 Namaskar. I'm Professor Devdi Purkayastha from the Indian Institute of Technology, Bombay. Welcome to my course, Business Fundamental for Entrepreneurs Part 1, Internal Operations. As part of the course, I'm very pleased to welcome Professor Umakan Jayaram, who is a very illustrious finance industry veteran to share a few modules. Professor Umakanth is an alum of IIT, Bombay, and he went on to do his MBA, post which he has 30 years plus of industry experience in various aspects of finance. He has worked extensively in the banking industry, he has founded his own company, he has sold his own company, and he serves now as a public interest board member at the Bombay Stock Exchange. So it is my pleasure to hand over to Professor Umakanth for his module. Hello, welcome back. We're going to be handling the issues on relating to finance in this module. Specifically, we're going to talk about unit cost economics and how to write up a finance plan, and how do we actually tackle the issue of valuations in the startup. So let's look at unit cost economics first. What is unit cost economics? It's a study of the effects of changes in cost, prices, and profitability taken at a unit level of operations. Assume that all the things that go on in your startup gets translated to a unit flow of inputs and outputs. And we basically are paying attention to these five major areas of the operation. The volumes of the level of activity in the current period of time, the prices that you're fixed for selling your goods or services, the costs that are incurred in producing those goods and services. There are two types of cost, and we may as well define what these two levels are. One is those costs which are going to be incurred, whether or not you're going to be selling any output at all, or whether you sell 10 units of the output, or 100 units of output, or 1000 units of output. In other words, if your capacity was set up for producing the units of goods that you had set out to do is 1000, and whether you're actually selling zero, or whether you're selling 1000 units at full capacity, these costs remain the same. Such costs are identified as fixed costs. An example of fixed cost is management salaries. The salaries of the CEO, it's going to be the same no matter what the business is doing, or what level it's performing at, or how many units are being sold. Rent, phone utilities, selling and general administration expenses, these are all going to be more or less the same for a range of levels of activities, and therefore they are identified as fixed costs. Investments in property, plant and equipment are also identified as fixed costs, because these investments are upfront made and they're sunk, and whether you actually sell a single unit of output or not, these costs have been incurred. This is the nature of fixed costs. The nature of variable costs are those costs which directly vary with the level of output. To make one unit of an output, if you have to actually buy five units of a raw material and incur cost in running plant and machinery, either through direct cost or through labour or through manufacturing overhead, these are all variable costs or semi-variable costs. They can move with the levels of output, and such costs are called variable costs. And finally, the sales mix. If you are going to be selling more than one type of a product, the percentage proportion of each of these products is what is called the sales mix. So when we change the sales mix, or when we change and keeping all other things the same, we see what is the impact on operating profits. That is one experiment. When we change the level of fixed cost, or different units have different fixed costs, and you look at the impact on operating profit, you're basically looking at what is the capital efficiency of the unit. Then that is another experiment that we do in unit cost economics. Different levels of activity with different variable costs, if you actually look at what is operating profits, that is another way of looking at unit cost economics. Of course, with prices, which is a decision that we are taking only at the unit level, and volumes, we already saw a general experiment in the last session as to how management can take a decision on whether they should go for volumes, that is, market share, or they can go for margin, that is, unit selling prices. And those decisions are basically unit decisions, all of which combine together into the study of what we call unit cost economics. As you can see, this has all got a tangible impact on the kind of decisions that management and fund owners make on how they should run their business. The strategy of a particular business may be to be the cost leader in their category of products. This means that they will be able to actually sell at a particular margin at any given cost, compared to, say, the cost of competition. They can even basically be lower than that. Their prices can be much lower than competition because the cost of manufacturing is much, much lower. An example is, say, aluminum makers in India, because of the proximity to aluminum mines and resources of raw materials, the lowest cost aluminum maker is usually the ones who have those advantages. And they can outbeat the competition in terms of prices. Such a strategy is called the cost leadership strategy. You could also have a differentiation strategy, where you can actually be a margin seeker. You can take extra margin because you have that kind of market power and you exercise the market power by being a price taker or a price maker, not a price taker. And therefore, your margins for the level of sales that you're actually operating on is the highest. An example of that would be, say, luxury car industry or high margins. Maybe the output is low, but they make high margins. So you could take any one of these two general strategies, pursue it based on experimenting how the unit cost economics behaves. It's also a very good tool for planning the development of your business. One of the key things, as we saw in our early sessions for startup owners, is to survive the valley of death. All startups over a period of time need to demonstrate that they can actually make money from a loss making situation which is basically required for investment into the business and for establishing product market fit and for earning revenues over cost. And once you establish the break even point where you're making enough revenues to cover all your cost, you're supposed to grow and scale faster than anybody else. This is the desirable trajectory