Foresight Startup Q&A Blog Series: Modeling Unit Economics

 

The Foresight team regularly spends time answering our startup clients’ most pressing questions regarding Financial Modeling, IP Strategy, Valuation, and more. We’ve decided to share some of these important insights in our Startup Q&A Blog Series. This article deals with modeling Unit Economics for your early stage business.

Question:

How Do I Model My Unit Economics? 

One of Foresight’s startup clients approached us asking for advice on how to model the Unit Economics for 2 different business models that the company was considering. The client was launching an Airbnb-type venture and weighing the pros and cons of a Subscription model and Commission model. Although the 2 business models are very different, the Unit Economics modeling is fairly similar, with the largest difference being the Monthly Recurring Revenue (“MRR”) component.

Answer:

  1. Identify the Unit 

The first step to modeling Unit Economics for a majority of (if not all) businesses is to identify the Unit. The Unit is the revenue generating component of your financial model. For a Consumer Software/Subscription business (i.e. Spotify, Microsoft Office 365, etc.), the Unit is likely a single subscriber. Conversely, for Enterprise Software-as-a-Service (SaaS) businesses (i.e. Salesforce, Workday, etc.), the Unit may be an entire organization with many users. In any case, the best starting point for thinking about your Unit may be identifying your “average customer.”

In the case of our client’s Airbnb-type business, the answer is somewhat counter intuitive. The Unit in both cases, Subscription and Commission, is not the end-consumer (the people using the platform to rent). Instead, the Unit is the “Host” – the owners of the assets that are listing their property on the platform. This is because the Hosts are ultimately driving revenue for the business, either through monthly subscription fees or by sharing a portion of their rental proceeds.

  1. Determine Your Customer Acquisition Cost (CAC) 

Once you’ve identified your Unit, the next step is to determine how much it will cost your business to “acquire” them. By definition, for your Unit Economics modeling it is important that you isolate the cost to acquire and onboard a single Unit. There are commonalities among almost all businesses that will be included in your CAC, such as sales expenses, marketing expenses and salaries, but it is also important to consider less-obvious costs that may be more unique to your business, such as data hosting expenses, legal fees, etc.

Again, since the Unit was consistent for our client across both business models, the components of the CAC were also consistent. However, differing business models have significant implications for the CAC that are important to consider. In this case, the Marketing Expenses required to acquire a Host under the Commission model are likely much less than the expenses under the Subscription model. At the most basic level, this is because the costs to acquire a paying user is typically far greater than the costs to acquire a free user.

  1. Calculate Monthly Recurring Revenue (MRR) 

The MRR for your Unit Economics model is another critical input that looks at the amount of revenue that your business collects from each Unit on a recurring basis. The simplest determination of MRR is for a subscription business with a single subscription tier. If the business only offers 1 subscription level, to 1 type of customer, then the MRR is equal to the monthly subscription fee. The MRR calculation becomes more detailed as you begin to add additional subscription tiers, different types of customers, add-on features, etc. In these cases, you should again undertake the exercise of determining the characteristics of your average customer, and calculate the recurring revenue generated based on these features.

For our client, MRR is the component of the Unit Economics model that differs the most between the 2 business model options. For the Subscription model, the determination of MRR is again fairly simple – it is equal to the monthly subscription fee that the average Host will pay to list their assets on the platform. For the Commission model, however, the calculation becomes much more involved. Because the revenue generated from the Unit under the Commission model is not uniform or guaranteed, many assumptions need to be made about the transactions. These assumptions include Average Transaction Size, Average Number of Transactions per Month,  Average Number of Listings per Month, etc. From this example, it is clear how quickly the MRR calculation can complicate.

  1. Know Your Industry Benchmarks (Churn Rate) 

Particularly in the early stages of your business and Unit Economics modeling exercise, it is important to be acutely aware of your industry benchmarks. For inputs such as CAC and MRR, although each business will have unique values, it should raise a “red flag” if your inputs are orders of magnitude away from what similar companies are reporting. If solid justifications exist for your deviation from industry norms, proceed with your modeling but be prepared to answer questions about the abnormalities.

While CAC and MRR are determined using internal inputs and assumptions in conjunction with industry benchmarks, Churn Rate (“Churn”) will come exclusively from benchmarks for all new companies. Churn is defined as the percentage of customers that you lose each month. In the early stages of your business, you simply lack the operating history to know how “sticky” your service is, so instead you should turn to the market to tell you how frequently customers leave (unsubscribe, cancel, become inactive, etc.) similar platforms.

Using these 4 steps as a starting point, you should be well on your way to constructing a solid Unit Economics model. This will become the foundation of your Financial Model as a whole, and help you determine your specific funding requirements among many other key details about your business. For a more in-depth explanation and example of Unit Economics modeling, check out Foresight President, Efrat Kasznik’s talk titled “Telling Your Story with Numbers,” and register to attend one of our upcoming talks!

