While much digital ink has been spilled in recent months about the state of the global economy, its impact on the valuations of publicly traded technology companies and the financing environment for startups, some of the companies continue to receive new investment.
Investors have become more cautious about the founders’ growth plans and spend more time understanding the startup’s underlying unit economy.
Unit economics provides a summary of your startup’s performance, both historically and prospectively. It measures the profitability of the sale of a product or service per unit.
A startup’s past and present unit economy is often a guide to its future performance.
What is a unit?
The unit of measure may vary depending on the type of business. For software companies, the unit is often a single average customer, but it can also be a single seat, location, or license type.
For e-commerce businesses, the unit can be a single customer, order, or item. For marketplaces, a unit can be a transaction between buyers and sellers or the activity of an average buyer or seller.
To assess whether you have a suitable unit, can you calculate the customer acquisition cost (CAC)? Can you identify all the costs involved in purchasing this type of unit?
CAC must include all costs associated with sales and marketing, including related personnel, for a particular unit.
For example, if a startup spent $50,000 in sales and marketing expenses and made 50 sales in one month, the CAC per sale would be $1,000.
The suitability of a unit is also tested by asking: is there a level of consistency in the CAC for that unit, along with a consistency of activities directed by that unit?
If a startup makes very few sales and each through different sales channels, the calculation of CAC can be difficult and less reliable compared to a startup that makes a larger number of sales through one channel.
The same applies to the turnover determined by the unit of measure. If the startup sells a single product, it is easier to calculate the unit economy compared to a startup with a plethora of offers.
Building on the example above, let’s say the $1,000 CAC is made by a software company with an average annual subscription value of $750 with a gross margin of 80%.
This results in a payback of 20 months ($1,000 / (($750 * 80%)/12))).
Assuming the average customer subscribes for a three-year period, the Customer Lifetime Value (CLTV) is $3,000 on revenue and $2,400 on gross margin ($3,000 * 80%).
Defining key metrics
Here’s a guide to key unit economic statistics:
- Average Customer Life (ACL) is the average time that customers buy products before churning
- Average order value (AOV) is the average value of a customer order
- CAC Refund is the average number of months of sales before CAC costs are recovered
- churn is the percentage of customers who cancel their subscription in a period
- Customer Acquisition Cost (CAC) is the average amount spent on sales and marketing activities, including labor, to acquire a customer
- Lifetime Customer Value (CLTV or LTV) is the average amount of revenue or gross margin earned per customer over their relationship
- Gross profit margin is net income minus cost of goods sold
- LTV/CAC ratio compares a customer’s average lifetime value to the cost of acquiring them
Profitability per unit versus profitability in general
It is critical for companies to understand their LTV/CAC ratio. If the ratio is less than 1:1, it means you are spending more money acquiring the customer than the value (or margin) they will create for your business. This ratio can be improved by reducing the cost of acquisition (e.g. changing sales models, creatives and channels, different target market) or by increasing the value generated by customers (e.g. adjusting prices, onboarding customers, increasing loyalty).
While LTV/CAC ratios of 3:1 or higher are considered beneficial, the right ratio for your business will depend on your business type and the level of competition. For companies with very high ratios, there is a possibility that they will not grow as fast as they could.
Companies with shorter CAC payback periods require less working capital, allowing them to grow faster. In the example above, a 20-month payback period requires the software company to raise enough capital to fund the CAC plus any operating costs for that window.
If a startup has a strong unit economy, such as a favorable LTV/CAC ratio and CAC payback, they are more likely to receive funding, even if the company loses money overall. That’s because investors like us recognize that all startups must reach a certain level of scale before their gross profits cover their operating expenses.
If the startup needs to expand its team into new markets or product segments, operating costs will rise again along with the new level of scale needed to cover these costs. The problem of recent times has been with startups that have grown rapidly but with poor unit economy.
There’s nothing wrong with a startup losing money overall, as long as the unit economy is strong, there’s a clear path to scale, and the ability to build a sustainable competitive advantage. Therefore, losses can still be gains.
- Benjamin Chong is a partner at venture capital firm Right click on capital letterinvestors in bold and visionary tech founders.