Doubling Down on the Importance of Unit Economic Profitability
Why it becomes even more important to focus on unit economic profitability in the COVID era and beyond
A couple of years ago, I wrote about the importance of unit economic profitability at the earliest stages, when I was investing at the Seed stage at Corigin Ventures. I’ve moved over to Highland and now invest in early growth, but it feels right to re-visit this topic with a fresh lens, especially now that we’re entering a really uncertain time.
Remind me: what’s unit economic profitability and why do we care?
As I mentioned in my referenced blog post, unit economic profitability is a measure of profitability on a per-unit basis, or a customer basis. In its simplest terms, this is revenues minus any costs associated with selling, which usually includes cost of goods sold and marketing, or customer acquisition cost.
The really important part here is to include any attributable cost associate with one customer, including marketing and acquisition spend, or retention spend. Too often, marketing or acquisition costs (broadly speaking) can be forgotten, muddling the understanding of true unit economics.
For true unit economic profitability, a company should at least break even per customer transaction. From day one, the company should be able to sell a widget without having to pay a customer to buy it from them. It’s ok, and encouraged, for a high-growth company to lose money at the corporate level at the beginning because often times these expenses are front-end loaded (investments in the team, brand, infrastructure, technology, etc.), and spending early on these should lead to explosive growth for the company. That’s what we’re seeking!
What’s changed now?
All of my arguments for focusing on unit economic profitability versus corporate profitability still hold true. Unit economic profitability must be the main focus for a company early on, in order to prove that the company can become profitable one day. There’s no way to out-scale negative unit economics, except in rare cases (those are typically companies with extreme volume discounts or with network effects).
There are now additional reasons that make it more important than ever to focus on unit economic profitability, no matter the stage of the business.
1) New uncertainty on fully-baked unit economics
We are entering a period of uncertainty, and potentially a prolonged period, as many experts (including the IMF) are projecting. It becomes harder than ever to assess steady-state unit economics. Digital advertising is more effective than it has been in a while, with Facebook CPMs down 57% from November 2019. This can create a false narrative that CPMs will remain depressed. The answer is that we don’t know. Similarly, we don’t know the sustained effect of potentially damaged supply chains, for example.
Given all of the uncertainty going into the unit economic equation, it is hard to have a firm view on where they stand long-term. That means companies should be extra cautious when making assumptions and keep a keen eye on fluctuations.
2) Customers may have less ability to spend
With less consumer discretionary income, or smaller corporate budgets, consumers may be willing to spend less, which may mean they won’t purchase with the same frequency. Similarly, AOVs and ACVs may be reduced. As a result, it becomes harder to argue for a higher upfront acquisition cost, banking on repeat sales or contract upsizes. This in turn makes the need for the initial sale to be profitable all the more important.
3) Venture funding may be uncertain
We will not know what the next several months will look like for venture funding. Some indications show that investors are more active, some not. Companies may need to make big adjustments to their business models and expenses. While painful, it is easier to reduce the size of the workforce, work remotely permanently, or think about other corporate expense cuts, rather than lose money per customer transaction. It’s also untenable as the source of money coming into the company.
There may have been business models seeing fast growth with unsustainable marketing expenditures during the previous market, but those funding sources may not be around for an early-stage company to try and figure out their unit economics. Thus, the emphasis on unit economic health early on becomes imperative to be able to preserve cash.
So how do we wrap this all up?
We are entering a period of extreme uncertainty — the economy could recover quickly, or we could be in for a few years of extreme recession. In order to best wade through this environment, it becomes even more important to focus on unit economic profitability to ensure, at a minimum, a company can preserve cash on each transaction. After all, money in the door should be a good thing, not a loss.
