Although accurate, we must admit that it’s rather upsetting that more than 90 per cent of tech startups fail within their first few years. Considering that it takes two to three years, on average, to get to profit-making status, it seems odd that a failure of the majority is accepted as a norm by newbie founders and startup veterans alike.
Today, with even unicorns pulling up their socks in the current macroeconomic climate, this statistic needs more attention and context. The key here is in ‘unit economics’ - these are the key financial fundamentals of building a business. In simple terms, it is the direct revenue minus the direct cost of the product.
Any successful business would need to sell units at a greater value than the cost to make them. While there are several reasons startups fail, the most common one is that they simply run out of cash, and that comes down to whether they can make the switch from negative to positive unit economics. Many companies in the startup space initially prioritise growth and user acquisition over profit per unit. In these situations, startups and scale-ups build their business around future potential profitability, which normally revolves around increased spend by the customer and economies of scale on product costs. ‘Negative’ unit economics are typically designed to attract customers with competitive pricing.
A pointed discounting
The startup makes a strategic decision to take the losses, normally funded by the investors, to acquire customers fast. Such losses are healthy because, in effect, the startup acquires as many customers as possible with great service and products. In return, customers are loyal and repeatedly buy products or services. This growth gives the startup power with suppliers and customers.
If the scale of growth and unit economics align then large amounts of profit can be made. However, a model cannot indefinitely sell something worth Dh100 for Dh75. Of course, you may temporarily mask failure and create the illusion of growth when you’re selling at those rates, but absorbing losses month after month to drive revenue growth won’t work in the long run.
Research by CB Insights last year found that about four out of 10 startups failed because they ran out of money and 15 per cent failed because of pricing and cost issues.
If a business cannot ultimately capture part of the value it has created, its model is fundamentally flawed and it begins to fail. Nearly one in five of startups fail because their business model is flawed, CB Insights said.
Making the switch to positive
Startups with a strong awareness of their unit economics will usually have a clear route to profitability – going from negative to positive unit economics – and this is what founders pitch to investors to win funding. Founders get this wrong by poorly mapping out their direct costs, cost of acquisition, competitive landscape or customer lifetime value, or they simply fail to execute the business plan.
How do you map the negative to the positive? The switch from negative to positive economics is a journey founded on good budgeting/planning, amazing product and a well-executed vision.
* Be brutally honest with yourself and the fundamentals of what your business can achieve. A strong business plan and unit economics are founded on executing economies of scale, lower acquisition costs and a sticky attractive product.
* Be realistic about potential risks. The more scenarios you can account for, the better you can plan to mitigate them.
Sharing economy companies like Udrive focus on growth over positive unit economics when they first start. Our first three years were always designed to have negative unit economics. We were honest about this with investors and focused on building a brand and experience that could be difficult for competitors to beat.
This growth gave us a loyal customer base and viral customer acquisition, which has a low acquisition cost. This, in turn, gave us a seat at the table with suppliers to negotiate better rates and reduce our unit costs.
Effectively, we became big enough to benefit from economies of scale and trust built with our suppliers. This is when we were able to make the switch to positive unit economics have a route to net profitability.
In the end, negative unit economics are viable only when you are confident that your strategy can be profitable over time.