Exploring the 'Shangri-La' of good unit economics
‘Shangri-La’ refers to a fictional place in the mountains where everything is harmonious and plentiful. In the startup world, there is almost a mystical aura that surrounds startups which achieve mastery over unit economics. But achieving this feat at an early-stage company is by no means a fictional exercise.
The goal of sound unit economics is now sacrosanct in the startup industry. Many successful startups have mastered the science (and art) of good unit economics and are reaping numerous benefits. They are the ones that frequently get courted by VCs, engaged by corporate development groups, desired by job seekers, and are generally admired in the ecosystem. They essentially live a classically utopian existence - milking profits, entertaining investors (on a selective basis), hiring the best, and basking in the limelight.
Startups should build an organisation around good unit economics - not with the narrow motive of attracting venture capital investments (though this is often one positive outcome) - but with the goal of developing a sound scientific principle on which to predicate a viable business.
Let's get down to brass tacks. By definition, unit economics is a measure of the profitability of each 'unit' that a company builds and sells. This unit could be one food order, one license for using a SaaS product, one customer, or even one page view. It is done, typically by calculating the Lifetime Value (LTV) of each unit and subtracting the costs involved in selling that unit.
One has to make some simplifying assumptions here. For example, the sales and marketing cost per unit is often calculating the total for a period and dividing by number of units. It does not involve calculating fixed costs such as engineering costs (with the exception of customised engineering charges).
The idea is simple: If you calculate unit economics using the above formula and the outcome is attractive, then you have a sustainable business model.
I have to be a bit subjective here, because 'attractive' can mean different things in various industries, geographies, among other facets. Using the computed valuation for your unit economics, calculate how many such units you need to produce and sell to cover your fixed costs - and by extension, how much time it will take.
Further, one can then extrapolate to address more important questions like whether it would be more prudent to take outside capital to reach this magical number, or whether should you grow organically. You will also know what the organisation will need to look like to achieve ideal unit economics in terms of team size, office locations, pricing models, among other factors.
Good unit economics typically takes some time to get concretised. Startups frequently have to try out different parameters and then optimise each one of them.
For instance, advertising expenditure has to be fine-tuned to identify the right media or combination, and within those one has to optimise on parameters like keywords, media spots, and more to get the lowest cost per acquisition (CPA) per customer.
Similarly, pricing takes time to get optimised, in terms of what variables to restrict - users, concurrency, storage, bandwidth, and features. Sales models have to be tweaked to optimise how much to sell directly versus through channels and how to create the optimal incentive structure for each channel.
The beauty of this exercise is not necessarily to charm investors and speak from a position of strength. Sure, that helps. But what also helps is the ability to chart a powerful course towards building and running a viable business with a proven model. There is also the ability and power to tweak metrics like pricing and sales commission structures without causing finances to go out of whack, and the allure of controlling your destiny, to reassure yourselves and internal stakeholders that this is a feasible model that works. Add all these up and you see why I refer to such a scenario in Shangri-La hyperbole.
Devang Mehta is a partner at Anthill Ventures, an early-stage investment firm and scaling platform.