Silver bells and cockleshells won’t do it, but improving unit economics and scale certainly will.
Nursery rhymes have astonishingly dark and juicy histories when you dig into them, disguised by children innocently singing lyrics about everything from the bubonic plague through to the fertility of royals. They sound sweet enough until you look closer and read about what’s really going on.
Isn’t that true of far too many businesses as well? They look good from the outside, yet the core ingredients for a great valuation are sorely lacking.
Now that we have your attention, we can all agree that the less said about Mary’s garden, the better. Let’s focus on the concepts of unit economics and scale instead. You’ve undoubtedly heard these terms before, but do you really understand what they mean and what impact they have?
Unit economics: the building block
The concept of unit economics refers to the benefit of selling one item. This can be a product or a service, obviously depending on the business we are looking at.
The simplest type of business is a retailer that buys an item and resells it for a profit. It’s very straightforward to work out the gross margin, which means the unit economics are well understood. Things get a lot more difficult in manufacturing entities, as doing a proper costing of the products requires significant work on calculating manufacturing overheads and exactly what should be allocated to the products.
Cost accounting is one of the most interesting areas of finance and with good reason. Companies live and die based on this understanding. Both for running a business and trying to sell one, being able to show a robust understanding of profitability is key.
In a services business, analysing unit economics requires a solid understand of the effort that goes into providing a service. The time can then be properly accounted for.
A common misunderstanding among founders is the difference between financial accounting and the metrics required to actually run a business. Even if you don’t have cost of sales on your income statement (perhaps because you run a services business), there is of course a cost of sales in practice. The cost is the time of the people required to provide the service, along with the systems needed to support them.
And of course, customers don’t just fall out of the sky. There are far too many companies that have failed because the cost of acquiring a customer is high. The marketing expense sits somewhere in the overheads, yet it is often variable in nature. The situation is different when marketing is a small component of total costs and is related more to brand awareness than anything else. But when each new customer is the result of a marketing campaign with the likes of Google, then you have to be extremely careful.
The end result of a unit economics analysis is two important metrics: gross margin (expressed as a percentage) and contribution margin (expressed as an actual amount i.e. the profit per item sold).
Armed with this information, we can quickly assess how appealing the core business is. If the unit economics are problematic, then scale won’t help at all.
In fact, it will just turn a small problem into a bigger problem, while burning cash along the way. The exception to this is where scale can drive improving unit economics, which is a promise that many companies have made and failed to deliver on.
Scaling into profitability
We’ve already touched on the first potential benefit of scale. Importantly, unit economics improve with scale only if there are efficiencies that come from being larger.
For manufacturing companies, this is practically a guarantee. Overhead absorption per unit is lower when there are more units being produced. This comes through in a concept called operating leverage, which describes a scenario where operating margins improve at a faster rate than revenue, thanks to the fixed costs in the system that should grow at a slower rate than sales.
For retailers, the improved unit economics are harder to achieve. Eventually, the benefits of supply chain efficiencies and negotiating power with suppliers can be realised, but it’s a tougher journey to get there.
Service businesses arguably struggle the most to achieve improved unit economics. It’s less about the benefits of scale and more about building a stronger brand over time that allows for higher pricing. There are only 24 hours in a day no matter what your business does, so selling time means that unit economics depend more on pricing than anything else.
Even if unit economics are steady as the business grows, the benefit of scale is that overheads become less of a drag on profits over time. In the early days of a start-up, the overheads eat up the contribution margin and the company typically loses money, which is why funders are needed. A critical inflection point is eventually reached when the cash burn stops. This is simply the point at which the contribution margin and overheads are equal (assuming that income and expenses being cash in nature).
The payday
Of course, the goal cannot be to just breakeven in a business. The final part of the unit economics vs. scale analysis is to understand how big the business can get, with the unit economics assumption applied to work out what the profitability might be.
In our opinion, this is where the rubber hits the road for a valuation. An eventual exit of a business to a financial investor depends on having profits to show for the effort. Sure, you can hope that a strategic investor comes along and bails you out of a difficult business model, but hope is not a strategy.
In our concierge offering, we work with you on a detailed valuation to establish what that likely payday might be and what the resultant value is today. In our bootcamps, we take it a step further by taking you through the concepts that investors will focus on when assessing your business. And if you need help with modelling around concepts like unit economics and profitability, we can offer tailored solutions to you with the same ethos as the rest of our products: putting the entrepreneur at the centre of all that we do.