The Importance of Unit Economics

Note: For the purposes of this article, I’m going to use the phrase “unit economics” as a broad descriptor that includes not just Average Revenue per Customer or Average Subscription Price and Customer Acquisition Cost, but also Customer Lifetime Value (“LTV”) and traditional sales efficiency metrics, namely LTV:CAC.  

Happy New Year!

Something I’ve noticed:

Very few executive teams pay close attention to their unit economics.  And, if they do, they don’t understand what the numbers mean.  In their gut.  

In my experience, not understanding your Customer Acquisition Cost is the easiest way for a VP of Sales to get fired.  

The reason: You’re spending too much money trying to hit your revenue target through your hiring plan (ie the path to disaster), and end up at the Board Meeting ill-equipped to discuss how your investments (because of course that’s what hiring is, an investment) are driving efficient returns.  

You get fired when your CEO and the BOD feel like you are no longer a careful steward of their capital.

You get fired when you only know how to spend money but don’t understand how much you’re supposed to make in return.

And, finally, you get fired when the product is broken, you know it, you don’t say anything, and you hire up a ton of reps without any marketing investment and the business doesn’t move (because you’ve got the order of operations wrong).

The Story of Your Business

Unit economics tell the story of your business.  

They are not just the province of the CFO.  They articulate something fundamental about your product, your customer’s satisfaction with your product, and the relationship between the price of your product and the value it’s delivering.  

Put another way, if you’re spending a large amount of money to get a customer and they are not paying you very much back in return, something is off.  Something is broken.  And it’s not just your sales execution.  

Bad unit economics tell you that you are not ready to scale or to grow profitably.  That in fact you might have to go back to the drawing board and rethink the product.

Good unit economics tell you you have room to invest.  That there might be room to grow.

So what’s good?  

Here’s what we’re looking for:  

You are paid back on your acquisition costs within 12 months.

There are plenty of reasons why folks will tell you that 12 months is too conservative.  And the true answer to what’s acceptable is directly related to your margins and your renewal rate (ie your Lifetime Value) and your sales cycle.

But the reality is that most LTVs are inflated because most businesses where LTV is applied are too young for the metric to mean anything.  

And the further reality is that people defending anything more than 18 month payback are almost certainly lying to themselves.  

To be safe, we like to see a $1 spent in 2017 result in $1 of Annual Recurring Revenue in 2017.  

Yes, it’s simplistic.  But we’re going to use simple back-of-the-envelope math to get a quick read on our business before we decide if now is the time to start pouring gas on the fire.

Let’s take an imaginary company with $5M in ARR on January 1st, 2017.  

On January 1st, 2018, the company is at $8M in ARR.  

With 90% revenue retention, the new business team actually added $3.5M in new ARR ($8M - ($5M * 0.9)).

Now we look at total Sales and Marketing cost and ask ourselves,

“Did we spend more than $3.5M in Sales & Marketing to get that $3.5M?”  

If the answer is “Yes”, we might have a problem.  If the answer is “No” we might have an opportunity.  The numbers will tell us a story.  If we listen.  

For example, assume the following:

• You hired a bunch of sales people.  Many of them didn’t work out.  They had trouble selling such a conceptual product.  
• You paid those sales people higher than market commission because you told yourself you wanted the best. Instead of paying 10% on Year 1 ACV, you paid 15% on total bookings.  
• You poured a bunch of money into a big booth at a tradeshow, scanned a bunch of leads, but somehow can’t point to any of them becoming customers. That was 6 months ago.  
• You agreed to approve $50K in paid acquisition efforts, at the behest of your new Demand Gen Director.  And you generated a bunch of leads.   But still can’t point to any of them entering the pipeline.

Adding up all of these elements (including recruiting fees, all marketing designed to get customers, benefits, SDRs, etc), it turns out you actually spent $5M to get that $3.5M.  At first you were happy about $3.5M.  But now it looks like even at back of the envelope, it’s taking 17 months get paid back.  

Your money machine isn’t very impressive.  

The Biggest Mistake You’ll Make Next

You’ll assume those bad unit economics are simply the result of bad execution.  That if you had the right drip campaigns in place, a better Demand Gen manager, or a VP of Sales that wasn’t pushing you to pay break-the-bank commission rates, everything would have worked out.  Those bastards in Sales and Marketing screwed you again.  It’s not your fault and it can’t be the product.  

But that’s false.

The reason those things were happening is because something is off.  Something isn’t quite as good as you made it out to be.  Something is harder than it’s supposed to be.  

About the product.  We’re talking about the product.  

That’s why it’s hard to hire great sales people.  That’s why they can’t get the sale quickly.  That’s why your Marketing isn’t as effective as you’d hoped it would be.  That’s why the channel that worked so well for your friend’s company doesn’t seem to be as productive for you.  

When you’re building a business, everything is connected.  Everything is related.

And all those signals are telling you a story if you’re willing to listen.  They’re telling you, it’s not the time to start hiring a ton of people.  Or spend a ton of money on marketing.  The signals are telling you there’s still core work to be done.  That you’re not there yet.  That you aren’t quite at product-market fit.  Even though you just told your Series B investors the exact opposite.  

Great unit economics mean you have something special.  You put in $1 in January and get $2 in May.  Everything is easier than it was supposed to be.  

Great unit economics are a strong indication that you’re onto something and you might actually have a use for venture capital.

Bad unit economics are a very clear and strong warning sign that something is off.  And it’s almost certainly not just poor execution.  Something is fundamentally off.

Step 1 is to know what your Customer Acquisition Cost is.  It’s your responsibility to understand how much you’re spending to acquire a customer.  

Step 2 is to understand how your CAC relates to your ability to generate new revenue.  We’ll worry about margin later.  

Step 3 is to keep a close eye on revenue retention and always have a conservative back-of-the-envelope LTV at the ready.  

Improving Your Unit Economic Visibility

So here’s what I want you to do next:

1. I want you to calculate Customer Acquisition Cost regularly and surface that data as part of a management dashboard at least every month and preferably every week. 
2. Fully load your CAC. Include all commissions for sales, all headcount expenses for sales including SDRs, all acquisition efforts from Marketing, all sales and marketing tech investments (eg. Salesloft, Marketo, Chorus, Troops, etc) and a conservative estimation of your Marketing headcount investment for new business vs retention (let’s say 75%)
3. I want you to review your 2018 revenue growth projections against your budgeted investment in sales and marketing.  In all likelihood, you are not budgeting enough. In our previous example, that company that’s now at $8M in ARR wants to get to $16M by end of 2018.  At current ratios, that means they’ll need to spend $11.4M to get there just in new business acquisition alone.  
4. Make sure there are no fanciful notions that up-end your fundamental existing economics.  Assume your CAC gets worse as you spend more money, not better.  Assume no improvement in LTV:CAC over the course of the year.  
5. I want you to use the twin KPI’s of change in CAC coupled with Net Promoter Score to give you a firmer understanding of whether you have actually achieved product-market fit or not.  Please build a dashboard (or have someone on my team help you) that pairs CAC to Unit Retention, Revenue Retention, and NPS so you begin to have an intuitive understanding for how product delight is driving your cost structure.  

Your unit economics will tell you a story.  The story is about all of your business, not just your sales and marketing efficiency.  That’s because sales and marketing efficiency are a function of what existing customers think about your product.  

So please pay attention.

And email if you need help on any of the above.