Startup Unit Economics – the What, Why, and How
While everyone in the startup community has certainly heard of unit economics by now, it is not so often we talk about why we really care about it. Getting unit economics right can be equally important for your startup in bad times (i.e. when you’re looking to conserve cash [1]), as well as in good times (i.e. when you’re focusing on growth and optimising your business model). I hence gathered my thoughts in three sections below:
1. What is Unit Economics
1.1 LTV / CAC ratio
Conceptually, unit economics seeks to quantify the total return of investment per some pre-determined unit of measure. In software startups, the most common unit of measure is per customer, and the most common return metric used is LTV / CAC ratio. YCombinator lists this ratio among the key metrics for a range of business models from SaaS to Advertising [2].
LTV / CAC ratio refers to customer lifetime value and customer acquisition cost ratio (sometimes also referred to as CLV / CAC). The ratio shows how much you expect to earn from each of your customers over the total lifetime (that is over the entire time they stay as your customer) relative to how much you spent on acquiring them.
e.g. LTV / CAC ratio of 3.0x indicates that if you spent €1,000 in acquiring a customer, you would expect to earn back €3,000 from that customer over the entire time they remain as your paying customer
Or taking it vice versa – if you’re aiming at an LTV / CAC ratio of 3.0x, and a customer you are targeting is expected to return €3,000 over the entire lifetime, you should not be willing to spend more than €1,000 to acquire that customer.
1.2 CAC Payback period
Another rather frequent example of unit economics measure is CAC payback period. CAC payback period shows you how fast you expect to earn back the total amount of money you invested into acquiring that customer.
CAC payback period is particularly relevant in early stages, as well as when your company is particularly under strict cash constraints. In fact, ensuring you make the transition to more cash-based measures such as CAC payback period is an important step when you’re looking to conserve cash and extend your runway [1].
1.3 Other Unit Economics measures
While customer-based metrics are most common in software startups, unit economics could also be measured per different unit, such as per product sold. In this case you would be focusing on the contribution margin of each of the products sold and comparing it to the amount of investment made to producing them. These measures may be more relevant for hardware business models that handle physical devices (e.g. physical product marketplaces).
The article is written primarily from the perspective of software startups, and hence focuses on the LTV / CAC ratio.
2. Why does Unit Economics matter?
Understanding the unit economics of your business is equally important for good and more difficult times of your startup. It helps you answer several business critical questions, and to optimise your business model.
2.1 Unit Economics helps you understand whether you have a working - that is economically sustainable and profitable - business model
Unit economics helps you understand whether the investment you made in acquiring a customer is returning any marginal profit -?and if so, how much and / or how fast.
As a starting point, you want to make sure you’re not spending more to acquire a customer than what you expect to earn from that customer (i.e. to make sure LTV / CAC > 1x). To generate any return, the customer should in fact return much more than what you spent on acquiring them.
to reach breakeven in the long-term, you want the money earned from your customers to not only cover the costs of sales & marketing, but also all the other business expenses (such as investment in product and technology, general and administration etc)
If the above does not hold, you do not really have an economically viable business model and you would need to rely on external financing for the foreseeable future.
There are some exceptions to this – such as early days of a multi-sided marketplace, or other network-based business models. In these kind of business models, you may need to first achieve a certain critical mass before the business model itself can become viable. In these cases, you’re focus in early days is likely on capturing the market (almost at any cost), and hence spending temporarily more than what you expect to earn from the initial customers may be justified. This is well conceptualised by Reid Hoffman in his idea of "Blitzscaling" [3].
I want to stress, that spending more than what you expect to earn from the customer does not apply by default to majority of startups and would always need to be temporary. In every such case you need to have a valid plan to earn all that investment back at a later stage.
2.2 Unit Economics helps you better manage cashflows?
Knowing how much and how fast your customers are expected to return the initial investment, you can better project your cash-flows. It helps determine how fast will you start earning back the money from the customers and hence indicate, how long you need to subsidise your business with external funds. Similarly, it can help you determine the investment in sales & marketing needed to reach your growth targets.
2.3 Unit Economics helps you to learn, iterate, and improve your business model
Most directly, LTV / CAC helps you identify the most optimal way to reach your customers - that is the customer acquisition channel that returns the most profitable customers the fastest.
Through analysing unit economics, you can also iterate and optimise your pricing model. Unit economics considers the complete commercial equation in serving your customer (the average value returned, the lifetime, etc). You can hence use it as a reference when iterating and optimising your pricing model.
e.g. if increasing your prices by 10%, the average customer lifetime decreases only 5% - it may be a good idea to roll out that 10% price increase
Similarly, identifying the customers that deliver the best unit economics and analysing how they stand out compared to the rest of your customer base, you can identify potential improvements in your business model. That goes towards what segment these customers belong to, how you acquired these customers, which parts of product and service these customers are using more, etc. Bottom line, you want to replicate more of the actions that distinguish these higher return customers from the rest.
To draw value out of the unit economics you need to go beyond the total blended level of metrics and perform the analysis per customer segment, customer group, and / or customer cohort. Looking at the total blended level of the metric can hide ugly truths about the inner workings of your business model, such as how a few select customer segments are unintentionally subsidising the rest of your operations.
