How Venture Capitalists Evaluate Unit Economics

Unit economics is a term that can ignite excitement or induce confusion in the heart of Venture Capitalists. The ability to accurately evaluate a startup's potential can mean the difference between a multibillion-dollar exit and a catastrophic failure. One critical, yet often misunderstood, aspect of this evaluation is understanding a startup's financial health and future profitability. What critical metrics do VCs focus on to evaluate a startup's potential profitability? In this comprehensive guide, I delve into the essential components of unit economics and the skills necessary to assess them accurately, using a practical example from a hypothetical SaaS startup to illustrate my points.

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The Importance of Correctly Analyzing Unit Economics in Startup Evaluations

The term "unit economics," first developed by economists, is grounded in cost accounting. It helps managers make informed decisions about scaling operations, pricing strategies, and overall business viability. Over time, analyzing unit economics became a key practice for businesses, particularly startups, which operate with significant losses in their first years of existence. What exactly does unit economics mean, and why is it crucial in Venture Capital?

Defining Unit Economics

Unit economics refers to the profitability of a single unit of a product or service a company sells and is a vital indicator of a startup's potential. By isolating revenue and cost on a per-unit basis, Venture Capitalists can assess whether a startup's business model is viable in the long run.

The unit economics analysis helps VCs understand the startup's future revenue potential, break-even point, and the overall health of its business operations when it is at scale, i.e., the company reaches a point where it generates enough revenues to absorb its costs thanks to economies of scale or a critical mass.

Another way VCs assess unit economics is by asking, "What will it take for this startup to become profitable?" and comparing the corresponding number to the market size.

For example, suppose a startup needs to sell 1 million subscriptions to break even, but the estimated market is 10 million potential clients. In that case, it will be difficult for an Investor to get comfortable enough to invest. Even if the startup could take a 10% share of the market—which is quite rare—that would make it barely profitable.

In most cases, companies in that situation will not command the fabulous valuations VCs need to make sizeable investment returns. If the investment doesn't "move the needle" for the fund, it will be a pass. Read more about the secret criteria like this and others in the article below.

Go Further: The 7 Secret Evaluation Criteria Venture Capitalists Use To Make Investment Decisions

Using Unit Economics To Identify Key Challenges

Many aspiring Venture Capitalists and even some already on the job believe no financial skills are required for early-stage Venture Capital. They justify their claim by arguing that no financial data exists to analyze.

As I demonstrate in another article, analyzing and sensitizing financial projections makes sense even in the startup world, where most business plans never materialize. Understanding financial statements, metrics, and crucial financial ratios is a fundamental requirement. The ability to interpret these financial documents provides a foundation for assessing startups' economic viability at two critical stages of their development.

Initially, startups' early-stage fragility requires capital infusions to endure the journey toward product-market fit. Upon reaching this milestone, additional financing rounds become essential to fuel their growth.

Startups are planning to run out of cash.

William Sahlman - HArvard BUsiness School (source: Harvard Magazine)

VC-backed startups deviate from conventional business norms, as they often defer profitability in their early stages. Harvard's Bill Sahlman, who pioneered entrepreneurial finance courses in the 1980s, routinely reminded his students that startups "schedule to run out of cash periodically."

Successful entrepreneurs grow new business ventures through a series of experiments, each requiring the proper metrics to assess the success or the need to pivot.

Analyzing unit economics is also vital for startups entering their fast-growth phase, which puts pressure on the company's finances. Investors must comprehend how revenue is generated, how margins are formed, and how cash elements such as working capital vary when the startup scales.

You can grow bust.

Robert C. Higgins - Analysis for financial management (McGraw Hill)

Growth often brings opportunities and challenges; an Investor's ability to foresee potential changes in financial performance can make the difference between a successful and a failed investment.

In the remainder of this post, I will explore the unit economics of a Software-as-a-Service (SaaS) startup to illustrate the points made above. But first, I want to address a fallacy. Many Investors argue that unit economics do not matter in Venture Capital because growth should be the primary focus. I disagree, or rather, I do not subscribe to this idea at all stages of the startup's development.

Unit Economics Resolve the Growth vs. Profit Conundrum in Venture Capital

The tension between growth and profit is a central issue in Venture Capital. In this section, I delve into the nuances of this dilemma and illustrate why understanding a startup's unit economics is crucial. I unpack the concepts of first movers and fast seconds, winner-takes-all markets, and the role of profitability in ensuring sustainable growth in the tech industry.

The Growth vs. Profit Debate

The discussion of unit economics is at the heart of a critical debate in Venture Capital: growth vs. profit. Traditional business wisdom suggests that companies should be profitable. However, in the startup world, growth often takes center stage. The rationale? A startup can focus on profitability once it has achieved a substantial market share.

Here's where unit economics provides valuable insight: if a startup has negative unit economics, it is unlikely that merely growing bigger will lead to profitability. Instead, it may lead to amplified losses.

Consider Uber. Despite being a dominant player in the ridesharing market, Uber has famously struggled with profitability. The main reason? Unit economics. For each ride given, the costs (driver payouts, subsidies, promotional discounts, etc.) have often exceeded the revenue earned. This situation, where the unit cost surpasses unit revenue, leads to negative unit economics, a serious concern for any startup, irrespective of its market size or growth rate.

In the early stages of a business, be patient for growth and impatient for profits.

Clayton Christensen - Harvard (Source: The Innovator's Solution)

One of the best frameworks for solving the growth vs. profit debate comes from the esteemed Harvard Business School professor Clayton Christensen. He offers valuable advice for Investors and entrepreneurs alike: nurture patience for growth but harbor impatience for profits. This tenet underscores the importance of carefully carving out a profit strategy before rushing to scale a business.

