In this post we are going to touch upon some of the concepts that occur in…
Unit Economics For Startups
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Unit economics are basically a summary of your company’s current performance. They are intrinsically specific to the business model you have. However, there are some common patterns.
Nowadays the key to building a sustainable business is recurring revenues. I am not explicitly saying you should build a business based on a SaaS subscription model. Your business can be based on an annual license, or it could even be a one-time purchase. The important thing is to keep these people interested and have them use your service again.
Regardless of the business model, it is essential that you know what percentage of your revenues is considered recurring. This is what VCs look for. They want to see that your business is able to generate a minimum amount of monthly recurring revenue before considering you for investments. They want to know that if you stop investing in your business today, you will still have a certain amount of recurring revenues that you can manage. This also lowers the risk of your proposition.
Saying that you made 50K revenues recurring from last month, for example, means that there is a high chance this 50K will be replicated this month, too. This not only lowers the risk of the investor, but also increases the budget that you have to re-invest in the growth of your company.
Why do unit economics matter?
Most startups do not have positive metrics when it comes to general metrics of profitability such as profits. As I mentioned before, until the company reaches a stable point, profit is just an option. It would be silly to focus on a small profit today instead of re-investing it in the growth of the business. Hence, the opportunity cost of making a profit today is higher than the profit that you would make.
That is where unit economics kicks in. Having positive unit economics metrics means having high potential and immediately turns your business into a viable investment opportunity.
Firstly, you should know what portion of your revenues is recurring. This is usually calculated on a monthly basis – monthly recurring revenue (MRR). You could also calculate it on yearly or quarterly basis – whatever works best for your analysis.
Customer Lifetime Value (CLV)
If a customer comes in, you should know how long he/she is going to stay that is you determine your customer’s lifetime value (CLV). Determining the lifetime value is computing the value of initial interaction with a customer and then forecasting how much that user is worth in future revenue. (Check out this article from Wharton on how big corporations are adopting this metric)
You calculate the CLV as follows:
CLV = (Revenue per User * Gross Margin %) / Customer Churn Rate
Example SaaS model
If you have a SaaS model with a monthly subscription and the average customer is subscribed for 4 months. Also the price of your service is $100 per month. Then every 4 months you have to rebuild the revenue that comes in with that customer. You should be aware of how long is the customer going to bring in revenues, before you have to re-generate it.
This can also be translated into how many times a customer makes purchases per period. This is mainly useful for startups with marketplace business model. In this case you want to know the number of purchases a customer does, as well as, the average transaction cost. This helps in determining the cost of acquisition per customer.
Churn rate is the percentage of customers who have cancelled a service/subscription within a certain period of time. Churn can be calculated monthly, quarterly etc. In the following example, churn is calculated monthly.
Let’s take for instance that you made 50K one month ago and this month of the same cohort you made 40K. This means that 10K churned – you lost the recurring revenue. This implies that, not accounting for the new revenues coming in, the 50K from last month will disappear within 5 months on average.
Churn rate = Revenue lost from a cohort in a month/Recurring revenue per month
Churn rate = 10K/50K = 20%
What this number suggests is that 20% of the revenues from last month will not come in this month.
Churn rate is very useful in determining the amount of new revenue that should come in in order to not only compensate the loss but also continue growing revenues. It goes without saying, the lower the churn rate, the better.
How do you account for the fact that some of these people will make more purchases in the coming year. You can calculate the revenues of this year and you can assume that a certain part of them will churn – they will not make a repetitive purchase next year. When it comes to companies that are not SaaS businesses and do not charge for monthly subscriptions, profitability tracking is done by finding average number of transactions per customer per year. In this case, use the average to calculate what amount of revenues are going to come in during the following year.
Customer Acquisition Cost (CAC)
The CAC is calculated accounting for any direct costs of acquiring a customer (i.e. paid ads). General recommendation is to take revenues you generated within a period – let’s say a month, and then how much was spent in terms of variable costs and even fixed costs(HR costs) that went into generating these revenues.
Customer acquisition cost = Total cost of generating the revenues / The number of customers
A general rule of thumb is that the cost of acquiring one customer should be lower than the lifetime value of the same customer.
If on average a customer stays for 6 months, and it is not likely that he will return, then the lifetime value is the monthly cost multiplied by 6. If the CAC is higher than this, then you are in fact losing money.
Whenever you present an investment proposition to investors, they are going to break it down to unit economics metrics. We mentioned before that the burn rate is an option just like the profit, so if it is negative it isn’t going to stop investors, as long as, your unit economics are positive. In this case, your business is a viable investment proposition. And this is exactly what they want to see.
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What about your experience with unit economics? What kind of metrics do you use to track your profitability? Let us know in the comments!