More specifically, there’s no problem if a startup is experiencing negative cash flow because it is incurring the fixed costs necessary to establish the foundation which will allow it to scale its business. These include investments like building a team, acquiring warehouse space, and adopting IT infrastructure. The concern arises when a startup is experiencing negative cash flow even before its fixed costs are taken into account. In this case, the startup’s variable costs exceed its sales revenue. In other words, the more units the startup sells, the more money it is losing. The difference between a startup’s sales revenue and variable costs per order is commonly referred to as its unit economics.
Let’s use a more concrete example to better understand the concept of unit economics. An e-commerce startup’s sales revenue is the average order size of its customer base. To be accurate, the average order size needs to take into account discounts offered by the startup and customer returns. The variable costs required to make each incremental sale are the cost of supplying the product and acquiring the customer. Assuming that the startup acquires its customers through search engine advertising, it pays a certain amount for each customer that visits its website. This is called the cost per click. After the startup attracts a visitor, it then needs to convert the visitor into a customer. This is called the conversion rate. The startup is deemed to have positive unit economics if the following equation holds:
Average order size > Cost of goods sold + Cost per click / Conversion rate
Note that this equation ignores the repeat purchases which can be made by a customer once the customer has been acquired. It can easily be extended to take into account such repeat purchases which enhance the lifetime value of a customer. In addition, the cost of acquiring a customer is valid specifically for those customers that come from search engine advertising. Other channels will require a different customer acquisition cost calculation. Finally, the equation ignores any credit card processing commissions paid to banks, and assumes that the startup fully recoups its shipping costs from its customers.
However, the key takeaway is clear. There is a big difference between a startup that is experiencing negative cash flow with positive unit economics relative to one with negative unit economics. While the former is making money on each incremental sale, the latter is simply losing more money the more it sells. Apply these simple calculations to your own startup to make sure that your growth will be sustainable in the long run.