While much digital ink has been spilt in recent months discussing the state of the global economy, its impact on the valuations of listed tech companies and the funding environment for startups, a chunk of companies continues to receive new investment.
Investors have become more circumspect about the growth plans put forward by founders, spending more time to understand the underlying unit economics of the startup.
Unit economics provides a summary of your startup’s performance, both historically and prospectively. It measures the profitability of selling a product or service on a per unit basis.
The past and present unit economics of a startup is often a guide to its future performance.
What is a unit?
The unit of measure can vary based on the type of business. For software businesses, the unit is often a single average customer, but it could also be a single seat, site, or license type.
For ecommerce businesses, the unit might be a single customer, order, or item. For marketplaces, a unit may be a transaction between buyers and sellers or the activity of an average buyer or seller.
To assess if you have an appropriate unit, can you calculate its customer acquisition cost (CAC)? Can you identify all the costs involved in acquiring this type of unit?
CAC should include all the costs associated with sales and marketing, including related staff, for a given unit.
For instance, if a startup spent $50,000 on sales and marketing costs in one month and made 50 sales, the CAC per sale would be $1,000.
The appropriateness 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 that are driven by that unit?
If a startup makes very few sales and each through different sales channels, for example, calculation of CAC can be difficult and less reliable compared with a startup making a larger number of sales through one channel.
The same is true for the revenue that’s driven by the unit of measure. If the startup is selling a single product, it’ll be easier to calculate its unit economics compared with a startup with a plethora of offerings.
Building on the example above, let’s say the $1,000 CAC is incurred by a software business whose average annual subscription value is $750 with a gross margin of 80%.
This results in a payback period of 20 months ($1,000 / (($750 * 80%) / 12))).
If we assume the average customer subscribes for a period of three years, the customer lifetime value (CLTV) is $3,000 on a revenue basis and $2,400 on a gross margin basis ($3,000 * 80%).
Defining key metrics
Here’s a guide to key unit economics metrics:
- Average customer lifetime (ACL) is the average amount of time customers purchase products before they churn
- Average order value (AOV) is the average value of a customer order
- CAC payback 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 of money spent on sales and marketing activities, including labour, to acquire a customer
- Customer lifetime value (CLTV or LTV) is the average amount of revenue or gross margin earned per customer over their relationship
- Gross margin is net revenue less cost of goods sold
- LTV/CAC ratio compares the average lifetime value of a customer with the cost of acquiring them
Profitability per unit v profitability at large
It’s critical for businesses to understand their LTV/CAC ratio. If the ratio is less than 1:1, it means you’re spending more money on acquiring the customer than the value (or margin) they’ll create for your business. This ratio can be improved by reducing the cost of acquisition (think about changing sales models, advertising creative and channels, different target market) or increasing the value generated from customers (think about adjusting pricing, customer onboarding, increasing loyalty).
While LTV/CAC ratios of 3:1 or greater are considered favourable, the right ratio for your business will depend on your business type and they level of competition. For businesses with very high ratios, there’s the possibility they aren’t growing as quickly as they could.
Businesses with shorter CAC payback periods require less working capital, allowing them to grow faster. In the above example, a 20-month payback period requires the software business to raise sufficient capital to fund the CAC plus any operating expenses for that window.
If a startup has strong unit economics, such as a favourable LTV/CAC ratio and CAC payback period, they’re more likely to receiving funding, even if the business, at large, is losing money. That’s because investors like us recognise that all startups need to achieve 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, its operating expenses will increase again along with the new level of scale required to cover these costs. The problem in recent times has been with startups who’ve been growing quickly but with poor unit economics.
There’s nothing wrong with a startup losing money at large, so long as its unit economics are strong, there is a clear pathway to scale and an ability to build a sustainable competitive advantage. That’s why losing can still be gain.
- Benjamin Chong is a partner at venture capital firm Right Click Capital, investors in bold and visionary tech founders.
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