A Guide to Unit Economics for Startups
90% of startups fail within 3 years. It’s a pretty harrowing statistic that does not reflect well on the Australian (and global!) business market. Could this be avoided with a larger focus on simple Unit Economics? Thanks to our friends at FundSquire, we’ve given you some more information below.
Understanding Unit Economics in the early stages of a business is key in predicting current financial conditions and future growth. Associated with the most basic principles of a business model, you can use the unit economics concept to calculate revenues, profits and losses, and much more.
“Data-driven startup” is undeniably one of the new buzzwords in business. This guide exists to offer more context to the data available surrounding unit economics and give information on direct revenues and costs. More specifically, early-stage investors are likely to perform unit economics analysis when deciding between proposals and will give a good insight into scalability.
Before you apply for any form of capital raising or the like, these are the unit economics numbers to figure out.
Unit economics refers to a company’s revenues and costs related to an individual unit of production. A unit is simply one separate, quantifiable element that the company can create and sell and that adds value to both customers and the business.
Calculating The Economics of One Unit
The key is in the name. To determine the unit economics, you must first identify one unit. This may depend on the industry and business model, but it is typically one single customer or client. For example, SaaS will know the unit as a “software user”. On the other hand; the unit of a brick-and-mortar shop will be a buyer or customer.
To calculate the unit economics, you are determining two primary factors:
How much does the business spend to acquire the unit?
How much revenue does the unit generate for the business?
You may already know this as Customer Acquisition Cost (CAC) and Customer Lifetime Value (LTV), respectively. These are the direct revenues and costs associated with unit economics.
In order to calculate Customer Acquisition Costs CAC: total all of the costs associated with marketing, staff salaries, and sales over a given period. This includes everything from pay-per-click campaigns to any related wages costs and more. Then, divide this by the number of units within that same given period.
For example, a SaaS Startup spent $100,000 on advertising, marketing, and sales costs over one month. In the same period, they received 1,000 software sales. 100,000 / 1,000 = CAC of $100.
To determine Customer Lifetime Value LTV: total the revenue generated by every unit since they first purchased from your business. To work out the average, divide this total by the number of units. Now, both your CAC and LTV are on a per-unit basis.
For example, UnitA has earned $1300, UnitB has earned $400 and UnitC has earned $2500. The average LTV is (1300 + 400 + 2500) / 3 = $1400.
It’s important to note that there are various other ways to calculate the Customer Lifetime Value which would depend on the unit economics of your specific business model. For example; if you run a shop, you should take into account:
Customer retention rate or churn rate
Number of purchases per month
The average cost of each purchase
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Unit Profitability
These unit economics metrics also give insight into unit profitability, which is defined as the profitability on a per-unit basis. It also explores the relationship between LTV and CAC.
You can calculate as follows:
LTV – CAC = Unit Profitability.
Continuing with the examples above: $1400 – $100 = $1300 profitability per unit, on average per lifetime. You can, however, break this down further on a month-by-month basis.
As you decrease the CAC and increase LTV, the unit profitability should increase; creating larger gross profit margins.
Unit economics analysis can be performed by focusing on unit profitability or other financial aspects of the business. This includes looking at the payback period, gross margins, or ROI (return on investment) of sales and marketing efforts, for example. The specifics of yours will depend on whether you have a product or service business, cash flow, whether your venture is still early stage, and long term plans.
Improving the relationship between CAC and LTV
The ideal ratio between LTV: CAC is 3:1. This means that each customer generates at least three times in profit of the money you need to acquire them. Proving this ratio is a BIG win for investors looking for low risk, long term financial growth opportunities.
Those with a lower ratio (2:1) would naturally look to improve their unit economics. In early-stage startups lacking cash flow, it can be challenging to optimise unit economics as there may be a lack of historical data, customers, or lack of resources to conduct the research. But it shouldn’t be impossible (even in the early stage) as these are the key fundamental metrics to track before looking at financing options.
To improve your unit economics, you need to either:
Increase your Customer Lifetime Value (or)
Decrease your Customer Acquisition Cost
To increase LTV, you need to increase your average order value, customer retention rate, or frequency of orders, by:
Including add-ons or special offers at the checkout area
Taking a closer look at your analytics or track user sentiment. How do customers feel about your business and your products?
Tracking user cohort behaviour for more effective segmentation of your audience, leading to a lower churn rate
Improving your frequency of orders is all about customer experience. When you make it easy for customers to sail through the process, there are lower cart abandonment rates, for example. This could also positively impact the number of new customers you take on, although this may not affect lifetime value.
Let’s take the case of Adobe, which reported a cart abandonment rate of 70.50%. Some of the most popular reasons cited for cart abandonment included:
The site wanted me to create an account
Too long/ too complicated checkout process
The website had errors / crashed
Alternatively, decreasing CAC is about smart targeting. Ensure your marketing is pinpoint so that resources are not wasted on irrelevant prospects, and set-up retargeting campaigns to keep costs low.
It’s also important to continually test the copy on your campaigns, emails, and sales resources, which early-stage E-commerce app Ideall.ro highlighted in a case study. They showed that once A/B testing was applied to their copy, churn rate decreased and conversion rates improved by 22% over a 6-month period. This is likely to have made a big difference to their overall unit economics.
Of course, the longer your start-up can collect data, the more accurate and insightful these unit economics are likely to be. But continual testing is only as useful as the changes made from it, so ensuring all customer touch points are optimised should be the ideal goal.
Staying on top of your Unit Economics isn’t just good for business, it’s indispensable for communicating with funders and investors interested in understanding your business model.
Conclusion
It’s only natural to want an airtight financial application when you are applying for funding as an early-stage startup. But before focusing on the fancier side of a start-up business, considering the fundamentals of unit economics to make your case. If the foundations aren’t solid, the whole operation could topple.
By taking a Unit Economics approach to your business; you get more insight into its current health, alongside concrete growth and scaleability predictions. These are the direct revenues and costs per unit and give a huge insight into your margin. So, whether your business is product or service-based, focusing on these financial figures can aid you in beating the statistics and becoming one of the 10% of successful startups.
We hope this article gave you more of an insight into how to quantify and improve your unit economics. If you’d like to add to the conversation, please comment and share the article if you enjoyed it.
