Negative Unit Economics Create the Illusion of Success

David Sacks: People are already familiar with core metrics like unit economics. The question is: Why does negative unit economics catch startups by surprise? The answer is that, in a lot of cases, unit economics are hard to measure.

Selling dollar bills for 90 cents

It’s easy to understand that negative unit economics are bad—you’re selling your product for less than its variable cost. Nothing will give a startup the illusion of success like negative unit economics. You can grow very quickly when you’re selling dollar bills for 90 cents.

Startups all lose a lot of money. Unless you correctly attribute your spending between corporate overhead and cost of goods sold, you won’t know you have a unit economics problem.

This problem particularly afflicts tech-enabled startups, which have software and physical world components.

A brutal restructuring at massive scale

For example, a delivery company might think it has product-market fit because it’s growing fast. So, it expands to multiple cities. But the finance function is immature and costs aren’t properly attributed.

They hire a finance team, which says, “Slow down. The gross margin picture is unclear.” But the founder has to keep moving fast because they’re in a race with four other companies. The founder says, “Why don’t you figure out what’s going on and get back to me.”

They’re already operating in 50 cities by the time they realize they have negative unit economics. Since they’re already at a massive scale, they have to undergo a brutal restructuring. In an ideal world, you wouldn’t expand to multiple cities until you knew the first city was contribution-positive. But competitive pressure convinces you to expand sooner.