of all startups. And our planning process is supposed to optimize those decisions that can help this transition from the loss making business happen to the growth curve on profits. In other words, the transcendence of how a company basically moves over the hockey stick curve or the transition is determined by shrewd decision making and a good understanding of how economics works on a product's businesses. There are two ways to do this exercise. It really depends on how you have set up your business. If your business is all about selling goods then obviously you should be able to sell enough goods at a cost structure which basically gives back all the cost both fixed and variable. And then that particular volume of sales which you should get from the marketplace is all the break even point. One way of looking at whether you're going closer to the break even point or not is to focus on the unit level of activity. For a unit sales, we saw in the earlier example of the e-mouse trap, we had taken the decision that the selling price of this mouse trap could be anything between 2 and 6 rupees. Suppose we chose 5 rupees and for making each output, each trap, the variable cost, one that directly contributes to the production of the e-trap and remains constant for all the volumes of sales is 3. Then you're making a contribution of 2 rupees per unit sold. If the overall set up cost for putting up this business facility is say 1,500 rupees, then the contribution margin of 2 rupees needs to actually be multiplied by a volume which is a break even volume in such a way that you bring back 1,500 rupees and no profit, no loss basis. This volume is 750 units in this example. If this business is such that it needs to actually deliver a minimum 15% return to those who contributed to the set up cost, then the target profit that is needed for this business is in a year's time about 15% of 1,500 rupees which is about 22.5 rupees. So we need to actually make more than just the break even level but also deliver the target profit which is an additional 11 new units for a 15% return, sorry 1,100 units for a 15% return. In other words, in order to actually deliver your profit target, the business should be able to contribute through the contribution margin multiplied by the volumes sold minus the fixed cost, minus the target profit. And this is the way in which you will actually design your entire revenue target for the business plan. There's another type of business which is most often being encountered nowadays and this is not to do with actually making a linear flow of production of products which is sold into the market which is more in terms of marketplaces or software as a service. For these businesses, the unit cost economics works differently. We define the unit here of business as a customer as opposed to a unit of product output. We define it as a customer. This customer buys our service. The unit cost economics is now determined by a ratio. This ratio is of two different metrics. One is when a customer is acquired, what is the cost of attracting the customer? Total cost of attracting the customer in terms of marketing, discounts, free trials, all kinds of input or IO conferences, whatever, go to market expenses, all of that you add it up and you can divide it by the number of customers that you can reasonably attract through your campaign and you'll get the figure of cost of acquisition per customer. This is one metric. As against that metric, we shall be actually having in the numerator the lifetime value that the business can actually derive in the form of revenues for that customer and what is the lifetime of the customer? The lifetime of the customer is how long is he going to remain your customer before he churns out, before he goes to a competitor or stops using your product. This is in time units. If you're going to be a customer with us for three months and he churns out and every month, if he's actually going to be worth 20 units of revenue, Rs. 20 worth of services that he actually buys from us, the lifetime value is Rs. 60. And this is what the top level metric is. The ratio of these two is the unit economics metric, lifetime value divided by customer acquisition cost. The aim of a business, a startup, is to keep increasing the prospects of this metric. Usually, by rule of thumb, businesses are considered to be potentially on the path of profitability if this metric is three and a half times or more. There are ways in which you can actually forecast lifetime value. There are two ways, in fact. The first one is what is called a predictive lifetime value. In many circumstances where you have a stable state business, a product market fit has happened, then you basically have a very good onboarding of customers and a good clip for which they have, for example, if you're a software as a service and you're giving CRM services and every transaction that they actually execute through you is actually handled with a transaction value priced to him. You can actually predict the lifetime value by doing a product of the number of transactions processed through you, the average order value of a transaction, the average gross margin for this transaction, and the average lifetime value for the unit of customers who are giving this transaction. Suppose it was a financial clearing service for market entry, and if your service has actually been accepted by a bunch of customers who are your target customers, say hedge funds, and you want to know what is the predictive lifetime value of each hedge fund, all you have to see you do is look at the amount of billable transactions that your customer is going to do through you, multiply that by the average order value of each transaction, multiplied by a figure called the average gross margin, which is nothing but the total revenue that you earn from each of these transactions minus the cost of selling those transactions as a percentage of the total revenue that you earn. It's a margin figure for this percentage. And multiplied by the lifetime that he will be a customer with you, which is one minus the churn rate, or the churn rate which is defined as the number of clients that begin with you in a period, the number of clients that you ended up over that period, divided by the number of clients in the beginning of you. So when you take a product of all of this, you can actually predict what's the lifetime value of your business. And then you obviously have to divide it by cost of acquisition, and then you get the metric. The second method, and this is