Optimal Decision Dynamics - Should You Acquire that Company? It Depends on the Unit Economics

This is the first part of a series covering unit economics and its importance when evaluating business health:

Acquiring or investing in a particular company is an expensive decision, often involving millions or even billions of dollars. But how do you know if a company is worth acquiring?

To improve the odds of a successful transaction deal teams conduct legal, financial, and operational due diligence processes. But some estimates indicate that ~60% of transactions destroy shareholder value.

With such involved due diligence, how can this be?

While there are many reasons under discussion, today I’d like to focus on an often overlooked fundamental question:
Does the business model make any economic sense?

Specifically, does the company have a realistic path to profitability that does not require strong or far-fetched market assumptions?

You should be asking this core question if you work in:

Private Equity
Mergers and Acquisitions (M&A)
Venture Capital

The company under consideration can attempt to overcome doubt from investors and potential buyers by discussing the following:

Recent financial performance
Ideal future economies of scale
Founder and executive management team track record

But each of these comes with a flaw:

True profitability can be masked using metrics such as EBITDA, and recent financial performance may not indicate future business conditions
Will the company achieve the scale to spread its fixed costs across thousands or millions more customers than it has today? Maybe, but it’s far from guaranteed.
Management track record is telling, but seems insufficient to justify massive investments on its own.

This is not to say that moonshot ideas and companies do not deserve investment, but instead that the justification must be defensible and well-founded. While metrics such as profit margin, working capital, and operating cash flow can be useful at a macro level, they obscure insights into how profit is actually generated.

Look to Unit Economics

The clearest way to evaluate profitability potential is rooted in actual analysis of profitability itself.

We could start to list all revenues and costs of a company, but that is really just an income statement. Instead, we can think about profitability at the unit level, in terms of the profit or loss one unit creates. This is called unit economics:

What factors impact the revenues and costs of an individual sale, customer, or financial transaction in a steady state of the business?
What is the effect of each factor on profitability?

The definition of a unit differs by industry. A unit could be one coffee, one subscriber, or one shipment. Note that a business selling multiple products has unit economics for each one.

If a business makes money at the micro level it has a healthy business model. That business can enjoy scaling profitably.

In contrast, if a business loses $1 to serve each unit of demand, then increasing scale simply increases loss. Such a business model does not make sense. Without looking into unit economics we might not realize that operating the business simply leads to larger and larger losses.

Additionally, unit economics reveals that a money-losing business at the unit level can only be profitable in the following ways:

A fundamental change in business model, meaning the company would have to change its fee and cost structures
Rely on scale and market power, and the latter is only debatably legal

(#1) is a question of strategy, and only feasible if customers and counterparties are open to the change in business model. (#2) hinges on major assumptions of the future that may never materialize.

Clearly, unprofitable unit economics means the target company may not be a viable long term investment.

What about Industries with Large CapEx to get Started?

Is unit economics applicable to companies with large, upfront CapEx? Yes.

Even these businesses have revenues and costs at the unit level. In these cases, it is still useful to assess unit profitability in a steady state, after initial startup costs have been invested. For example, how profitable is an outdoor equipment manufacturer after its factories have been built?

Profitability Equations: The Cornerstone of your Strategy

Representing the Business Model with Equations

In essence, unit economics converts a business model into explicit equations. Using these equations, we can solve for profitable business conditions. Specifically, we can assess the per-unit profitability or loss of multiple scenarios.

Each scenario details a value for each factor that impacts profitability. For example, if we run a lemonade stand these factors might be the following:

Cost per cup, prorated by package of cups purchased → denoted c
Cost of lemons, prorated per lemonade sold → denoted l
Sale price per lemonade (revenue) → denoted p

Therefore, our revenue per lemonade sold is p, and our cost per lemonade sold is (c + l). Comparing p and (c + l) is a form of comparing marginal revenue and marginal cost. While these are simple equations corresponding to a basic example, they illustrate the conditions under which each lemonade sale is profitable.

If prorated costs for cups and lemons cost $0.50 and $1, respectively, then each lemonade must be sold for more than $1.50 to be profitable, assuming there is sufficient demand for lemonade. In real-world examples, the number of factors (i.e., variables in our equations) is larger and the equations are more complex.

Using Factors as Profitability Levers

But what if the market will not bear a price higher than $1.25 per lemonade? In this case, we would lose $0.25 per lemonade sold. Consequently, if we expand lemonade market share and drive growth all we have accomplished are increased losses. From a profitability perspective, it would be better to shut down the business. This is an unprofitable scenario.

But all is not lost! (See what I did there?) Rather than lamenting the profitability factors as exogenous forces, of which we have no control, we could see them as profitability levers we can pull. These levers are opportunities.

What if the cup cost, c, was $0.15 instead of $0.50? Then we would turn a profit of $1.25 - $1.15 = $0.10 per lemonade. This is a profitable scenario.

We see that we can go from an unprofitable to a profitable scenario. At this point, the question in the lemonade stand strategy headquarters is the following:
Is it realistically possible to reduce our cup cost from $0.50 to $0.15?

How might we achieve this cost-savings?

Changing cup suppliers
Ordering different types of cups
Ordering in bulk, as larger packages could mean discounts per cup
Discounting the sale price for customers who bring their own cup, which also has environmental benefits

The deal team should evaluate each strategy to determine its viability, and whether the cost reduction would bring us to the ideal scenario.

Scenario Analysis Facilitates Coherent Strategies and Accountability

The process above empowers us to pick a target outcome scenario, while understanding all the profitability levers to get there. With our target scenario in mind, we can craft a plan to make that scenario a reality. This way of thinking requires the deal team to have a clear-cut, defensible approach to reach the desired outcome. For example, order cups in packs of 1,000 for $150 from supplier X.

Additionally, scenario analysis drives measurable accountability. In effect, the strategy gives teams explicit assignments. If the plan is to purchase cups for $0.15 each, then we can track cup costs over time and check in with our team to ensure this cost reduction actually happens.

Scenario analysis enforces a decision-first approach, which I have discussed in previous blog posts.

Let’s do some Unit Economics

If you have read this far you might agree on the merit of unit economics, which can serve as a key operational due diligence barometer for private equity, mergers and acquisitions, and venture capital teams.

Unit profitability can help deal teams determine whether that investment makes any sense at all.

The next post in this series will explore an example, walking through the analysis step-by-step.