Understand Unit Economics… Understand Scale (Part 1)
The financial aspects of fundraising diligence are exhaustive. Historical financials, pro forma financials, use of funds analysis, waterfalls, etc. Investors go deep to support a case for investment or pass on the opportunity. One set of metrics that get a lot of attention are Unit Economics – a measure of your profitability at its most basic level.
Unit economics can be a gatekeeper to capital as investors look to them to assess the true value of the opportunity at scale. A fuzzy or limited grasp on these weaken confidence in the management team and gives investors a reason to move on.
Identifying Unit Economics
Put simply, unit economics refer to the profitability of selling one unit of your product or service. It’s a reflection of performance broken down to the most essential, granular level and can be captured with a 4-step process:
- Identify the units for your business: A unit can be a client, software license, widget, t-shirt, medical visit or stick of deodorant. It’s different for every company. For product companies, units are easy to identify. Service businesses need to think about what their customers are buying – a segment of time, a project, an outcome, etc.
- Determine how much customers pay for that one unit: Sometimes this is obvious. Our t-shirt vendor sells t-shirts, and her customers pay for t-shirts. Every t-shirt has a price. In other cases, services may be bundled. SaaS companies often sell a software license + implementation + professional services in one contract. Identifying how much customers pay for each can be difficult. In that case, there are probably two sets of unit economics – one for each item and one for the whole project. Hint: This is your Revenue
- Capture all the direct costs incurred to provide one unit: This can be anything from what it cost to buy that t-shirt from the manufacturer to the hosting expenses for software that you sell licenses to, the amount you pay employees who deliver professional services or the customer success operation that supports customers using the product. The key point here is that this only includes costs incurred after the sale is made. Sales, marketing, and corporate overhead are not included. Hint: This is usually your Cost of Goods Sold / Cost of Sales but could also just be the variable costs incurred with each new sale.
- Smash it all together: Subtract #3 (COGS) from #2 (Revenue) for each #1 (Units) and you have your profitability of selling just one item or service. Hint: This is your Gross Margin or Contribution Margin.
Investors Love Unit Economics
Investors use unit economics to assess profitability at scale. Isolating the profit margin of providing one unit to one customer helps investors cut through any over-optimistic revenue projections and get a sense for what an injection of capital may lead to.
Isolate Profitability from Growth
Top line revenue forecasts are notoriously optimistic and for good reason. Founders want to impress potential investors with the growth case, which always goes “up and to the right.” But just selling more of something to more people is irrelevant if each of those sales is thinly profitable or unprofitable. Unit economics strip away these growth assumptions to unmask the true economic return on revenue. They eliminate the hype.
Impact of New Capital
If your company earns a healthy profit from selling one unit, then it stands to reason that selling a thousand units or a million units will multiply that return. This is the concept of scale – the ability to achieve your targeted return at exponentially higher levels of revenue. It supports the case for injecting new capital by signaling to investors the return they can expect as the business grows.
Some other factors to consider, however, are potential unit changes that come with scale. Does your pricing have to come down to incentivize buyers to purchase larger quantities, thus reducing your margin on those units? On the flip side, can you lower your unit costs by committing to higher purchase volumes (our t-shirt seller probably pays less per t-shirt for 1,000 units than he does for 10 units), thus expanding your margin at higher volumes?
Knowing your unit economics today and how the inputs change at scale give you the tools needed to build pro forma financials with responsible growth assumptions. “Up and to the right” is okay if the path is rooted in the dynamics that drive your business. Investors love profitable businesses that deliver ROI at scale.
Unit economics are critical for fundraising, but smart leaders understand that they’re just as important for internal use. Clear line of sight on unit profitability sets up more accurate forecasting and better resource decisions.
Don’t leave unit economics to chance. Build a process to ensure your systems can easily capture data at this level. Be detailed, obsessive, and conservative. Maintaining a granular look at your value generation is vital in early growth stages.
Keep an eye out for Part 2 of our deep dive on unit economics. And remember, CPM Advisory has significant expertise building systems to capture unit economics and using these metrics to drive better forecasting decisions and support fundraising diligence. Connect with us here to set up a strategy call.