Leonardo Da Vinci dissected cadavers to understand the intricacies of the human body. Dissections improved his ability to paint and sculpt. Here is a link to Leonardo Da Vinci: Lessons from the original polymath. Medical students dissect cadavers to study anatomy. Business discussions on TV or by your local water cooler, however, are dominated by growth rates or Price to Earnings ratios. These metrics are short cuts to business analysis. However, this analysis is superficial unless it includes the dissection of the most important metric – unit economics.
What is the meaning of unit economics? Simply put, understanding unit economics is focusing on the core business activity at a grass-roots level. Building on this core metric determines the true long-run profitability of a business. Let me show you how to break down the unit economics for any business.
The How-To Guide. For any unit-based business, whether a doctor’s clinic, a retail or restaurant chain, the goal is to understand the profitability of each unit. We can accomplish this by disaggregating this process into several steps:
1) The investment required to build or lease the unit/office.
2) The sustainable revenues this unit can generate when fully functional.
3) The total cash flow that this unit can generate.
4) Armed with this knowledge, we can calculate the payback of each unit.
A software or internet business has upfront fixed costs but low marginal costs. For example, a business must build its technology infrastructure before it can acquire customers. Once the application is ready, it can theoretically serve as low as a one, to as high as an infinite number of customers. Therefore, it is important to understand the return on investment in acquiring new customers. We can accomplish this by disaggregating this process into several steps:
1) The continuous investment in sales/marketing and R&D to acquire customers.
2) The revenues generated from an annual subscription
3) The cash flow this business would keep after paying for costs.
4) Using this information, we can calculate the payback on customer acquisition.
Rapid sales growth, by itself, is not a marker of a good business. Technology businesses sport high growth rates, but most lack customer loyalty, which makes the growth rates misleading. Acquiring or building new units, with bad unit economics, dilutes the total value of the business – despite the revenue growth. Raising capital is frowned upon by investors because it dilutes existing shareholders, but if pursued to accelerate business with strong unit economics, it increases the total value of the business.
Therefore, just looking at business growth or Price to Earnings ratio is a superficial analysis. In short, when it comes to business comprehension, one must be willing to get their hands dirty. When in doubt, dissect. If it worked for Leonardo, it will work for you and me also.
This material does not constitute an offer or solicitation to purchase an interest in Latticework Partners, LP (the "Fund"). Such an offer will only be made by means of a confidential offering memorandum and only in those jurisdictions where permitted by law. An investment in the Fund is speculative and is subject to a risk of loss, including a risk of loss of principal. There is no secondary market for interests in the Fund and none is expected to develop. No assurance can be given that the Fund will achieve its objective or that an investor will receive a return of all or part of its investment.
This material contains certain forward-looking statements and projections regarding the future performance and asset allocation of the Fund. These projections are included for illustrative purposes only, are inherently speculative as they relate to future events, and may not be realized as described. These forward-looking statements will not be updated in future.
I am an investor and these are my personal thoughts on investing, behavioral finance, markets, and sports viewed through the prism of a Latticework