Thoughts on Unit Economics

By Juan Linares

When thinking about unit economics the other day, as one does, I reminisced about the 90s’ powerhouse, Columbia House Records, and how it probably would have been a venture capital darling in certain hands…It had a backdoor SaaS model, a growing market where it held power and tremendous market share (15% at its peak), positive unit economics at scale and the need to spend a ton on sales and marketing to fund growth.

For those that do not remember the 90s’ stalwart, the company offered eight CDs (Google: “Compact Disc”) for a penny…and then required you to purchase as little as one more CD at a huge mark-up and also sent you follow-up selections on a monthly basis that you inevitably forgot to return and were on the hook for. By underpaying royalties, pressing their own substandard CD copies and significantly marking-up the post-offer sales, they were making an estimated $7.20 per sold disc and a healthy bottom line margin even accounting for the free CDs being shipped all over suburban America and for extensive sales and marketing.

Inevitably, the changing landscape of the music industry (Napster, iTunes, Spotify etc.) and some lawsuits spelled the end of the run, but for a few years the LTV/CAC must have been compelling. My guess is that the net promoter score (NPS) for the company was pretty abysmal and that their retention rate was solely composed of unwitting consumers (usually teenagers who were afraid to tell their parents they were now in debt for hundreds of dollars) and people trying to scam the company back. So all-in-all perhaps a business with shady business practices, angry customers and zero positive innovation was destined for failure.

In more modern times, many high-flying early stage companies have gone to the other end of the spectrum: cheery, socially-conscious, transparent companies 100% dedicated to the customer and beloved by consumers…and often with horrendous unit economics. As one pundit put it before the IPO of online mattress purveyor, Casper: their economics would work better if they sent you a mattress for free and stuffed it with $300.

Many of these businesses (Casper, Facebook, Uber, Netflix, DoorDash) are counting on increasing returns via one of two ways: 1) the dual leverage of classic economies of scale and demand side economics, whereby the more users on the platform the greater the willingness to pay more, which can be returned as consumer surplus if prices are held steady; or 2) dual leverage of economies of scale and monopolistic market share. Until that point the consumer surplus is subsidized via venture capital dollars. Unfortunately, not too many people are looking to join a mattress community and the online mattress market now has close to 200 competitors which dramatically increases the challenge to reach the required scale to make the unit economics work well

As a side note, if nothing else, tons of venture capital dollars going into companies that don’t work out isn’t necessarily just burning money. It’s a transfer of money and a multiplier of money – something the Fed has been trying to do for years now without much success. All the venture capital dollars spent on offices, cloud services, sales and marketing, employee salaries went to a counter party who we can assume spent that money on their employees, office rents, buying lunch, getting dry cleaning, etc. Sure as an investor or LP maybe you wish they really had just burned less of your capital in a trash can, but those kombucha drinks at the corner juice shop aren’t going to drink themselves.

For early stage companies it is important to have a good handle on unit economics and be cognizant that not all growth is healthy or sustainable. In certain cases, companies will overspend on non-efficient sales and marketing channels or will over hire personnel without establishing true product-market-fit or engaging in thorough customer surveys, A/B testing and other efforts to understand the marketplace.  This can be particularly risky after an early capital raise when there is pressure to deploy funds to grow, grow, grow. Depending on your own philosophy, make sure you align yourself with capital providers that are on the same page with regards to timing and use of funds.

If unit economics do not make sense from an early stage it could be due to a lack of product-market-fit, profligate capital management or perhaps a mispricing of your product or service. For those with continuing upside down unit economics, there needs to be a compelling path to achieving demand side economics or significant market share with significant barriers against competition. Otherwise, that capital is going to get recycled somewhere else.