actually more true for less stable businesses, those are in the early stage of startups, where certain changes can be expected to have happened to your business, which impacts customers, churn rates, and even sometimes margins and prices and so on. Things are a little dynamic. We use an approach called the flexible lifetime value approach, which is the gross margin which is multiplied by the retention rate, which is discounted using an effective discount. The gross margin is multiplied by total revenue, divided by the number of customers in that period. That's GML, which is multiplied again by the retention rate, which we have actually defined here as ALT, and divided by a discount rate, which is 1 plus D minus R, which is effectively the kind of rate in which the business is going to grow into the future, estimated to grow into the future. And this is a gross estimate of the lifetime value for such a business, which is dynamically changing. In either case, LTV divided by CAC is your metric, and the target is to basically to see that the trend keeps moving up so that you get more and more profitability, although in the case of flexible FT, it can go up and down. And there is some threshold, which is defined by a competitor analysis. You have to be better than your competitor at least, and you have to be at least two times more than your cost of acquisitions and remain stable out there. Once you show that, you're reasonably comfortable in presenting your business case to investors as well as to your other stakeholders in showing that your immediate liabilities are taken care of, your business is on a profitable clip, and very soon it can turn around. Unit cost economics is a very good way to actually present the business case as to whether it is either successful already or is on the path of being successful in a few periods of time. And what is important to know is whether this trend or successful periods of review is positive or at least remains stable. If it is going negative in the sense of it's going down, then there is a need for us to analyze what is causing the fall in the profitability in the firm. We shall take an example to actually demonstrate how unit cost economics works. Let's take the example of a food delivery app, on-demand food delivery app. It's an aggregator model. There are two sides to value creation. One is the restaurant side, the other is the diner side. And the entire app is aimed at coming out a very efficient solution, technology-driven, to conduct all the following activities. First, basically get diners and customers to come on to them, help them to actually search through a content engine for all the kind of food choices and restaurant choices that they really want to order from, and allow them to actually select what they actually want to order at this point in time, the items, and confirm those orders, and basically pay for them using different payment methods, and process through a payment gateway partner. Once this order is actually executed and the payment is received, the order gets shipped into another part of the application, which is the other side, which is manager application. This manager basically conducts a search and passes the order into the right restaurant where the order has been made on, and executes the order or monitors the execution order from that restaurant partner. And upon execution of the order, they actually give the option to the restaurant partner if they want to deliver it themselves, or they want to actually use the services of the app to avail the delivery option through their own delivery partners. If they have to not use their own option of delivery partners, then the app will actually provide an order to the delivery partners who will go into the restaurant, pick up the order, and deliver it to the customer, such as the entire scheme of operation. In order to do this, the envisage setup cost, which is basically the application development, application can be on web as well as mobile, and a whole bunch of APIs to actually interact with the payment gateway partners, to interact with delivery services or logistic partners, to interact with restaurant engines, if there are any engines there, and other kinds of partners that they want as affiliates. So several APIs there. Network infra, of course, everything works through a network infra. And basically a content engine, which will be constantly the communication to the clients, as well as offering choices, discounts, information, value added services. A transaction engine, which is the exchange of payments as well as order slips for deliveries. And then some analytics around the uses of customer-based analytics for the restaurant as well as for the aggregator as a whole. And for customer, he can get analytics on whatever he's ordered and track that for future reference, or even for pricing matching and so on. So this is all setup cost. Operating cost with every transaction, a transaction here is identified as an order delivered. For each order, the setup cost has been defined. The operating costs are basically to make sure the restaurants basically are signed on for and are engaged for each order. Delivery partners, advertising, and all kinds of revenue lines which are fees, charge backs, incentives which could be cost as well as fees, discounts, and so on. The broad revenue lines for the business is subscription fees, advertising fees, because it's a content engine. Commissions, both received from the restaurants as well as paid to the delivery partners and maybe to restaurants also. And net delivery fees in the sense that amount of delivery fees paid to the delivery partner and how much of it is actually got from the restaurant. So with this kind of a model, we should be looking at what is the unit cost economics for this food delivery app. In order to look at that, various steps in which we can identify units of activity. Of course, activity can be on orders placed, but not all the orders placed are necessarily going to get confirmed. There could be cancellations from the diner or cancellations from the restaurant for non-availability, which is actually subsequently put in to the system. But confirmed orders ideally in an ideal world should get transferred to food deliveries at the same level, 100% of them. If a confirmed order does not translate to food delivery, then it's considered to be a defect. There is some problem. Either the restaurant did not prepare it in time or the delivery partner did not deliver it in time. That's a fail. But in a very perfect situation