With venture funding in the U.S. having grown over 120% in the past five years, both founders and investors have become increasingly comfortable with low-margin business models. However, success stories like Amazon and Facebook often obscure the reality that plenty of sectors don’t thrive under the same “grow now, profit later” philosophy. Most businesses in these spaces fail to sustain themselves, proving that profitability and sustainability still matter.
Using historical examples, he provides insights into why developing a sustainable economic model is critical for the long-term success of any startup.
What Are Unit Economics and Why Do They Matter?
Simply put, unit economics is the measure of the profitability of a single unit of a product or service. For a company to have positive unit economics, revenue generated from a sale must exceed the variable costs associated with creating and delivering that product or service. In other words, unit economics helps founders evaluate whether selling one unit (or serving one customer) is profitable.
For example:
- A widget company would measure the revenue from selling one widget against the costs of manufacturing, packaging, and delivering it.
- For a service company like Uber, unit economics would consider the revenue from a single ride against the costs of driver payouts, servicing, and transaction fees.
Unit economics evaluates how much profit is generated before fixed costs, which is essential for calculating breakeven analysis—the sales volume required to cover all fixed costs and achieve profitability.
For startups, this kind of analysis is crucial to understanding the long-term sustainability of a business and the point at which it can reduce dependency on external funding.
Why Unit Economics Matters: The Case of Food Delivery Startups
The rise—and fall—of many well-funded food delivery startups serves as a cautionary tale. Apps like DoorDash, Postmates, and Blue Apron initially thrived by offering convenience at unrealistic prices, heavily subsidized by venture capital funds.
A Quartz article famously described these startups as “VC-subsidized meals,” where “free lunches” for customers were bankrolled by investor money. The problem? Poor unit economics. In most cases, food delivery startups were losing money on every sale. Instead of scaling profitability, these companies were scaling losses—a financially unsustainable approach.
Why does this matter? As Bill Gurley, a renowned venture capitalist, pointed out: “If a business loses money on every sale, then growing that business will only increase the amount of money that is lost.”
Without scalable and profitable unit economics, no amount of customer growth or fundraising will make a business truly successful.
Measuring Unit Economics
Creating a successful, sustainable business starts with understanding unit profitability. Unit economics can be approached in two ways, depending on how a “unit” is defined:
1. Contribution Margin (Per Unit Product)
One way to calculate unit economics is through contribution margin:
Contribution Margin = Revenue per unit – Variable costs per unit
Contribution margin shows how much revenue remains after covering costs directly tied to the sale. These variable costs could include manufacturing, delivery, payment processing fees, and other incremental expenses.
2. Customer Lifetime Value (CLV) and Customer Acquisition Costs (CAC)
Another approach focuses on defining the unit as the customer relationship itself. Here, unit economics evaluates the customer lifetime value (CLV)—the total profit a business derives from a single customer over their lifetime—against the customer acquisition cost (CAC).
For startups, acquiring new customers often means upfront losses. However, if the business retains customers for repeated transactions, it can recoup the initial investment and generate profits over time. A healthy business would aim to have a customer CLV significantly greater than its CAC (e.g., a CLV-to-CAC ratio of 3:1 or higher).
Both models help guide a startup’s breakeven analysis: when contribution margins or customer metrics offset fixed costs, allowing the business to become profitable.
Common Pitfalls in Unit Economics
Early-stage startups often miscalculate their unit economics because of common mistakes, including superficial analysis or underestimating hidden costs. Here are three critical areas where founders get it wrong:
1. Misidentifying Fixed vs. Variable Costs
The biggest mistake is incorrectly categorizing costs. Unit economics analysis focuses on variable costs—those that fluctuate with sales. Founders sometimes misclassify significant expenses as fixed costs, underestimating the true cost of scaling.
For example:
- Customer service costs are often tied directly to sales and transactions, making them variable, not fixed.
- Returns for eCommerce businesses are another variable expense often overlooked.
- Technology costs, such as server costs, can scale directly with customer or product volume.
Properly accounting for these quasi-variable costs changes unit economics calculations dramatically.
Example: The True Cost of A Sofa Startup
A fictional startup, Sofas.com, sells sofas for $700. Initially, it calculates variable costs such as manufacturing and shipping, showing a contribution margin of 38%. At first glance, this looks promising: the company projects breaking even within two years.
However, upon closer inspection, other costs are added—returns, customer service, and server fees—cutting the contribution margin significantly. This pushes Sofas.com’s breakeven timeline by an additional two years, underscoring the importance of comprehensive cost accounting.
2. Ignoring Absolute Numbers
Contribution margins expressed as percentages alone rarely tell the full story. Absolute profit per unit often matters most, particularly when fixed costs are the same across scenarios.
Consider Sofas.com again:
- Selling a smaller sofa at $500 may generate a 55% gross margin, appealing to a larger audience.
- Alternatively, a larger sofa at $900 yields a lower 40% margin but brings in greater absolute profit per sale.
The higher revenue per product gives the company more flexibility to absorb fixed costs, making the premium option potentially more profitable.
3. Confusing Cash Burn with Growth Investment
Burning cash is acceptable for startups—if it’s geared toward substantive growth. However, negative unit economics (losing money per sale or customer) signals fundamental issues.
Cash burn is more forgivable when:
- Leveling Up Productivity: Companies make capital investments (e.g., improving technology or infrastructure) to unlock future growth.
- Speeding Up Growth: Startups fast-track scaling by temporarily sacrificing profits—for instance, attracting customers early with discounts, assuming long-term retention.
But if unit costs exceed unit revenue in perpetuity, scaling will only exacerbate losses.
Why Negative Unit Economics Are Risky
While some businesses argue that negative margins are a strategy to scale, this can be a slippery slope. Scenarios where it “might” work include:
- Economies of Scale: Bulk purchasing may lower COGS at higher volumes.
- Marketing ROI: Acquisition costs upfront (e.g., discounts) are worthwhile if customers stay loyal.
- Customer Retention Efforts: Thin initial margins may build loyalty through later upselling or subscription models.
However, these strategies are risky. Customers may resist price hikes, upselling may fail, and cost-cutting initiatives like automation often underdeliver.
As Y-Combinator’s Sam Altman remarked: “Most great companies historically have had good unit economics soon after they began monetizing. Building around razor-thin or negative margins is far more dangerous than founders realize.”
Final Thoughts: Don’t Scale Without Profitability
Scaling an unprofitable business is a losing proposition, no matter how much VC funding is secured. As the cautionary tale of failed startups like Bento demonstrates, negative unit economics create uncontrollable cash burn, resulting in eventual collapse.
Startups must prioritize profitability early by:
- Studying their unit economics carefully.
- Ensuring all variable costs are included.
- Making sure their contribution margin remains positive.
Startups aren’t just about innovation—they also need sound economics. Building a business without understanding unit profitability is like piloting without a compass, leading to costly mistakes. Entrepreneurs should avoid becoming the next victim of a “scale now, think later” approach and instead focus on sustainable growth from the start.