Webcast: What are unit economics and why are they important for startup founders?
Webcast: What are unit economics and why are they important for startup founders?
Unit economics are a relatively new metric that are coming to dominate discussions between startups and investors. Essentially, they provide a roadmap for your business’ finances, working with almost crystal ball type powers to offer you a view of what your company could look like financially in the future.
Most importantly, they make it possible to actually project how profitable a company could be, even if right now it’s not turning anything close to a profit.
Being able to understand these metrics will give you an edge - investors are able to see, with confidence, ‘if we invest now, this company can make a lot of money.’
A sometimes confusing or daunting area to delve into, Sara, our CEO and co-founder, and Andre, our original co-founder, talk about the ins and outs of these funky measures. They cover the basics, through to optimising them best for your business and using them in strategic decision making, as well as in external stakeholder conversations.
This blog post is the first in our unit economics series, to get you clued up on the basics and introduce you to some key aspects. If you want to learn more, we have new posts coming soon that go into more detail, so keep your eyes peeled for the titles below!
- How to approach a discussion about unit economics with investors
- What is a good LTV:CAC ratio? And other important unit economics rules to follow
- Making unit economics work for you and your business in the long term
Did we mention we made a webcast on the topic? Follow along by watching the video here!
Sara: Why don’t you start by just explaining what unit economics are?
Andre: Unit economics are the economics of a business, distilled to the core, to the fundamental unit of that business. So, for SaaS businesses, the unit is customers. For airlines, it could be seats sold or kilometres flown. For lawyers, it could be hours billed. But generally, when you read stuff about it online, it tends to be a customer.
“They wanted to be able to figure out, ‘okay, which one of these is going to make money in the future?’”
Sara: So, why are they so important?’
Andre: It’s because it distills the core of a business into units. And the reason is, there are a lot of early stage businesses that don’t make money. And investors and stakeholders need to be able to assess if this unprofitable business is going to make money in the future.
And - I’m not sure if it’s true - but I read somewhere that unit economics was developed back in the 90s by VCs, because they had exactly that problem. Most of the businesses they were looking at, in a conventional P&L sense, were losing money. So, they wanted to be able to figure out, ‘okay, which one of these is going to make money in the future?’ And so, they came up with the concept of unit economics.
Sara: Right. And what do they actually tell you? What would they tell an investor or a company?
Andre: Well, there are two primary things - there are probably 5 real drivers in unit economics - but there are two key things:
One of them is customer acquisition costs (CAC). So, how much does it cost, in terms of sales and marketing, to acquire a new customer?
And then, lifetime value: ‘how much money am I going to make in the lifespan of this customers’ relationship with the firm?’
Within lifetime value, you’ve got a couple of other drivers. You’ve got the revenue per unit (or per customer), you’ve got the cost of developing the product that you’re selling to that customer.
And then you have to divide that by the lifespan of that customer’s relationship with the firm. To do that, you use a concept called churn. If you’re looking at monthly data, churn is the number of users you lose in a month. So, if you lose 20% of customers in a month, that means the customer lifetime is 1 divided by that, so 5 months.
“Every business starts out with bad unit economics. That’s just how it is. But the question is: how are you going to improve them over time?”
Sara: Can you maybe put this into context a bit? Because we have been working on Canaree’s model and looking at our unit economics as well. Can you you talk a little bit about how we’ve used that to make decisions, or at least assumptions and thoughts about how we run Canaree and our business model?
Andre: Every business starts out with bad unit economics. That’s just how it is. But the question is: how are you going to improve them over time? And in fact, it’s led to discussions at board level as well because older investors, or ones who don’t have experience with unit economics, they look at balance sheet or profit and loss and they say, ‘okay, well why are you not going faster here? Why don’t you have enough customers at this point?’
“Unit economics shows you the moments when you need to slow it down and not burn as much cash and the moments where you need to just go for it.”
What we did when we were doing the modelling for Canaree is, we tried to find product market fit. Going towards that, the customer acquisition cost is obviously going to go up in the early stages as you enter a new market, or whenever you’re trying to attract new customers. And then the lifetime value, before you start generating revenue, of any customer is going to be infinite and then it comes down. It’s all very convoluted and complicated in the beginning. It leads into other discussions around some of the key ratios we’ve been looking at for unit economics.
