When asking pre-seed companies about their anticipated burn rates and cash spend over the following twelve months, I often get a boastful response along the lines of, “well, we’re profitable now, it’s just a matter of how much we want to spend”. That’s great, and I applaud pre-seed or bootstrapped companies that have found profitability, but it doesn’t mean much. In fact, I’d rather the company not be profitable. At the pre-seed, where a company may make $15k a month and have three employees, it’s not hard to be profitable. That revenue is covering three meager salaries and some server space.
What early-stage companies (Pre-Seed to Post-Seed, where Corigin writes initial cheques) need to solve for is unit economic profitability, not corporate profitability. There are a whole host of reasons for this, which I’ll explain. But first, I want to clearly define who I’m referring to in this post. My intended audience is high-growth, potential unicorns.
Financial health is important, so please don’t misconstrue this post for a directive to ignore it. Early profitability is also very applaudable, but often doesn’t yield fast-growing companies. Not everyone wants to build a fast-growing, tech startup, and that’s ok, but this post is intended for those founders.
Why not Corporate Profitability?
Profitability is usually achieved at the expense of growth. In order for the business to grow substantially, a decent amount of investment is required today. Since revenue is usually a trailing factor when compared with expenses, it takes a while for revenue to catch-up and even outpace expenses. The best way to illustrate this is through talent: in building a start-up, many companies go from a couple co-founders to a company of ~10–15 people in one year. If each employee takes a couple months to ramp up, that’s a decent lag on their revenue potential. With so many employees being hired in a short amount of time, and relatively little revenue coming in, it’s easy to see why profitability is very hard.
Early profitability is generally meaningless. Profitability is generally achieved through unsustainable cuts to expenses, rather than explosive revenue. That startup I referenced in the opening paragraph can boast about profitability, but its founders probably won’t want to take a significantly below-market salary later on, and they certainly won’t want to continue eating ramen! In other words, this early profitability isn’t really scalable. To further this point, they’ll likely lose money in the following couple months if they decide to hire an additional employee.
It can be misleading and make founders ‘chase’ the wrong thing
Founders often look at achieving explosive growth at the expense of building a healthy customer base. There are many startups chasing triple-digit growth that do so by spending piles of money on acquiring customers, that they usually don’t attribute to customer acquisition. They may assume that driving towards that rapid ascent will assure them that in a couple years they’ll be profitable because they’re growing so quickly that revenues will fast outpace expenses. However, those customers are often easiest to lose and most expensive to retain, making the long-tail of their revenue generation scarce.
It’s not indicative of long-term success
As mentioned, it’s not difficult to have a profitable business when staff is incredibly lean and the company’s landed a pilot project with their first client. But, this doesn’t really translate or provide any indicators of long-term success. The amount of growth that a company will have to undergo before it becomes a mature, sustainable company is monumental. Achieving profitability on $15k of revenue doesn’t give me any indication of where they’ll be when they’re mature. It certainly doesn’t hurt, but similarly, it doesn’t prove anything.
What’s Unit Economic Profitability and Why do you Care?
The definition of unit economic profitability
Unit economic profitability is a measure of profitability on a per-unit basis, or a customer basis. In its simplest terms, this is revenues minus any costs associated with selling, which usually includes cost of goods sold and marketing, or customer acquisition cost. Revenue and COGS per customer are relatively understandable, so I want to explain marketing spend. Too often, many costs associated with acquiring a customer are forgotten, which can include marketing and sales salaries, brand spend and even sales commissions. More obvious sources are direct acquisition costs like paid advertising or partnerships.
Why does this matter more?
I often meet founders that are losing money per customer and assume they can figure it out later. While there is a great deal of ‘testing’ that needs to occur at the early stages of building a company, unit economic profitability is very hard to achieve if not done almost immediately. In other words, I (as an investor) don’t want to subsidize your customers’ purchases. Unlike corporate profitability, unit economic profitability is a real measure of the health of what you’re selling. Where there are set-up costs and significant investment in the business, it shouldn’t cost you money to sell your product.
Unit economic profitability can, and in healthy businesses, is, achieved very early on. Corporate profitability isn’t. As an investor, I know I’m looking at a healthy business when unit economic profitability is present, and one that is scalable. If a founder has proven that there is demand for a product and can make money per customer, I know that business can scale. After that, it’s a matter of increasing marketing spend to attract those “healthy” customers.
To further this, I’ve written a more fulsome post on understanding cohort analyses and why they’re important. This digs deeper into understanding customer bases, and gets into why LTV:CAC is an important measure. The more the ratio increases, the more value can be extracted per customer for a lesser amount. The “investor standard” seems to be a 3:1 ratio minimum, but this can largely vary per business model. In order to achieve profitability, it needs to be a minimum of 1:1.
A company’s ‘healthiest’ customers are often the cheapest to maintain. Significant upfront discounts generally lead to quick sales, but high churn. It’s much harder to acquire a customer because they just love the product than it is to acquire a customer with a ‘deal’. By focusing on understanding per-unit sales and how to make them profitable, it’s much easier to acquire customers and let them keep contributing revenue for relatively little. By contrast, if focusing on top-line revenue only, those cheap customers usually don’t last long and take a lot to bring back, driving up costs over time.
So Now What?
Founders: I often get boastful remarks about early profitability, and I am proud of your financial watchfulness, but I’m not interested. Stop telling me why modest amounts of revenue create a profitable business and instead tell me how you’ve built a really healthy, robust, sticky customer base in which you understand per-unit economics. That’s what I need to know that you can build a unicorn.