When Losing Money Is Strategic — and When It Isn’t
A simple but often overlooked analysis of unit economics can help entrepreneurs know early on whether they are driving for unhealthy losses.
The bike-sharing company Ofo was founded in 2014 by members of a Peking University bike-riding club without much fanfare. They initially focused on bike tourism but swiftly switched to what they saw as the bigger prize: a bike-sharing app. In the next three years, the company’s growth exploded. By 2016, Ofo had a fleet of 85,000 bicycles in China, and it soon began to open locations around the world, including India, Europe, Australia, and the United States. The company would eventually raise a staggering $2 billion in funding. But by 2018, facing stiff competition and cash flow stress, its leaders considered filing for bankruptcy several times. A year later, Ofo was out of business.
What went wrong?
Ofo, like many new ventures — especially those backed by venture capital — focused on growth in its early years. Often, that means a venture will lose money. That’s not unexpected in a startup, of course, but the key question is whether such losses are healthy or unhealthy.
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If the business model anticipates both creating and capturing value, the losses occur purely because the entrepreneurs are investing in growth and scale. Over time and with scale, the losses should take care of themselves. These are healthy losses.
But if the business model is fundamentally flawed and fails to capture a part of the value it creates, then scale is not going to convert the losses into profits. Contrary to conventional thinking, the approach of absorbing losses year after year to drive revenue growth will not work for most entrepreneurs. As Ofo found out, it can be a path to certain failure.
There is, however, a simple but often overlooked analysis that can help entrepreneurs determine early on whether they are driving for healthy or unhealthy losses: unit economics (UE), or the contribution margin per unit. This is calculated by taking the expected revenue of the unit under consideration and subtracting the costs the company incurs from offering that unit. The key insight is that if the company sets the price above avoidable costs, larger volumes will likely lead to business profitability; if the price is below avoidable costs, even high revenues will often fail to prevent high losses.
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