Why “Unit Economics” are Silicon Valley Kryptonite

“Venture capitalists are pulling back from startups promising the rapid delivery of everything from groceries to dog walkers,” the Financial Times reported this week, “as the companies face pushback from workers and policymakers critical of their business models.”

“What we’re seeing is an increased scrutiny on unit economics that’s being imposed by investors,” said the head of investments for a venture firm.

When Silicon Valley investors start talking “unit economics,” you know the party’s over. It is like focusing on the health and nutrition content of the punch bowl (as opposed to spiking it with more alcohol).

This is partly because unit economics are a dry accounting mechanism, and Silicon Valley startups are powered by dreams.

To put it another way: If optimism is a Silicon Valley super power, unit economics are kryptonite.

By boom-time venture capital standards, a successful startup is one that loses large amounts of money for years on end. The money-losing aspect, at least in theory, is a byproduct of rapidly expanding market share.

The companies that burn up lots of cash tend to have a hockey stick revenue curve (sharply up and to the right). The cash burn is a means of powering that revenue curve — as the startup spends heavily to buy new customers — and a kind of honorary ritual to show how much growth potential the company has.

As a concept, unit economics are generally ignored in all of this.

Fast-growing startups often have terrible unit economics, or even non-existent unit economics in the sense of having no profit-based business model at all. The thinking in that type of situation is, “Just grow like crazy for right now, and we’ll find a way to monetize the audience later.”

Sometimes “later” never comes, though, as the company keeps burning cash as a result of terrible unit economics — until venture capital investors stop funding the bonfire.

The heart of venture capital investing is a hyper-optimistic view of the future. The magic of a Silicon Valley startup — and the juice behind the high valuation — is in the company’s blue-sky potential.

It is not about how the company will look today or tomorrow. It is about the hypothetical greatness of how much money the company could make, far off in the future, if things go fantastically well.

When the focus goes back to unit economics, though, all that goes out the window.

A hard pivot to unit economics is like asking: “Forget about the future for a minute, what is the profitability of this company today? What is the cash flow situation of the company here and now?”

The unit economics mindset is far more sober than the hyper-optimistic one. It tends toward deflated valuation models rather than wildly inflated ones. It reduces the perceived value of “unicorn” startups — especially if they are still losing money. And for some unicorns, the unit economics focus becomes a death knell.

All of this is troubling news for publicly traded unicorns (like Uber, Lyft, and Spotify for example) that are still losing money. And it could spell doom for another group of still-private unicorns, hoping to go public, who never make it to an IPO at all (because they go extinct instead).

TradeSmith Research Team