where your food delivery business is doing excellently well, you would expect this to be straight through process without any fails. The number of volumes of orders, you can track it over time and then you can find out how much of his deliveries are therefore on deliveries. You go on it when you actually deliver the food. And that's the unit volume for your activity. You can now move forward to actually see this unit volume of activity can be actually tracked in terms of revenues and expenses. So for each customer, the cost of food net of the restaurant discounts is one line of cash payment. Commissions retained by the food delivery app minus any discounts that it will give is actually a line of earnings. And that is shown as over here in terms of retained commissions. This is basically the movement of money, which is delivery charges as well as the cost of the food. Packaging charges in case there is a pass-through to a restaurant partner for packaging the food, then that will be separate that comes here. And then tips and everything has to be passed through to delivery partners and additional fees as well as additional expenses. So as a whole, there probably will be six payment flows in and out of the engine, which need to be processed efficiently. But of all the six payment flows, some of them are actually going to be recognized as operating expenses. Some of them are going to be recognized as operating revenues, and others can be recognized as pass-throughs. They neither revenues nor are the expenses for the engine. And let's see, if we have to look at it periodically, in this case we have a quarterly or put this an annual display of the total earnings that came through, which is one and three, that came through the system. Commissions and customer delivery charges in a waterfall. Delivery costs for payments were made. Discounts were offered to restaurants as well as delivery partners. And then there are some, these are all the kind of revenue lines which are up and down. And then there are variable cost for unit deliveries, what is the variable cost. And you end up with a contribution margin, which is negative. Obviously, this business has got a way to go before they actually start contributing towards the fixed cost. They're getting back the fixed cost. At the moment, they're only going to be recovering out all those part of the variable cost because they still got 30.5 million rupees to be recovered before they square off and they've recovered all that variable cost. The same business one year hence was reviewed again on the same basis. And you saw that, you know, yes, there are two revenue lines which have become bigger and stouter. The payments has remained more or less the same, but discounts has come down. It took a conscious decision to bring down discounts. As a result of which the plowbacks on variable cost has more and now it is green. This business has got a contribution which is not fully positive in terms of not recovering all the fixed cost, but it is definitely recovering all the variable cost. So there's a huge improvement from period to period in this business. And this huge improvement has come through because of decisions made here based on analysis of all the kind of revenues and cost expenses which are being incurred at the unit level. And the whole intuition is if we can turn around every delivery to make it operating profit positive, then we can actually apply that to scale and make our entire business profitable. And that is the approach of unit cost economics in practical terms. This is a live business which is actually very well known and is actually tracked a lot by the start-up community as well as by the stock markets. The big takeaways from unit cost economics is the ability to actually for management to make decisions, make several decisions. For example over here, if their main problem is to actually reduce this red box and make it green as soon as possible, management will be well placed to actually analyze the behavior of revenue lines based on different situations. For example, if the average order value being sought in the business is increased or is decreased, what is the impact on A, the commissions and B, the delivery cost? Basically the delivery costs are same no matter what is the order value. And if your average order value keeps going up, then the proportion of blue to this dark blue to this blue is going to be different and that's exactly what has happened here. You found a taller dark blue which is actually the commissions earned from the restaurants and a shorter light blue because for the same amount of work you'll be able to actually get more orders processed. The second is what about order volume? It is a fact that over here from this year under review and in this year under review, volumes went up by 25%. With volumetric changes there could be changes in the behavior of certain cost. It may not be in variable cost in terms of degree, but another cost and in other revenues as well. Definitely in the area of discounts and incentives. So by taking a decision on average order value and pushing sales and making sure that you actually process more volumes, this business has been able to make a remarkably good improvement in their operating profitability. This is an example of how unit cost economics works. In reality when your business is presented to external investors, the first external investors who is actually going to be a CDA round and it's almost going to make transcend this curve that is it started to make less and less of losses and it's going to start making profits from there on. A very strong scrutiny of the decisions that the management makes around unit cost economics is key to actually for the business to succeed to make sure that both the investor and the businesses are happy with the outcomes. This is perhaps the only tool that most early startup investors, institutional investors focus on and basically task the management with targets using unit cost economics on revenue behavior, on cost behavior and contributions. Later on when the business becomes stable state and is growing, then the dynamics of a full flown business with budgeting, planning, return on steering profits on total assets on all the kind of tools that you need to look at a business comes in. But initially it's unit cost economics that really matter. I'll stop here and we will move to the next topic which is valuations. How do you actually look at valuations after actually presenting a financial plan and how does the process work for startups?