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Understanding Unit Economics

Unit Economics is broadly defined as the sum total of all economic activities belonging to one unit of any product or service, loosely calculated as Lifetime Value (LTV) divided by Customer Acquisition Costs (CAC).

In other words, the amount of gross profits you expect to receive over the duration of the business relationship, divided by how much per unit you had to lay out to get each customer. Naturally, you want your LTV to exceed your CAC by as great a margin as possible in order to make your unit economics viable.

With ever-increasing commercial activities taking place in the cloud, estimating unit economics can be a hard task, since the business lifetimes are so variable. Indeed, customer attrition rates are so high that they've taken on a new descriptor – the churn rate. It's a very apt metaphor, as millions of customers constantly chop and change their subscriptions, cancelling or not renewing with frightening frequency as something new hits the market.

Many tech startups seem to be struggling with their unit economics and are failing because:

  • there's no accredited accounting system for valuing SaaS development costs
  • first-round valuations set the bar too high for subsequent rounds
  • valuations aren't relevant anyway in the world of intangible assets and IP
  • burn rate was too rapid
  • churn rates are unexpectedly high

With something as intangible as intellectual property, software and development codes, unit economics can be hard to pin down, and the above factors combined with churn rates are going to complicate any financial reporting. Some companies are balancing an overspend on sales and marketing by projecting their LTV into an unfeasibly long future, so that their LTV over CAC equation makes more sense. But if you're driven to, say, a CAC of $100, then you'd have to push your LTV up to at least double that before you could expect to make any profit at all, and to a much higher figure before you could think about any market growth.

The churn rates for most SaaS apps do not indicate that any one customer is likely to stay for two years, but unit economics are perhaps being determined on that expectation. Or that there are going to be 50 million customers in the first year, so that the the churn rate doesn't impact so much. Companies may also be basing their projections on reduced CAC, if their process can eventually be entirely automated, for example.

There's a traditional theme that you have to spend money to make money, and many are the stories of bold tech investors who've hung on in the long term for that ultimate rags to riches success story. It's true that some investors are prepared to bet long on a particularly promising venture, but you might not actually get to that point. If the development costs outweigh the time investors are prepared to wait before any monetizable product is launched, then your LTV is going to be zero. And although every tech entrepreneur dreams of having a unique new product that will monopolize the market for ever more, that sort of future is the exception rather than the rule.

Burning and Churning

A burn rate is not inherently worrying if you have correctly estimated both the business valuation and the amount of time you need to produce a marketable product. However, if you burn through all your investment and then need to ask for second round funding, you're not likely to get many bites. Alternatively, if you do produce a monetizable app but it turns out to have a high churn rate, your prospects of any long-term profits are pretty negligible. Scaling up the business will not improve matters in such a competitive market.

Your burn rate is also going to be affected by the extent of your initial capital investment. The metaphor for this is aeronautical, so that your burn rate is pictured as a plane speeding down your rapidly dwindling bank balance runway. If you have a short runway, a high burn rate will send you off a cliff, but if your runway is long you can afford to burn more fuel to take off.

All of these issues must be factored into a realistic assessment of unit economics and the prospects of floating your business or folding it.

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