Unit Economics: Lessons from Pets.com and Groupon

Founders need to be disciplined: before investing substantial time or money in a business, they must honestly assess its unit economics. From a microeconomic perspective, ask whether the business can achieve sustainable profitability. Estimating customer lifetime value and customer acquisition cost can help determine whether the business is profitable in its beachhead market. Customer lifetime value is an important startup metric. It can help establish whether a business can survive and identify the factors that drive its sustainability and profitability, so the company can focus on improving them. Pets.com is a valuable case study in customer lifetime value, customer acquisition cost, and unit economics. Founded in August 1998, the company sold pet products online. Its initial thesis was that many people were willing to spend money on their pets, and selling pet products online could avoid the cost of building retail stores, support high sales volumes, and create a sustainably profitable business through a new business model. The management team quickly raised several million dollars in venture capital from investors. During brand development and customer acquisition, it spent heavily on advertising across a range of channels, including an expensive ad during the 2000 Super Bowl. The company attracted many customers, but it had not rigorously assessed its unit economics. By the time management turned its attention to the problem, it was too late. Because product margins were low and advertising costs were high, customer acquisition costs did not gradually decline as they did at other businesses; they remained relatively steady. The company was therefore spending money to acquire customers while losing money on the business. As cash flow tightened, management remained convinced that the only issue was sales volume and that the business would become profitable once it had enough customers. That was wishful thinking: management had neither taken effective steps to increase customer lifetime value nor significantly reduced customer acquisition costs. As a result, the more customers the company acquired, the more money it lost. Investors soon realized that the company was a bottomless pit. In November 2000, Pets.com shut down and its assets were liquidated, leaving investors with a $300 million loss. Viewed another way, this was a $300 million lesson in entrepreneurship. It taught founders to be disciplined and to assess unit economics honestly before committing substantial time or money to a business. The lesson was painful enough that one might think no one would make the same mistake again. But that was not the case. Groupon later provided another example of the serious consequences of ignoring unit economics. Founded in 2008, Groupon grew slowly at first, then expanded rapidly after settling on its product. Groupon offered group-buying deals: each day, it offered steep discounts on a local business’s products in cities across the United States. Word of mouth spread quickly through social media, and the company soon became the fastest-growing sales company in the United States. For a time, Groupon was a darling of investors, the news media, and customers. But Groupon had a serious problem: it failed to establish a durable competitive advantage. As competitors copied its group-buying model, Groupon’s customer lifetime value gradually declined while its customer acquisition costs rose. Its mistake was again to ignore unit economics. Once the company’s moment in the spotlight passed and customers began comparing alternatives, the problem became clear. You need to determine customer lifetime value and customer acquisition cost. These metrics are equally important. Unless you can confidently conclude that customer lifetime value is substantially greater than customer acquisition cost, it will be difficult to cover other expenses, including product development, finance, management, and operating costs. #DisciplinedEntrepreneurship --- Robin’s note: “Starting a company is hard, and fundraising is hard too. Use every dollar carefully. The best money comes not from shareholders, but from customers.”