Basics of Unit Economics for Founders
Making sense of a business’s health and long-term viability is a notoriously difficult problem for high-growth startups, but unit economics offers a framework through which companies can evaluate their potential. Here’s a real-world example: in December 2013, Homejoy, the Y-Combinator-backed home cleaning disruptor, raised a fresh $38M Series B at an estimated $150M post-money valuation. Less than two years later, the company shut its doors. As covered by Wired, one of Homejoy’s primary challenges was that the customer acquisition cost (CAC) was much higher than the lifetime value (LTV).
Simply put, the objective of an exchange between a buyer and a seller is to create value for both parties. But, as Homejoy illustrates, value creation may not always be clear or reasonably assumed, especially in the early stages of starting a high-growth company.
Acquiring new customers is one of the most difficult challenges when starting a new business. Indeed, financial forecasts implicitly attempt to model the costs to acquire customers. But, as important as forecasts are, they are high level analyses that focus on the overall expectations of your business. Early stage companies need to analyze their business at a more granular level. Founders need to know how much value they can capture at a per unit level. This is unit economics.
What are unit economics?
The “unit” in unit economics is the fundamental minimum piece of your business that you can measure to understand where your revenue comes from. It’s whatever best represents the exchange of value which drives your business. For example, a unit for a SaaS startup might be a customer; for a car dealership the unit may simply be a car.
Unit economics, such as CAC and LTV, explicitly determine the true value-capturing ability of your product. They help answer the question of whether or not each dollar you spend for that specific sale generates or will generate more than it costs: how much does it cost your business to generate $1 of value? Strong unit economics create value with each new customer and give your business a chance of success. Weak unit economics destroy value with each new customer and accelerate failure.
In some cases, founders raise capital without this understanding. Capital may be raised for marketing and acquiring users. If a business has poor unit economics (i.e. you spend $2 for $1 of value), with no plans for improvement, growing your customer base too quickly will destroy value. Companies may be able to buy growth, but not all growth is created equal.
What should a startup measure?
In very general terms, you should know the following to determine your CAC and LTV:
- Annual revenue per customer
- Gross margin
- Lifespan of your customer
- Number of new customers over a specific time period
- Marketing costs over a specific time period
- Sales costs over a specific time period
You can download a very simple example to determine your CAC and LTV here. This analysis gets even more specific depending on the type of business. Pay-per-unit businesses, like Tesla, Warby Parker, and Casper, measure different units than advertising businesses like Google, Facebook, and Twitter. Marketplaces and exchanges like Uber, Airbnb, and Etsy, have different fundamental units from which they create and capture value. For example, Warby Parker cares more about gross margins and less about impressions than Google. Unit economic analyses are not the same for each company, but it’s a necessary exercise that can provide a common denominator.
Regardless of the specific units you measure, there are always a few key points on which you should focus:
- The costs for you to acquire a new customer / market participant / user / viewer.
- The value they bring to your business over the life of their relationship with your company.
- The expected change in your unit economics over time as your business moves from one phase to another.
Once you know your CAC and LTV, you can make the call on how each additional user impacts your business. If your CAC ratio, which is your LTV divided by your CAC, is 1.5x, you are generating 50% more than you are spending to acquire that user. Is this good? The answer depends on your business’s specific situation. A CAC ratio < 1 may be fine for your first 10 months if you have reasonable plans to improve it and enough in the bank. But if it’s under 1 and you have 3 months of cash in the bank with no plans for improvement, you’re in trouble. Some businesses target a CAC ratio of 3x. Others are happy if they are over 1, with plans for improvement, money in the bank, and growing.
Now that you understand a bit of unit economics, you are better equipped to apply it to your business’s ability to create value. Let’s say that you perform a unit economic analysis to learn that your CAC ratio < 1. You need to have plans to improve that, and know how long those plans will take. If you raised money from your aunt so that you can acquire more customers at a CAC ratio that will be perpetually < 1, then growing your business will destroy her investment. Remember, not all growth is created equal—and unit economics are the key to understanding whether or not your growth is worth the cost.
This article is intended for informational purposes only, and doesn't constitute tax, accounting, or legal advice. Everyone's situation is different! For advice in light of your unique circumstances, consult a tax advisor, accountant, or lawyer.