Why Good Unit Economics is Essential to Your Business
The Importance of Good Unit Economics
By now, most startup founders are exhausted by the seemingly endless talk of a tech bubble and the inevitable wave of destruction that never seems to arrive. It may not be time to hit the panic button, but the ever present buzz around bubbles provides a reminder that any business built without a strong foundation will be (and has always been) vulnerable as the favorable tides turn.
Eventually, all the delusions of grandeur you may have developed around your startup must be tested with a real financial model that’s easy to communicate to your investors. Sure, in the early days, you can attract capital by telling ambitious, untested stories of rapid growth and high margins. But when the rubber meets the road, the success of your business can’t be dependent on a series of hypothetical. Instead, you need to satisfy investors with an easy-to-explain model that demonstrates a formula for growth. That starts with a grasp on your company’s unit economics.
Unit economics are the foundation that sustains your business as it scales. If you understand your unit economics, you understand what needs to happen and what needs attention in your business in order to hit your goals. This is essential when it becomes necessary to determine how much you can invest in the business to get an expected return. With solid unit economics, you’ll develop your projected return on investment and also make forecasting easier in the future. No matter what stage your business is in, you need the following basics:
- How much direct revenue is coming in?
- What are the costs associated with the business?
- What’s our unit of measurement? (one customer per unit for SaaS companies)
Then you can begin to paint a picture for your investors of your company’s customer acquisition efforts and lifetime value projections that hopefully provide a high margin return on their investment. Triple digit revenue growth is meaningless if you’re not providing a path to earn real margins on the customers you are acquiring. As Sam Altman notes, many of the poorly constructed startups he sees today rely on wild assumptions untied from traditional unit economics considerations: infinite customer retention projections, an implausible reduction in labor costs or a highly doubtful steep drop in the cost to acquire users. “Most great companies historically have had good unit economics soon after they began monetizing, even if the company as a whole lost money for a long period of time,” Altman said.
The strength of your unit economics will be one of the key competitive advantages in a venture capital market that many predict will toughen considerably as the cost of that will toughen considerably for founders over the next 5-10 years. “In 2016, the question that will immediately follow, ‘What is your annual growth rate?’ will be ‘What are your unit economics?’” Tomasz Tunguz predicted. “This change in investor mentality is catalyzed by the increasing cost of startup capital.”
It’s not going to get any cheaper to run your startup or raise serious capital to keep things going. And if you’re earning low-margins, face a high-level of competition and are looking out on a short runway, your financials won’t inspire confidence in your investors. On the other hand, if you have racking up short-term loses on customer acquisition, but can clearly demonstrate your customer payback period and lifetime value, you’ll be an attractive target for investment.
Here’s a sample model we developed that helps you demonstrate your company’s financials. Below, you can see the secondary performance indicators to include to develop a wider look at your company’s unit economics:
|Average Contract Value (ACV)||$5,000||$5,000||$5,000||$5,000||$5,000||$5,000||$5,000|
|Customer Acquisition Cost (CAC)||$14,286||$14,286||$14,286||$14,286||$14,286||$14,286||$14,286|
|Sum of all Sales & Marketing Expenses||$500,000||$500,000||$500,000||$500,000||$500,000||$500,000||$500,000|
|Number of New Customer Added||35||35||35||35||35||35||35|
|Lifetime Value (LTV)||$53,125||$53,125||$53,125||$53,125||$53,125||$53,125||$53,12|
It’s wise to have this level of detail available to investors in your regular updates. With a model like this you can help answer some of the most pressing questions facing your startup: Are you maximizing retention rates to justify the cost to acquire? Are you delivering the expected conversion rate on the money you’re spending to attract new leads? Is the revenue per user outpacing the cost to serve? As your business scales, are you seeing an expected decline in churn rate?
Markets fluctuate and conditions will better and worsen as your time goes on. But with a strong approach to unit economics, you are making responsible choices and setting yourself up to easily handle investor communication. It might not be the sexiest approach to drawing interest from top venture capitalist, but it’s a solid foundation that helps you build any kind of business.