Unit Economics For Startups
Owing to the large scale investments, stratospheric valuation substantiated by these investments, wide coverage by media, grandeur announcements by central and state governments, Prime Minister’s focus and opposition’s criticism of 'Startup India', emergence of technology business incubators in educational institutes, plethora of activities organized every day, and omnipresence of services like Google, Facebook, Whatsapp, Amazon, Flipkart, Uber, Ola, Paytm and others, every college going person and her parents have some idea about the meaning of the word ‘Startup’. In last few years, an entire eco-system has gradually developed because of active involvement and support of technology companies, governments, educational institutes, private equity and venture capital investors, and above all the consumers’ willingness to experiment in receiving the products and services. At the same time, the challenge to come out with a ‘disruptive’ startup and attracting angel or venture capital funding has increased by many folds. The year 2014 will be marked as the year of unbelievable and gravity defying valuation for startups. Investments started getting cooled down in 2015; and for last two years, financing startups is becoming increasingly tougher. Startup entrepreneurs may consider raising capital as an achievement, but it is not qualifying requirement for an economically successful enterprise. The vital factor that startup entrepreneurs forget to include in their business plan and investors fail to evaluate is the unit economics of the startup.What is Unit Economics?
Unit economics is to the startups as breakeven analysis is to the traditional businesses. It is reflected in the direct revenues and the costs associated with a particular startup business model but expressed on a per-unit basis (that’s why the term – unit economics). Unit economics facilitates the projection of profitability of an enterprise. It indicates the strength of core values of a startup, and brings financial performance of a business under a realistic view.
Breakeven analysis computes the quantity of products or services that a business needs to sell to recover the cost of producing and delivering those products and services, reach at no-profit, no-loss performance. It is calculated considering the fixed cost of production, variable cost and price per unit of product. Analogous to that, unit economics estimates the optimum amount that a startup should spend to acquire a (paying) customer (customer acquisition cost – CAC) considering the potential future income from that customer or in technical
jargons – life time value (LTV). In other words, unit economics gives an estimate of the value of a customer for a startup. Apparently, a startup would get positive value or positive unit economics from a new customer when LTV from the customer exceeds CAC.
Relationship of CAC and LTV is like circular referencing in excel spreadsheet. They are inter-dependent. Knowing LTV of a customer help a startup estimate the maximum CAC a startup can afford for that specific customer. Each customer would have a different LTV and therefore, the startup should pay different CAC. A startup may be willing to pay high CAC for a high LTV customer and vice versa.
Calculating CAC & LTV
Calculating CAC and LTV will be a challenge for most startups. Simple (however, generally tough to answer) questions like ‘how much does it cost to get a paying customer on average across all channels’ and ‘how much does a customer spends over some reasonable time period’ would be the first step in calculating CAC and LTV respectively.
Customers are acquired through multiple channels like e-mails, website, mobile apps, search engine marketing, blogs, social networks, public relations, online and offline campaigns, tele-calling, advertisements, good old business development and referrals. Dividing the total of marketing cost across all these channels, salaries of marketing staff, cost of software, cost of professional services of designers and consultants, and marketing overheads by the number of customers acquired provides an estimate of CAC.
Customer LTV on the other hand, is influenced by the amount a customer pays each time she interacts with the startup, number or frequency of interaction, discounts offered, profit margin per interaction, customer retention rate or churn rate (percentage of customers cancelling a service/subscription within a certain period – a month or a quarter), possible conversion from free customer to premium one, time period that the customer spends with the startup, and diversity of order size. LTV’s most simplistic calculation is the product of the number of customer interactions in a year, revenue per interaction and life span of the customer. Some analysts also include profit margin per interaction while computing LTV.
LTV will be different for different kinds of customers. Startup should invest their time, effort and money in acquiring and retaining high LTV customers. It is obvious that customer satisfaction would result into increasing LTV.
Weighing LTV & CAC
A 1:1 ratio of LTV to CAC may put a start up in red due to other expenses. In the internationally best selling book – Zero to One, the author, co-founder of Paypal and now startup investor Peter Thiel groups CAC into four categories: viral marketing (CAC less than $1), marketing (CAC$ 100), sales (CAC $10,000) and complex sales (CAC $10 million). He has emphasized the need for startups to avoid the ‘dead zone’ between marketing and sales, where LTV is not high enough to justify high CAC. There is a caution in applying CAC and LTV for all the startup businesses. Knowing LTV and CAC is only useful where the people you market to are the ones buying your products/services. Unit economics would not be effective when they are different.
Conclusion
Sustainability, and not just acquiring customers must be the motto of every startup. The startups that fail the litmus test of unit economics have much higher probability of not making any money in the future. Powerful market forces would drive them out of contentions and it would not be a surprise if prospective investors do not touch them with a barge pole.
Relationship of CAC and LTV is like circular referencing in excel spreadsheet. They are inter-dependent. Knowing LTV of a customer help a startup estimate the maximum CAC a startup can afford for that specific customer. Each customer would have a different LTV and therefore, the startup should pay different CAC. A startup may be willing to pay high CAC for a high LTV customer and vice versa.
The vital factor that startup entrepreneurs forget to include in their business plan and investors fail to evaluate is the unit economics of the startup
Calculating CAC & LTV
Calculating CAC and LTV will be a challenge for most startups. Simple (however, generally tough to answer) questions like ‘how much does it cost to get a paying customer on average across all channels’ and ‘how much does a customer spends over some reasonable time period’ would be the first step in calculating CAC and LTV respectively.
Customers are acquired through multiple channels like e-mails, website, mobile apps, search engine marketing, blogs, social networks, public relations, online and offline campaigns, tele-calling, advertisements, good old business development and referrals. Dividing the total of marketing cost across all these channels, salaries of marketing staff, cost of software, cost of professional services of designers and consultants, and marketing overheads by the number of customers acquired provides an estimate of CAC.
Customer LTV on the other hand, is influenced by the amount a customer pays each time she interacts with the startup, number or frequency of interaction, discounts offered, profit margin per interaction, customer retention rate or churn rate (percentage of customers cancelling a service/subscription within a certain period – a month or a quarter), possible conversion from free customer to premium one, time period that the customer spends with the startup, and diversity of order size. LTV’s most simplistic calculation is the product of the number of customer interactions in a year, revenue per interaction and life span of the customer. Some analysts also include profit margin per interaction while computing LTV.
LTV will be different for different kinds of customers. Startup should invest their time, effort and money in acquiring and retaining high LTV customers. It is obvious that customer satisfaction would result into increasing LTV.
Weighing LTV & CAC
A 1:1 ratio of LTV to CAC may put a start up in red due to other expenses. In the internationally best selling book – Zero to One, the author, co-founder of Paypal and now startup investor Peter Thiel groups CAC into four categories: viral marketing (CAC less than $1), marketing (CAC$ 100), sales (CAC $10,000) and complex sales (CAC $10 million). He has emphasized the need for startups to avoid the ‘dead zone’ between marketing and sales, where LTV is not high enough to justify high CAC. There is a caution in applying CAC and LTV for all the startup businesses. Knowing LTV and CAC is only useful where the people you market to are the ones buying your products/services. Unit economics would not be effective when they are different.
Conclusion
Sustainability, and not just acquiring customers must be the motto of every startup. The startups that fail the litmus test of unit economics have much higher probability of not making any money in the future. Powerful market forces would drive them out of contentions and it would not be a surprise if prospective investors do not touch them with a barge pole.
