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Why is startup needs to focus on unit economics

Startups needs to focus on unit economics

Startups needs to focus on unit economics as many startups like to position themselves as tech companies even when their core business lies in other sector.Uber, Beyond Meat, Tesla and WeWork are examples. This is because Tech is sexy now and opens the door to larger pool of potential customers and investors.There is a higher potential to get a higher valuation.
Investors need to determine whether a company is truly a tech company.For that they need to ask whether the startups achieve unit economics with its tech products. The reason why tech companies come with higher valuations is because their products/services can be scaled for relatively low costs.
For instance in a SaaS model where the subscription costs is $20 per month, each new customer added will have a Sales/marketing costs but no unit labour cost.This makes the tech unit economics simply incredible.
In case of Wework, this isn’t the case.The company has created an app using tech to book conference rooms as well as connect other members of Wework through its network. Wework also uses technology to run all aspects of its business – operations, Finance and HR, but the core of Wework business model is in leasing commercial real estate, converting it into coworking space and then renting out the coworking space at a profit.This business model yields a far less margin than a commercial tech company.
The Wework business model does not have an unit economics that justify its premium valuations.Its competitors do not command the same premium valuation as Wework.

WeWork business model did not have an unit economics

WeWork debacle has literally disrupted the unicorn dream of raising huge money through IPO and unlock value from their investments.One key learning principles that is followed is that as the startup raises more money from its investors, the investors focus more on profitability and unit economics.
Whenever an angel investor or a VC invests in a startup, they primarily focus on the founder’s background, startup market opportunity and its topline growth potential.VCs want to make sure that the startup business is well positioned to scale.When it came to exiting the business, the investors and in many cases the Private equity firms want to see a clear path to profitability, low churn and a very clear unit economics.
The whole WeWork episode had clearly flouted these investment principles where investors – Softbank in this case clearly abandoned their investment principles and adopted a blind faith in the company’s topline growth.The outrageous thing was when Softbank offered to provide millions of dollars to WeWork founder as consulting fees for providing services to his own company and then buying back billion dollars worth of shares.
Inspite of WeWork debacle, investors will continue to reward CEOs and founders making questionable business decisions with billion dollar golden parachute payouts.At the same time, following things needs to change.

Topline growth should never substitute for poor unit economics

  • High growth rate is necessary but not sufficient for a startup.This is because a startup is using VC money to do business but end up doing business at a loss by selling products at a very low price to customers in order to scale faster. This is not good business sense.
  • Venture Capitalists helps a tech startup build a product/service and market that product/service to the right audience.It is alright if startups lose money in order to gain market share but at the same time there is a difference between poor unit economics in the shorter term and chronic unit economic issues.
  • Uber is facing the same problem where with every unit ride it offers to its passengers, it loses money.This might be great for Uber users but for investors and stockholders it is horrifying.

Recession/slowdown will not impact startups having good unit economics

  • Arguments that Wework misfortunes are result of it’s wrong timing because of a slowdown is utter balderdash.The IPO market does perform well when there is optimism among the investors for a better economic growth in near future.
  • At the same time Wework issues are not because of the current economic slowdown.The main issue is that the company’s unit economics does not justify a premium valuation.A tech startup that makes margin on each product it sells may make less money at the time of a recession but if the startup has a good unit economics, efficient management and have a sticky and a profitable customer base then a recession cannot push the business to a brink of a collapse .

Final Takeaway

Startups needs to have a great vision but also have the ability to build a business that generate profits at scale.A startup may have a charismatic founder who can woo investors with his enterprising nature, but sound unit economics would finally determine the long term success of a startup.