Ask a VC: why are unit metrics so important for your business model?
(Updated on 30 October 2023)
Very often after an entrepreneur finishes pitching his company and I start the Q&A session, I start drilling down on his unit metrics, trying to understand his business model, ie how he expects to make money.
Often, the entrepreneur says s/he is grateful for the questions, but more surprisingly to me, is how often the entrepreneur has not thought about his business with this tool/technique in mind.
Let’s kill a misconception immediately: a business model is not your list of different prices you expect to charge (for example: 9,99€/month for a music subscription service); this would be your rate card or price list. Why do I keep seeing this in almost all early-stage decks? Your business model is how you make a margin from whatever product or service you are expecting to sell or are already selling. And this means your business model has to take into account costs. And they have to be correctly allocated to the right revenue stream. Simply put:
Margin = Revenues — Costs
Simple? Then how is it that so many business plans and presentations never discuss their business model in this way?
Let’s dive into a bit more detail. Again, this is a simplification (that’s why we call it a model). I’m not a chartered accountant, and I use this approach to quickly model P&L for businesses I analyze and/or invest in.
Revenue is price x quantity.
Let’s use the example of a company selling branded T-shirts. If I sell 100 T-shirts (Q) at 10€/unit (P), then Revenue is P x Q = 100 x 10 = 1.000€.
If you have different product lines (and startups always seem to want to have different product lines ;), not just one), then R = R1 + R2 + R3…
I would recommend modeling your business on the main product line, building a whole P&L around it, and when the model is robust, start adding a second revenue stream, check that all works, and then a third revenue stream eventually. Beyond that, we’re getting into the realm of real science fiction modeling too many revenue streams.
Costs = Fixed Costs + Variable Costs x quantity
Variable costs represent all costs directly incurred when you have ONE extra sale. So if you sell one extra T-shirt, then the costs could be one unit of a white T-shirt sourced somewhere, the cost of the sticker ironed on the T-shirt, the 30 min required to iron the T-shirt + pack, the packaging costs, and the shipping costs. To be clear, if there is no sale, these costs are not incurred (= do not exist = are not paid).
Fixed costs represent all your costs incurred even if you have no sales. These are usually broken down into 4 main categories (no need for more):
Sales & Marketing Costs: these include the general marketing budget, costs of attending events and trade fairs, costs of a marketing site, SEO/SEM costs, costs associated with a marketing website, and costs associated with people directly working on sales & marketing. I would argue that Customer support should be included under this umbrella header associated with customer interaction (unless you can make them variable).
Technology: this includes people associated with R&D in software (developers), software licenses (Oracle for example) needed to build and run the product, costs of a transactional website (AWS servers for example), and costs of people associated with running these services. Product development (R&D), and Operations could be separated under this header.
HR / People: this includes costs associated with people not in sales & marketing, not in Technology. These are usually HQ people, such as management, admin, finance, etc. I would also factor in the costs of equipment for these people here (computers, etc.) and all extra benefits (private insurance, meals, etc.).
General & Administration: this includes everything else, usually professional services (lawyers, auditors, accountants), general bills not associated with a specific group such as office rentals, electricity, central phone bills, central amenities such as water cooler, etc.
so if Margin = Revenues — Costs, then
Margin = (Price x Quantity) — (Fixed costs + Variable costs x quantity)
Margin = Quantity x (Price — Variable Costs) — Fixed Costs
Margin = Quantity x Unit Margin — Fixed Costs.
We all want to have a positive Margin, hence Margin > 0, which implies
Quantity x Unit Margin — Fixed Costs > 0, or
Quantity x Unit Margin > Fixed costs.
And that’s THE great insight. An entrepreneur needs to understand how s/he builds a Unit Margin so that it becomes positive. Sell more than what it costs to sell. And make that Margin controllable, and large enough to be competitive. The difficulty here is to identify what is the unit: is it one contract with a customer, is it the lifetime value of a customer, is it one product, is it one license? Whatever makes it easy to understand and model the business.
I was talking to a marketplace operator the other day and remembered that there are costs associated with building the supply and costs associated with building the demand. Both should be taken into account vs. the revenue of a transaction on the marketplace.
Another insight here is that with volume, more and more fixed costs could be treated as variable costs. Examples:
Sales & marketing: if a cost is only generated when a sale is generated, then we can treat for example lead generation like a variable cost. Let’s say you pay 15€ for a qualified lead. If 25% of leads become paying customers, then acquiring a customer will cost 15€/25% = 60€. Each new sale has a variable customer acquisition cost of 60€. You’d better have a revenue above that.
Technology: if you are running a streaming video business for example, and if one server can handle only 500 simultaneous streams (hypothetical), then when you are acquiring customers by the thousands, you can associate a variable cost of 1/500 for each new customer. Specifically in Excel, you model this with a Mod() function, and a RoundUp(). With large volumes, the rounding for the last modulo is negligible (ie you only have 357 customers instead of 500 on the last batch).
People: If you have 1 accountant for every 50 large customers, for example, you can factor that in like a variable cost. This is where productivity comes in: the more work one person can do, and spread it out over more units, the better the unit margin.
G&A: try to affect costs to specific revenue streams, customers, etc.
4. Business model definition
Looking at the previous equation
Unit margin x quantity > fixed costs
The entrepreneur’s job is to
Understand the unit margin construction and make it as big as possible. Obviously, it has to become positive.
Increase the number of units sold. This has to be associated with the size of the market: a larger market makes it easier to have more units sold with the same market share :)
Focus on understanding when the generated margin from sales will cover fixed costs. This is what we call break-even! The money deployed until this point is the amount needed to finance the business, and this is why entrepreneurs raise capital.
Just getting to break even (not spending more cash than generated) is not enough. That’s the first quantity1 to understand. Then you need to generate more unit margin x quantity2 to be able to reimburse the deployed capital. This is typical of a loan, where you have to reimburse the “borrowed” capital.
Keep in mind that capital often requires remuneration or interest. It is very often the case for VCs for example, where we have to return a minimum interest for a fund (the famous “hurdle” rate). So a quantity3 is necessary to pay back the interest part of the borrowed capital. At this point, the entrepreneur has built a real asset, that generates unit margins with every new sale, after having financed its building (q1), and paid back the building costs (q2 + q3).
Of course, there is no one answer to a specific market opportunity. Marketing theory and Strategy recommend building different scenarios and choosing the one that maximizes the expected goal (profit if working on shareholder value, impact if that is your thing, etc. Another way to look at it is to analyze a volume-based business (usually low prices) or a price-based business (usually low volumes), or both (which means shifting the demand curve > this is for a future Micro-Economy post :).
As always, happy to hear your questions and comments.