investors or potential acquirers showcasing high revenue growth and relatively strong gross margins. And yet, only a very small number of venture-backed software businesses are sold at high multiples of revenue or trade publicly at high multiples of revenue over an extended period of time — high multiples of revenue being defined by me as the current SaaS company median of ~8–10x latest 12 months revenue.

So, what else distinguishes the successful high multiples exits (the relatively few) from all other venture-backed software businesses?

It is attractive “unit economics”.

“Unit economics” is the financial analysis undertaken to measure the marginal return on capital in investing in an incremental single unit. I’m focused here on businesses such as B2B software, B2C software or digital goods vendors, and marketplaces which don’t require meaningful fixed capital investment in PP&E. A similar albeit slightly different analysis can be done regarding more capital intensive business such as e-scooters or restaurants/retail.

Marginal return on capital is defined as the contribution margin attributed to a single unit divided by the investment required to create the incremental single unit. A unit is typically a single customer. Contribution margin is the direct revenue less all direct expenses for delivering the product or service to a new customer over a year. The cost to create this new customer is the fully loaded customer acquisition cost.

The marginal return calculation reveals how many months or years a customer needs to stay with the business (in a subscription relationship or through additional transactional activity) to pay back the acquisition cost. This payback period calculation coupled with knowledge of the customer life (retention rate) and the growth in customer spend over time helps an investor understand if the unit economics are attractive.

What are attractive “unit economics”? In a nutshell, a fast payback period of under 1 year. And fast payback period are driven by a combination of: (a) acquiring new customers at a reasonable cost relative to the amount they pay; (b) retaining the vast majority of those customers for a long period (i.e. high customer loyalty so you don’t need to spend again on replacing customers who take their business elsewhere); (c) having customers steadily grow their spend and/or transact again with the business over time; and, (d) strong gross margins. If these four things happen then the unit economics will be attractive. And, it will make sense for the business to invest aggressively in driving revenue growth.

LTV to CAC is another way to get at unit economics. Getting the ratio of LTV to CAC correct is critical to start-up success and value creation, as laid out clearly by venture capitalist David Skok who has written at length on this topic.

Building a sustainable and highly valued business requires maintaining attractive unit economics while scaling the business. Lots of businesses don’t focus enough time on the unit economics calculation until they realize they have a problem — at which point it is often really hard to fix. Changing pricing upward or entering new market segments (such as larger enterprises who spend more and are stickier customers) or changing the go-to-market strategy (such as adding a freemium product to create lower cost product led growth) are easy to put on slides but very hard to execute once the organization has gone down a different path for an extended period of time.

My advice to start-up leaders, particularly CEOs and Revenue leaders who will read and hear a lot about the importance of growth is to ask your finance team to calculate and present unit economics regularly. And beyond that to:

1. Pay close attention to customer retention (how many logos you retain when customers can choose to cancel) and revenue retention (how many dollars you retain), even early in the life of the business.
2. Track different measures of engagement and figure out which are truly indicators of customers getting value out of your product. Understanding how the product creates value today for customers and what you can add to create incremental value will help reduce customer churn.
3. Invest time alongside your product team figuring out how to increase customer spend over time — understand what the customer problems are and then figure out if you can sell them additional products or more of the same product, raise prices or increase utilization. Increasing customer spend will offset some lost revenue from natural customer churn and help keep your total net dollar revenue retention high. Businesses which trade a high revenue multiples usually have a high net dollar revenue retention figure (well over 100%).
4. Measure channel efficiency carefully and don’t simply evaluate channel success on customer additions. When tasked with increasing growth by launching new channels to market, whether marketing-driven (paid channels) or sales driven (more headcount), set targets for acceptable efficiency and measure them carefully.

These additional variables — high retention (particularly net dollar revenue retention) and efficient customer acquisition (attractive CAC) — when added to revenue growth and high gross margins, will ensure that your company receives and sustains a high valuation and high revenue multiple.

Long-term business success and value creation is about a lot more than just revenue growth. Building and maintaining attractive unit economics is necessary precursor to scaling and should be today’s problem.