Startup Q&A Blog Series: Valuing Early-Stage Startups

The Foresight team regularly spends time answering our startup clients’ most pressing questions regarding Financial Modeling, IP Strategy, Valuation, and more. We’ve decided to share some of these important insights in our Startup Q&A Blog Series. This blog deals with valuing an early-stage startup when dealing with seed investors.

Question:

How Do I Value My Seed Stage Startup?

A Foresight client was preparing for a seed funding round, and asked us the best way to value their business. Because early-stage companies lack operating history, and in a majority of cases lack any form of revenue, assigning value to the startup cannot be done with “traditional” methods such as a discounted cash flow analysis or a revenue “multiple” approach. The client is launching a smart wearable health tracking device, and looking to substantiate a $12M pre-money valuation.

Answer:

  1. Know the Current Market Comps

Because early-stage startups cannot be valued on cash flows, investors often turn to the market to determine the “going rate” for businesses in any given sector. This is where the entrepreneur should start as well. Undervaluing your business in negotiations with investors means you will likely give up greater ownership percentage than is necessary – something that should be avoided at any stage of the business, not just the seed stage. Conversely, overvaluing your business could kill the deal before it even starts. When both the investor and entrepreneur are educated on current market conditions, the starting point of valuation negotiations can at least begin in the same ballpark. The ColleyGO publication is a great resource for starting your market research. Below is a sample chart from this report:

Not only can we gather the median pre-money valuation for seed companies of which was $16,725,000 in 2024 according to this chart, but we can also observe trends in seed stage valuation over time. Various public sources are available for valuation research by country, market, etc. As a starting point, Foresight’s client knows that they within the median range with the targeted $12M valuation.

  1. Know What Matters to Early-Stage Investors

Although it is a great starting point, most investors will be a bit more sophisticated in their valuation process than simply taking the market median. In particular, there are certain characteristics of a business that investors will consider when assigning value to an early-stage company. In 2011, Dave McClure, founder of the accelerator 500 Startups, shared insights on his methodology for valuing such companies. McClure said that each of these 5 components of a business were worth $1M in value:

  • Market
  • Product
  • Team
  • Customers
  • Revenue

The value assigned to each point can change over time, and would probably be more than $1M today given the sharp increase in pre-money valuations since 2011.  Each investor has her or his own heuristics.

When developing your pitch deck for the seed round, it is important to keep these factors in mind, and highlight those that are strengths of your own business. If you have existing, brand name customers, make sure to call them out. If you operate in a particularly large or “hot” market, emphasize this and quantify it in any way possible. Our client happens to have a particularly strong founding team with experience working with and launching products in similar industries. This will be a great point to emphasize when negotiating for their target valuation.

  1. Efrat’s “Bonus Point”

One component that is noticeably absent from McClure’s list, and that is particularly pertinent to Foresight, is Intellectual Property. IP gives companies an inherent advantage over the competition, and as such, such advantages should be considered in the valuation of the business. Traditional valuation methodologies often overlook the true value of IP to a business – something that Foresight tries to combat. For this reason, entrepreneurs should be acutely aware of the business’s  IP value from the early stages and understand how it impacts the value of the business as a whole.

When considering your company’s IP and the value it adds to your business, make sure to consider all forms of IP,  not just patents. A granted patent is undoubtedly something to hang your hat on when negotiating valuation, but remember to also highlight things like a strong brand, customer relationships, trade secrets, customer data, etc. Even the potential to develop these strong IP assets is something to be considered for your pitch (for example, the potential of amassing customer data even though you may only have a small number of subscribers at this stage). With 2 design patents and 4 provisional patents, our client certainly has some increased leverage in the valuation discussion.

  1. Bonus Note for Hardware Startups

Hardware startups are still very viable businesses, although they come with a number of inherent challenges that software or service startups do not face. Because of this (and because hardware is not the most trendy space), some early-stage investors may shy away from hardware deals.

For those entrepreneurs dealing with hardware, Foresight recommends a few things. First, be creative when developing your business model. One of the main drawbacks of traditional hardware businesses is that revenue is restricted to a single transaction. Modern business models, like we see in software, integrate things like subscriptions or upgrade plans to increase the recurring nature of the company’s revenue. Second, think about how software can work with your product. Even something as simple as a mobile application can open many more possibilities for your hardware business (customer data, premium content, community building, etc.). Finally, be mindful of your audience when pitching your business. Knowing that the word “hardware” might raise some red flags, be creative in how you present your idea to keep investors engaged. For our client, we suggested simply replacing any mention of the word “hardware” with words like “device,” or “delivery mechanism”.

