Growth vs. Profitability: Why Growth Companies Need to Care About Unit Economics

It seems we can barely get through a news cycle without mention of the impending doom of Silicon Valley’s most treasured unicorns, leaving paths of destroyed valuations in their wake. WeWork, Uber, Lyft are just a few of the high-flying darlings who have come crashing down to earth as both VCs and Wall Street are increasingly demanding companies be able to demonstrate a realistic path to profitability. 

The pendulum is swinging from an emphasis on (charismatic) entrepreneurs back to capital & sound financials.” – Scott Galloway, Professor, NYU Stern

That is not to say that companies need to slow growth. Rather, early-stage companies need to anchor their strategy in sound financials and financial assumptions. At the heart of building a sustainable plan for balancing both growth and profitability is understanding the unit economics of your business as early as possible.  

A unit economics primer.

Simply defined, unit economics are a measure of the profitability of selling, producing, or offering one unit of your product or service. At a high level, the point of unit economics is to understand how much profit a business makes before fixed costs, so that one can estimate how much a business needs to sell in order to cover its fixed costs.1 

Depending on how a company defines a “unit”, will determine what is used to calculate the unit economics. For most early stage and growth companies in technology, including SaaS, and service companies, the two most important elements will be Cost to Acquire (CAC) customers and the Lifetime Value of a Customer (LTV – aka, your ability to generate revenue from those customers over how long you expect them to be a customer).  

In isolation, neither CAC or LTV can tell you much about your overall business. For example, CAC doesn’t reflect the length of the sales cycle so is can be difficult to apply if there are long or inconsistent sales cycles. Similarly, LTV may look great, but that number may require a significant amount of sales costs to bring in. 

Both CAC and LTV have to be used in combination to really understand the unit economics.  

Getting started with unit economics.

Depending on the stage of your company, unit economic metrics will change over time. If your company is a start-up or at an earlier stage of development, you won’t have a track record, so your unit economics will be largely based on assumptions will require a degree of caution. 

Tip 1: Get a solid handle on your pricing strategy. 

Pricing strategy plays an important part in your unit economics. Is your pricing competitive? Is it sustainable in the market? Once you have a good idea about potential price points for your product/service, test it against the market, complimentary and competing products.  Your pricing will dictate your monthly recurring revenues (MRR) and thus lead to your LTV.  

Tip 2: Don’t be seduced by low customer acquisition costs. 

 Early stage companies often start with a low CAC.  In the early days, companies may not have a sales team, or operate with junior sales people or subsidized salaries. Early customers are often the low hanging fruit, gained through referrals. All of these factors keep early CAC low. However, as more market entrants appear (or the market itself shrinks), the opportunity pool will decrease making it harder and more costly to acquire customers. Ask yourself, can your market size and its adoption rate support your CAC over time?  

Tip 3: Validate, Validate, Validate. 

 In these early stages when a large part of your business is assumptions based, it is important to set goals or milestones to use data to validate your assumptions and make adjustments as needed. For example, one of our clients set the goal of having a definitive proof point for their Series A funding that proved they could move beyond “founder sales” – meaning the product was capable of being sold by others and not just the founder. They would then be able to model out and test new assumptions on the CAC per individual.  

Going from assumptions to clarity.

As you grow and evolve your business and learn about your markets, your unit economics will evolve, become more sophisticated and more accurate in forecasting the overall health and profitability of your business.  

As you get more data and experience under your belt, it will become important to get a handle on your cohorts such as market segments based on vertical industry or size, as well as customer personas and “age of customer” (I.e. when they sign up). 

“As you get more data and experience under your belt, it will become important to get a handle on your cohorts such as market segments based on vertical industry or size, as well as customer personas and age of customer.”

For example, our client established three different price points for different cohorts and could see their metrics were very different for each segment. Perhaps not surprisingly, the cohort comprising the largest of their clients had the longest sales cycle. However, when they looked deeper into the data, they found their LTV to CAC ratio was much better over other cohorts.  

By understanding their unit economics, it gives them the confidence to continue to invest in growing the business while demonstrating a path to profitability. 

Balancing profitability with growth.

Investors are quickly becoming fatigued with five-year plans that show massive losses despite revenue growth and no line where the company will break even. So, when should a company prioritize profitability over growth and vice versa?  

If a company has a good understanding of what unit economics are for their business, and has the ability to break that down by cohort, there will be indicators that will signal when to make a decision to invest or focus on profitability: 

  • Look to gross margins. Are gross margins expanding or are they static or declining? If the latter, you will be getting less per dollar of revenue as you grow. That is a sign you should be focusing more on profitability than growth. 
  • How is your market adopting? Is your market adoption increasing or static and decreasing? If adoption is increasing, investing in growth may make sense.  
  • Comparing apples to oranges. Unit economics must be calculated consistently. Excluding a cohort, playing with variable versus fixed costs or otherwise manipulating the data because it’s not telling the “right story” is a recipe for disaster. If the data isn’t where you want it to be, it may be an indicator of a flaw in strategy that can be used to course correct and get back on track.

Debunking the culture of growth at all costs.

While there will be firms that will continue to be willing to take risks and push a growth at all cost strategies, we are seeing many VC firms reminding their clients / portfolio companies that they have to have an eye on profitability. 

“When you’re losing money on every transaction, you can’t make it up in volume. In fact, the more revenue that a business with negative unit economics generates, the more money it loses.” – David Sacks, Craft

 VC and investment firms will require more and more of their portfolio companies and prospective clients to be able to tell the story of their business strategy, be able to defend it convincingly, with data, and ultimately demonstrate their plans are sustainable and realistic. For example: 

  • Conversion of bookings to revenueInvestors will want to see evidence that you are converting bookings to revenue and at what pace. Is that increasing MRR/ARR? By what percentages?  
  • Pay attention to churn.  If you sign a customer for $1,000/month, on the face of it, that is a five-year LTV of $60,000 which would be great. BUT this relies on your churn rate being 20%, if you are churning your customers at more than 20% annually, your LTV will be much less.

Many growth companies, don’t have the expertise or manpower to handle this type of analysis and build it into the overall business strategy. InfiniteCFO can help. Our solutions combine technology, process, and domain expertise to deliver a well-run finance function that can support companies through all stages of development – from funding to growth through to exit. 

Interested in learning more? Download our corporate overview or contact us.