2.4 Unit Economics helps you more accurately model the future expected results including future breakeven?point
Using unit economics in the forecasting, you will keep the key variables of growth directly interlinked – revenue, gross profit, and customer acquisition costs. This helps you be more realistic towards your future expectations towards both: (a) how much you could expect your sales & marketing investment to return in the future, and (b) how much additional sales & marketing investment you should make to achieve the targeted growth.
Unit economics is also particularly good to help you project how much you must grow to reach the breakeven point. As the return is inherently normalised per customer, you use the unit economics to better project how many customers you need to reach that breakeven point (i.e. to cover all your fixed costs).
2.5 Unit Economics helps benchmark your business to industry standard
As unit economics is widely used across the industry, it provides a good reference point on how you’re doing compared to your peers. This can be good for your startup internally as well as for signalling purposes with external stakeholders, such as investors.
Internally, you can use the unit economics to understand if you’re business model is working good enough and to identify whether there could be room for improvement.
Externally, it is a direct signal for investors whether your business model is working. The better it’s working the higher the likelihood of better valuation and investment.
e.g. for SaaS businesses an optimal LTV / CAC ratio is considered to be between 3-5x
If your LTV / CAC ratio is lower than 3x, you are unlikely to reach breakeven any time soon. If you’re LTV / CAC ratio is 5x or higher, you may be under investing in marketing activities and may be losing out on growth opportunities.
3. How to calculate Unit Economics?
LTV / CAC ratio is calculated exactly as it says – total customer lifetime value divided by the amount spent on acquiring that customer. Below I’ll walk through how to capture each of the elements.
3.1 Establish the total monthly value per customer – the “V” of LTV / CAC
Value in the LTV / CAC formula refers to the gross profit earned per customer per month.
Gross Profit should include Revenue less all the Costs of generating that Revenue. When considering which costs to include as part of gross profit calculation it is important to remain first and foremost honest to yourself.
In a software business Gross profit should consider:?
3.2 Establish the total lifetime per customer – the “LT” of LTV / CAC
Once you know the additional monthly value your customer generates, you want to know the length of the customer lifetime. Customer lifetime is a measure of the total time a customer is expected to stay as your paying customer.
If you have long enough history, you can observe the total lifetime of some of your early customers directly. This information is, however, very lagged and does not allow you to make timely decisions. For more timely indication, customer lifetime is estimated based on the observed monthly churn rate.
When your customer stops paying for your service, they are considered as “churned”. The churn rate itself is calculated as a ratio of number of customers churned (during a month) relative to the total number of customers at the start of the month.
e.g. if you have 1000 customers in the beginning of the month, and 25 of your customers cancel their subscription during a month, your churn rate is 25 / 1000 = 2.5%.
The above calculation based on the number of accounts churned is also often referred to as the “logo churn”. If 2.5% of your customers leave every month, you can estimate the average lifetime of your customers by simply taking inverse of the churn rate.
e.g. 1 / 2.5% (monthly logo churn) = 40 months of estimated customer lifetime
It may be easier to think about it this way: if you have 1000 customers, and every month 25 of these customers leave, how long would it take until you ran out of customers? That would be 1000 / 25 = 40 months
Note, that there is also a churn calculation that uses revenue rather than no of accounts as a basis. For the purpose of estimating the customer lifetime, you want to use the logo churn as explained above. Revenue-based churn calculation is relevant for other business health metrics, such as understanding the net revenue retention numbers, but is not appropriate for LTV calculations as it can often overestimate the actual customer lifetime.
3.3 Establish cost per unit – the “CAC” of LTV / CAC
Customer acquisition costs should include all the expenses related to your efforts in obtaining the new customers. These costs should include all direct and indirect expenses related to your sales & marketing activities, including:
For LTV / CAC purposes you want to divide the total monthly cost as above with the total number of new customers obtained during the period.
e.g. if you’re average monthly sales & marketing cost was €100,000, and you acquired on average 50 new customers each month, your CAC was €100,000 / 50 = €2,000 per customer
There is often a delay between the sales & marketing spend and when you gain the new customers from these efforts. The delay will depend directly on how long your sales cycle is – for B2B companies that can often extend beyond 6 months. To counter the delay effect, I would recommend to use a rolling measure instead a direct monthly one to calculate the CAC. E.g. to calculate a 3-month rolling CAC for June, use the average sales & marketing costs and the total number of new customers gained over previous 3 months (April, May, June) instead of only June.
Should you worry about your Unit Economics?
Unit economics becomes really relevant in your startup journey once you’ve reached a growth stage – i.e. you have found an early product-market fit and you’re starting to experiment to find the most efficient ways to scale. Before reaching this stage, it doesn’t hurt to understand how unit economics works to think through some plausible business models for your product, however, you will likely not be able to draw real value from calculating the metrics based on your current data. Hence, in the early days of your startup, focus on finding that problem - solution, solution - product, and early product - market fit, before obsessing over Unit Economics.