Living in a Bubble? Demystifying Startup Valuations

Just when it seemed as though start-up valuations had peaked in 2013, the year 2014 has started with an opening shot in the form of the reported $3.2 billion acquisition of Nest Labs by Google, followed with Facebook’s $19 billion acquisition of WhatsApp. It now looks as if this year continues the perfect-storm conditions, which will sustain the trend of high valuations for exits (M&A and IPOs) and transactions in coveted markets such as the Internet of Things, where Nest has a strong foothold.

From my vantage point in Silicon Valley, I am frequently asked whether we are in the midst of a ‘valuation bubble’. The answer to that goes back to the definition of a ‘bubble‘, which inherently involves some irrational behavior driving otherwise rational participants in the marketplace to stray from reasonable prices that could have been anticipated under similar circumstances. Understanding the factors driving business valuations hinges on understanding the valuation framework, access to capital, liquidity conditions and the overall technology landscape. With that in mind, let’s look at some of the major trends that are shaping startup valuations in order to establish whether current valuation levels actually represent irrational, bubble-like conditions.

1. Demise of Financial Fundamentals: Rise of KPI-Driven Valuations

Valuations in certain high-growth industries are undergoing a paradigm shift, with financial fundamentals making room for valuations based on key performance indicators (KPIs) such as user stickiness, churn and conversion rates. A common pitfall involves trying to benchmark valuations of pre-revenue companies against traditional financial valuation fundamentals, such as revenues and profit multiples. This might give people a false sense of irrationality when they try to justify the valuation. This may sound like a radical idea, but it is the only way to explain the price parity between Instagram and Ducati, two companies purchased on the same week in April 2012 for around $1 billon. Instagram, a high-flying social media start-up with no revenues and 50 million users, commanded the same price as Ducati, a century-old Italian motorcycle manufacturer with €500 million in revenues. Last year saw a proliferation of KPI-driven valuations, with pre-revenue start-ups such as SnapChat and Pinterest valued at billions of dollars.

2. JOBS Act and Crowdfunding: New Platforms for Funding Innovation

Reward-based and equity-based crowdfunding platforms are emerging as prominent means for funding innovation, with over $2.7 billion raised in more than 1 million campaigns across all types of crowdfunding platform in 2012. Equity-based crowdfunding was made possible by the Jumpstart Our Business Startups (JOBS) Act, which lifted the 80-year ban on public solicitation in the United States. The long-awaited equity crowdfunding Title III Securities and Exchange Commission regulations are expected to be released later this year, marking the full launch of equity crowdfunding in the United States (which is currently limited to accredited investors only). At the same time, reward-based crowdfunding is becoming increasingly popular, with major platforms such as Indiegogo and Kickstarter helping start-ups to raise millions of dollars and bring new products to market.

3. Supply and Demand: Cash is Abundant

The consensus in US investment circles is that there is a lot of cash on the sidelines waiting to be deployed. Several factors are at play here: corporate cash levels are at an all-time high, creating shareholder pressure; high liquidity is fueling private equity investors, which are moving into growth equity; and venture capital investors are increasing their funds, resulting in higher investment rounds. The abundance of cash for investment is pushing up valuations to higher levels across the board – a trend that is expected to continue in the near future.

4. Multiple Paths to Liquidity: Intense M&A and IPO activity

In 2013 the NYSE reported a total of 230 IPOs with a combined value of over US$55 billion across all major US stock exchanges. Companies going public in the United States are generally more mature and are staying private longer. Subsequently, pre-IPO liquidity in secondary markets is very important, especially to early shareholders and investors. M&A activity saw some decline in 2013, with slightly over 10,000 deals reported overall, including about 2,200 technology deals with a combined value in excess of $100 billion. IPOs and M&A deals represent alternative paths to liquidity, which drive valuations up as companies have several options. These pricing pressures are expected to continue through 2014.

5. Hot Technology Sectors: Major Disruption Ahead

Some technology sectors represent particularly high-growth opportunities, and are expected to rise above the tide and generate M&A activity and higher valuations in 2014. One such sector is the Internet of Things (IoT). The IoT represents the vision of a connected universe where objects, devices and people will all share a common network of communication. IDC estimates that the number of connected devices will grow to 212 billion by 2020, with about 30 billion devices smart enough to operate without human control. A study by GE concluded that the IoT market over the next 20 years could add as much as $15 trillion to global gross domestic product, which is roughly the size of the current US economy. The Internet of Things is gaining momentum with industry leaders such as GE and Cisco, which adopted it as a key element of their corporate vision in 2014 and beyond.

So, are we living in a valuation bubble? The answer is probably somewhere in the middle, and perhaps we could characterize current valuation levels as “somewhat inflated, but mostly expected” under existing market conditions. These are exciting times, when disruptive technologies finally meet the right market conditions and capital infrastructure that allow for the kind of unprecedented valuations witnessed in recent years.

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