The coronavirus crisis has got everyone focussed on margins, unit economics, fundamentals, and revenue. Avnish Bajaj, Founder and MD, Matrix India Partners, in conversation with Rajinder Balaraman, Director, Matrix India Partners, said, for the next 18 months or more, unit economics will be the key.
“Everyone is going to ask if what you’re doing is fundamentally adding economic value. However, the focus on unit economics is cyclical too. It comes into fashion for two to three years, and goes out again. The last cycle where unit economics was not in fashion was in 2014-15, and before that it was 2010-11. It was again back in fashion in 2016-17 and went away in 2018-19, and is back now,” says Avnish.
This focus on unit economics is generally linked with the overall funding scenario. Avnish explains that these cycles are important too, and unit economics not being the focus for some time is a rational behaviour.
This has changed not just because of COVID-19. There was also the WeWork debacle towards the end of last year that made investors wary and cautious. Avnish adds, the minute cost of capital goes up, the focus turns towards returns for that capital. But if the cost of capital is low, returns is not the focus.
The shifting focus
“I’ve been an entrepreneur, and if I was being given money for ‘free’ – I would go and acquire as many customers as possible. So, it’s actually rational behaviour,” says Avnish. But this also teaches ‘bad behaviours’ as one can start assuming this to be the new normal, and a sudden shift towards the focus on unit economics can be difficult and painful.
Thus, the focus should be towards building a business no matter what the cycles show. But what should the focus be towards in that? Gross margins or contribution margins?
While gross margins have been in existence for a while now, contribution margin as a term, Avnish adds, has been invented by the internet.
“The reason we use it is because in the internet businesses, you are often underwriting future cash flows,” says Avnish.
He adds, in order to get proxies for those future cash flows, all of these margins have been created.
“And more so created by later-stage investors as they are trying to underwrite profitability, and in the absence of current profitability, they need proxies for future profitability. So, if I have a one-line description of contribution margin in the internet world, it is proxies for future profitability,” says Avnish.
Why contribution margins matter?
Contribution margins are important for internet businesses. Citing an example, Avnish says, if one were to define gross margins, the simple question an entrepreneur needs to ask is how much work does it take to get it right?
If the gross margin is high, not much. Or if you have created a value proposition that makes it easy to price above all costs. Gross margin then is revenue minus direct costs like raw material, labour, etc.
If you take this in the current internet businesses, which is delivering goods, the company is bearing payment gateway charges, logistics charges, charges for returns, etc.
“In the net revenue line, there should be a gross revenue line that would be netted off with returns and discounts, which people don’t do,” explains Avnish.
This is why contribution margins become important as it calculates the margins after all the deductions. Contribution margin 1 (CM1) is gross margin minus other costs like logistics, payment gateways, etc.
If one were to sell something below cost and get a higher marketshare, they can go for it during the bubble periods. But that would mean negative gross margins, which can be a problem during times like these.
“If you are to sell something where it costs you more to make that product and deliver that product, but you are still selling it below that cost, you would still have customers. Those are all CM1 negative companies, and believe it or not, people still fund them. Next, it comes down to what does it take to grow this business? In internet businesses, it’s generally the variable cost associated with digital marketing,” says Avnish.
The different levels of contribution margins
This means that CM1 minus digital marketing is CM2. Now that minus brand marketing and it comes to CM3, which has contribution margin and fixed costs and CM3 minus fixed costs is your EBIDTA.
“Thus, CM1 basically says I can make money, but I don’t know if I can grow. The way I would use CM1 is in conjunction with Lifetime Value (LTV) to customer acquisition cost (CAC). So, if you have very high LTV to CAC, I am okay with CM2 being negative. Because your cohorts are strong. So, if you’re doing CM1 level investing or CM1 level analysis, please look at cohorts and LTV to CAC, if your CM2 is positive, you don’t even need to worry about it because it’s paying back immediately. A long explanation, but these are all proxies for future profitability and one’s that venture capitalists have to use because we don’t have present profitability,” says Avnish.
If you were to not focus on margins early in the analysis, the focus then needs to be strongly on the product-market fit. Avnish says, as investors, there are three types of risks – product-market fit, scalable product-market fit, and the scalable profitable product-market fit.
“If somebody is giving away things below cost and below their ability to make money, they should show a lot of traction. But the minute you switch that off, do the customers run away? This is why we all know that discount-driven customers are the most disloyal customers,” says Avnish. He adds that for him, CM1 is a red line. CM2 may or may not be a red line, as it depends on LTV to CAC.
“So, if you’re asking me to take a CM2 risk, I would want to see enough history in the company to know that LTV to CAC would work. If you don’t focus on these things, are you getting wrong signals on product-market fit?,” says Avnish.
However, there are also other factors like network effects and operating leverage. One would also look more at user experience, network effects, and operating margins.
Quoting the notable investor Warren Buffett, Avnish says, “There’s price versus value, and price is not the value – we often confuse the two. I think these kinds of frameworks help you understand how far you are and that is where investors also help. But I think as a founder, it is also critical to focus on the fundamentals.”
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