The great benefit is that it shows you the moments when you need to slow it down, and not burn as much cash, and moments where you need to just go for it.
You could say that unit economics are kind of like your business’ fairy godmother. They tell you when to go for it and when to reassess. Just instead of telling you to be home before midnight, they tell you if and when it’s time to scale your business. Cool, right?
Andre and Sara also discussed some of the key areas of unit economics that are crucial to get your head around so you can use them and discuss them with confidence. Here’s a few final takeaways from them, to equip you well for using unit economics. Follow along with the webcast here!
Sara: If you have one thing that founders should remember about unit economics, what would it be?
“If you can explain the assumptions behind those key drivers of unit economics and how you’re going to improve them over time, that will lead to a great discussion with investors.”
Andre: That you need to know them. So that, when you go into an investor meeting, like we said, if it’s a VC, they’re going to ask ‘what are your unit economics’, and see if you can explain all of those key numbers that we talked about.
So, the ARPU (average revenue per customer), the COGS (cost of goods sold), the churn rate (customer dropoff), the CAC (customer acquisition costs).
If you can explain all of them and you can explain all of the assumptions behind all of those key drivers of unit economics and also, how you’re going to improve them over time, that will lead to a great discussion with these investors and they will really think you know the ins and outs and the drivers of your business.
“If you remember the two main ratios - LTV:CAC and CAC payback - that already is a great start for a founder.”
Sara: Is there anything else we need to cover on the basics of unit economics? That you remember?
Andre: If you remember the key drivers, the key points of unit economics, if you remember the two main ratios (LTV:CAC and CAC payback), that already is a great start for a founder. And, understanding that it’s not going to be great at the beginning and that it will get better. .
Sara: And of course, I have to make a little plug for Canaree. We calculate unit economics automatically, and with the next few months, we will also be able to, or enable, founders to play around with their unit economics and see how that affects various sides to the business. We build in all the rules of thumb that you’ve just gone through, actually into the product. So if you’re way off, we will actually give you a little notification to keep an eye on that, at least.
Andre: Really useful.
Sara: Yeah, I think so. It’s one of those elements of finance that not a lot of people really grasp before they really work with it, so I’m excited to see that in action.
Using unit economics is one thing, but truly understanding them is another. Being able to discuss these metrics with confidence can be the difference between walking out of a meeting with funding, or having to go back to the drawing board.
Unit economics provide you with a logical, understandable blueprint of your company’s financial potential. They show you, and most importantly, your investors, how profitable your company can become.
Now we’ve got the basics of unit economics, how do you utilise them? Learn more about that in our next blog post!
LTV : an estimate of the average revenue that a customer will generate throughout their lifespan as a customer.
CAC : any sales and marketing costs related to acquiring a customer.
LTV:CAC : one of the key ratios in unit economics. This ratio measures out the cost of acquiring a customer against the total value gained from that customer. As a general rule of thumb, your LTV:CAC ratio should be at least 3, so your LTV is 3 times greater than CAC. If LTV:CAC is 1.0x, the Gross Profit over a customer’s lifetime only pays for CAC. It won’t cover the operating expenses of the business. If LTV:CAC = 3.0x, you’re making 3x as much from your customers than it cost to acquire them. More importantly, your Gross Profit covers CAC and contributes further to the net profit of the business.
CAC payback : the amount of time (in months) that it takes to make back the amount of money it costs to acquire a customer and start making a profit off that customer. As a general rule, your CAC payback should be 12 months or less. The faster your CAC payback, the less external capital you will need.
ARPU : The average revenue per unit/user/customer per month.
COGS : the cost of goods sold, referring to the direct cost of producing the goods sold by a company. This is most commonly used for businesses with physical products, but can be used for SaaS businesses too.
Churn rate : the rate at which customers stop doing business with a company. The lower your churn rate, the higher your customer lifetime value will be, and ultimately, the higher your profits will be. The higher the CAC of a customer, the more important lower churn becomes. For example, if you pay £1,000 to acquire a satellite TV customer, you can’t afford much churn and make money from that relationship. If you pay only £30 to acquire a mobile customer, your churn can high and yet you can still have good unit economics.