Unit Economics for Startups: Why It Matters and How To Calculate It
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.
What Is Unit Economics for Startups? A Crash Course
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 positive 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.
Related Resource: Our Ultimate Guide to SaaS Metrics
What are the Components of the Unit Economics?
To best track and understand your unit economics you need to understand the individual components. Learn more about the components that are used to calculate and influence your unit economics below:
Depending on your business model, how you classify a “unit” might differ. For a software company, this could be one customer. For a company selling a physical product, this could be one product.
Customer Lifetime Value (LTV)
A crucial aspect of your unit economics is understanding the value of a single customer. LTV is simply the lifetime value of one customer (or average order value (AOV) for an ecommerce store). This not only helps inform your unit economics but can help teams develop go-to-market strategies and product decisions.
As an example for a startup company, let’s say their customer’s lifetime is on average 22 months and they pay $100 a month. That would be a lifetime value of $2,200.
Customer Acquisition Cost (CAC)
As we wrote in our guide, Customer Acquisition Cost (CAC): A Critical Metrics for Founders, “CAC is the sum total of the amount that it takes your business to acquire a customer, including time from your sales representatives and marketing and advertising expenses.”
Customer acquisition is important when calculating your unit economics because you need to understand what it to takes to acquire a customer.
Related Resource: Customer Acquisition Cost: A Critical Metrics for Founders
Lifetime Value (LTV) vs. Customer Acquisition Cost (CAC)
In order to better understand your acquisition efforts, you can calculate your LTV:CAC ratio. As we put in our guide on LTV:CAC ratio, “to make your cost to acquire is worth the lifetime value of the customer, it’s helpful to check the ratio between both. LTV:CAC ratio measures the cost of acquiring a customer to the lifetime value. An ideal LTV:CAC ratio is 3 (your customer’s lifetime value should be 3x the cost to acquire them). “
Customer payback period is exactly what it sounds like – the amount of time it takes to payback the acquisition of a new customer.
For example, let’s say it costs a company $500 on average to acquire a new customer and they pay $100 a month on average. That would be a payback period of 5 months ($500 CAC/$100 MRR). Note: This is the simplest form of calculating a payback period — there are formulas that take into account gross margins.
According to Investopedia, “churn rate is the annual percentage rate at which customers stop subscribing to a service or employees leave a job.” Churn rate influences your lifetime value which in turn influences your unit economics. If you can improve churn, you’ll be able to improve your unit economics.
Going hand in hand with churn rate is retention rate. Being able to retain and grow your existing customer base is a surefire way to improve every aspect of the economics around your business.
What is the Most Important Aspect of Unit Economics?
Your business model will dictate the different components and aspects of your unit economics. However, the most important aspects will boil down to how your business and acquisition model scales. Unit economics for certain business models may make sense from day 1 — for example, if you are going after large contract sizes and building a custom solution. On the flip side, there are models that will take years to make sense — for example, if you have a smaller margin business that requires massive scale and customers.
No matter how you slice it and dice it, investors want to understand that your business has the ability to turn to profitability and grow efficiently with the product and acquisition efforts you have in place.
How To Calculate Unit Economics for Your Business
Now that we understand what unit economics are and why they matter to your business. We need to find a way to calculate and track them specific to your business.
Method 1: Defining the Unit as One Item Sold
Calculating your unit economics based on a single item is sold is very straightforward. You simply take the revenue per unit and subtract the costs to sell 1 unit.
Method 2: Defining the Unit as One Customer
When calculating the unit economics for one customer (or one software user). You use the customer acquisition cost and lifetime value metrics we mentioned above. You can use the LTV:CAC ratio to understand this relationship or subtract your CAC from LTV to understand the profitability of a single customer.
Example Unit Economics Table
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:
Scenario A Average Contract Value (ACV) $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 Gross Margin 85% 85% 85% 85% 85% 85% 85% Gross Profit $4,250 $4,250 $4,250 $4,250 $4,250 $4,250 $4,250 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 Churn Rate 8% 8% 8% 8% 8% 8% 8% Expansion Rate 0% 0% 0% 0% 0% 0% 0% 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?
Why Should Startups Use Unit Economics?
Having a clear vision and path to profitability is a must for any startup. At the end of the day, if a startup fails to be able to pull a lever to generate profit, it will cease to exist. Learn more about why you should track and monitor your unit economics below:
Identify Obstacles to Profitability Early?
As we previously mentioned, solid unit economics is the path to profitability. By modeling your unit economics in the early days you’ll be able to paint a picture of your potential for profitability. If your model and plans aren’t demonstrating what you’d like to see down the road you’ll be able to identify obstacles and focus on those in order to achieve profitability.
Evaluate Potential Strategies
As we mentioned in our previous point if your unit economics are not demonstrating a clear path to profitability it might be time to tweak your strategy. By identifying the weak components of your unit economics you’ll be able to inform strategy for the coming months, quarters, years, etc. For example, if you find that you are spending too much to acquire new customers, you’ll want to focus on bringing that number down.
Analyze and Update Financial Model
As we wrote in our blog, Building A Startup Financial Model That Works, “No matter who you are talking to – team members, investors, potential investors – company storytelling doesn’t stop, it simply changes contexts and mediums. A financial model is one of those mediums through which your company can tell its story, even without the operational history one might assume would be necessary to persuade investors or make smart decisions about the direction of the business.” Unit economics will certainly play a role in this direction. By manipulating your unit economics, your financial story will need to be changed and updated as you seek capital from potential investors.
The Importance of Good Unit Economics for Startups
Unit economics are the lifeblood of a business. Without a scalable and profitable way to acquire customers, a business will cease to exist. In order to improve your unit economics, you need to keep an eye on and track your efforts. Check out a few examples below:
Raising Venture Capital
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. “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. Learn more about raising capital in our guide, The Understandable Guide to Startup Funding Stages.
Tracking your unit economics forces you to keep an eye on your acquisition efforts and go-to-market strategies. If you launch a new acquisition campaign and begin to see your CAC is on the rise — it might be time to evaluate and tweak your new acquisition model. Keeping tabs on your acquisition efforts is a surefire way to grow your business.
Growing & Scaling
As we mentioned above, tracking your acquisition efforts is a great way to grow your business. By doing so, you’ll be able to understand what channels work best. You’ll be able to invest in the channels that work best so you can grow your company in an efficient manner.
Track Your Key Metrics with Visible
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 capitalists, but it’s a solid foundation that helps you build any kind of business.
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