Finally, Some Good Fads – Unit Economics and Capital Efficiency, Part 1
The folks at InsideSales.com just announced they have raised $17M from an unnamed strategic investor. In that announcement, Dave Elkington said that investors are paying a lot more attention to “unit economics.”
I was about to forward the announcement to colleagues and friends and say, “See? The CEO of the best-funded sales acceleration company in the world is saying it’s time to pay attention to making money, or at least losing money more slowly.”
Then it struck me: maybe some of my colleagues and friends won’t get it. Not just that they won’t get how exciting it is that business sanity might be sprouting in the land of the unicorns, but they might not even know what Dave was talking about.
What It Is
So, with apologies to all of you finance experts out there, I decided to take a stab at explaining — both what and why it’s important, not just for VC-funded startups trying to figure out how to stretch their now-precious funding, but for everyone who is responsible for selling. As a bonus, in Part 2 I’ll take a shot at unit economics’ buttoned-down brother, “capital efficiency.” And then I promise to come back to earth and talk about more practical stuff.
First, what is “unit economics”? Fundamentally, unit economics is the relationship of how much it costs to make, sell, and deliver your product to how much your customers actually pay for it. Normal business people are, at this point, rolling their eyes and saying, “Duh” — under their breath, of course, because who wants to be that guy. Their “Duh” is based on the obvious fact that, for “real” businesses, if the unit economics are not good, you lose money. And you not only lose money now, but you continue to lose money until you fix your unit economics.
Why It’s Important
Ever watch the TV program Shark Tank? Once the Sharks start to get a feel for what problem the product solves, they ask, “What’s your gross margin?” Why are Sharks so hungry for the answer? Because gross margin — the percentage of your revenues you get to keep after paying for the cost of merely producing and selling a unit of your product tells them pretty much everything about whether your business has any chance. That gross margin gets fed to the rest of the machine — overhead, sales, marketing — and if there isn’t enough to make the machine work at scale, you are “going to zero.”
Of course, true unit economics can’t just stop at gross margin. It needs to take into account the rest of the costs driven by selling and servicing units. For some products, this is easy. A jar of Wicked Cupcakes flies off the shelf to become a midnight snack — not much service, and the cost of sales is in the past as well, neatly wrapped up in a deal with a distributor.
For SaaS companies, like InsideSales.com, the units come with a little more economics. Customers need to be sold, one at a time — and that costs money. SaaS companies are pretty happy if they recover the cost of just selling their product in a little more than a year. (Normal business people, please take a moment to clean up the mouthful of coffee you just spluttered all over your keyboard.) Really, it’s not all that bad: your gross margin is super high. (Servers and electricity and internet access are pretty cheap.) But still — waiting a year for “dollar one” to come home takes patience. And the faster you sell, the more dollars you are waiting for. And servicing your SaaS product in the field, helping your customers actually get some of that promised economic return (you set their expectations pretty high to get the sale in the first place) only adds to how long you have to wait. Those dollars sometimes will hang out for a lot longer than is comfortable, often enjoying their vacation for a few more months before coming home.
When You Come Right Down to It
Of course, if you are a normal SaaS company, you got paid up front, so in addition to your scads of venture capital, you have customer cash to cover your overhead. Except for one thing. Your sales force. Strangely, your salespeople want to be paid every day, even before they have sold anything. If you could put them all on straight commission, there would be no unit economics problem. Your gross margins are high. Your customers prepay. As long as you can avoid burning too much on fancy conferences, overpriced office space, and at-your-desk pedicure service, you’re good!
So…it turns out the unit economics problem, at least in the world of the funded, comes down to sales performance. The real unit turns out to be the expensive sales rep’s base salary, benefits, and expenses. Standard accounting sort of hides this fact by shoving Sales “below the line” — that is, as something paid for by gross profit. But it turns out that Sales is actually a speculative investment. You buy salespeople in quantity, at retail, and hope they produce future returns (way future: remember that 1+ year of waiting for your dollars to come back home).
So, now we have simplified it. The “unit economics” question, at least in the SaaS world, is really code for “sales performance.” So the only question for everyone in the SaaS world, now that the easy money is gone, is:
How fast can you improve your sales performance to bring your unit economics in line with financial reality?
Link to Part 2, Part 3, or Part 4 of this four-part blog series.