Is Fast Growth At All Costs Always Justified?

Advocates of the "growth-first" approach often emphasize the concept of a first-mover advantage, arguing that gaining market share as quickly as possible is essential. The idea is that being the first to establish a dominant position could preclude competition. This notion can be misleading.

First-Movers vs. Fast Seconds

Research points to the success of fast seconds—companies that are not the first to enter a market but rapidly learn from the pioneers' mistakes, refine their strategies, and often surpass the first movers.

Apple is a prime example. It was not the first company to invent the digital music player or the smartphone. Yet, Apple has dominated these markets by learning from the missteps of early players, creating superior products, and executing impeccable go-to-market strategies.

Organizations that end up capturing new markets are those that time their entry so they appear just when the dominant design is about to emerge.

Constantinos MArkides & Paul Geroski (Source: Harvard BUsiness Review)

Proponents of the growth-before-profits approach point to the need to dominate in a winner-takes-all market. In a winner-takes-all market, much like a game of poker, the player or business with the highest hand or the best strategic position takes the entire pot—in this case, the whole market.

However, these markets are less frequent than most Investors imagine.

Winner-Takes-All Markets Are Rare

Just as a player's highest-ranking poker hand allows them to claim all the chips on the table, in a winner-takes-all market, the company with the strongest position—through unique technology, network effects, or other competitive advantages—secures the majority of the market share, leaving minimal opportunities for competitors. In both scenarios, there is little room for second place; the rewards are heavily skewed towards the top performer.

A prominent VC once asked me: "Where is Facebook's competition? Or YouTube's? Or LinkedIn's?" While the allure of winner-takes-all markets is powerful, such markets are the exception rather than the rule.

Even in tech, where network effects can be strong, there are countless examples of successful competition and coexistence among different platforms and solutions targeting different market segments. Such strategies saw the rise of platforms like Instagram (before its acquisition by Facebook), Snapchat, and Vimeo. As a side note, network effects are also rare; read more about how to identify them in the article below.

Go Further: Venture Capitalists: Here’s How To Identify Network Effects

While speed matters, understanding unit economics and having a clear path to profitability could be the more sustainable strategy for most startups. Building a business that can endure and thrive in the long run unlocks more value for all stakeholders.

I do not mean to say that profitability should always be the priority. I adhere to Christensen's view that once a startup achieves product-market fit and solidifies its business model, infusing hundreds of millions of dollars to spur growth becomes the chosen course of action. My point is that banking solely on future rounds to sustain the startup's viability poses considerable risk. Prioritizing a path to profitability is a sounder strategy.

Additionally, each industry has unique factors that can impact unit economics. Venture Capitalists should have a solid grasp of the startup's industry to interpret unit economics accurately and choose the best course of action.

The Focus on Unit Economics Ebbs and Flows With Economic Conditions

In the last two decades, it became apparent that economic and financial conditions impact VCs' focus on growth vs. profits.

In periods when the Venture Capital markets are less exuberant or "frothy," the focus inevitably shifts towards profitability. When investor sentiment cools and the availability of capital tightens, startups face heightened scrutiny. They must demonstrate a clear path to profitability to secure funding and ensure survival. In such environments, sound unit economics and a commitment to achieving profitability become imperative for companies to weather the storm until market conditions improve.

Profitable companies do not require emergency capital injections, or "bridge financing," to stay afloat until funding is possible to fuel future growth. The recent COVID-19 pandemic and VC market reset in 2022-2023 demonstrated these points. VC firms had to triage their portfolio to invest their meager reserves in the potential winners. Read more about the challenges of such decisions in the article below.

Go Further: Bridge Financing: When Venture Capitalists Throw Good Money After Bad

Similarly, when the financial markets prioritize profitability for companies aiming to go public, Venture Capitalists are compelled to emphasize the same. As Investors seek solid returns and stable investments, VC-backed startups must align with these market demands. The pressure to deliver profitability increases the chances of a successful IPO, a significant exit route for VC firms.

While growth dominated financial markets' minds in the 2010s—culminating with the IPO of Snap, a company without any visibility on monetization selling shares deprived of voting rights—WeWork's botched process signaled the end of the growth-only mantra.

The end of the 2020-2021 hyper-bubble signaled a return to more traditional metrics, with eight quarters of strong growth and metrics required to go public.

The public markets don’t care as much about your growth but more about pure financials, good-old profitability and margins.

Alan VAksman - Launchbay capital (Source: Crunchbase)

The Main Metrics Venture Capitalists Use To Assess SaaS Startups' Unit Economics

The Software as a Service sector has become a prominent recipient of Venture Capital investments worldwide. The reasons are twofold. First, SaaS businesses' scalability and recurring revenue models offer a promising return on investment. These companies can rapidly grow their user base and revenue without a corresponding cost increase. Secondly, the predictability of SaaS metrics enables a style of investing often called "spreadsheet investing."

In the VC context, "spreadsheet investing" refers to the ability to forecast future performance based on a few key metrics. Venture Capitalists can use these metrics to model various scenarios and determine an investment's viability and potential return. In essence, the investment decision in SaaS startups can be primarily driven by data.

The main metrics SaaS investors pay attention to are:

• Monthly Recurring Revenue (MRR)
• Churn Rate
• Lifetime Value (LTV)
• Customer Acquisition Cost (CAC)

Let's unpack each with a hypothetical SaaS startup, "SaaSPro".