What is Unit Economics?
Nov 17, 2021
It is significant for early-stage startups to take time to understand the concept of Unit Economics. Understanding Unit Economics concept will give you more opportunities to gain investment opportunities and reduce the risk of failure.
What is Unit Economics?
Unit Economics is the method used to determine the potential success of a business and to predict its financial stability. There are many Unit Economics metrics. For early-stage startups, there are three main basic metrics they need to understand.
Customer Acquisition Cost (CAC)
Customer Acquisition Cost (CAC) is all the costs startups spend per each new customer to bring them on board and convert them to paying customers. For example, if a company spent $10,000 on sales and marketing in a year and acquired 1,000 customers in the same year, their CAC is $10.
Customer Lifetime Value (CLTV)
Customer Lifetime Value (CLTV) is the amount of revenue startups generate from the time customers start using their product/service to the time they stop. For example, a customer uses the product for five months, he pays for it $10 per month, during that period he pays $50; thus, the $50 is determined as a CLTV.
CAC Payback Period
CAC Payback Period is the amount of time required to earn back the money invested in acquiring each customer and breakeven. For example, a startup spends $200 to acquire a customer, and that customer pays $20 per month; thus, it has 10 months of payback period.
Each metric can be used to illustrate different business scenarios and provide insights relevant to their potential. Startups can and should apply these calculations to improve their business model and strategy. The following are optimistic and pessimistic scenarios of CAC, CLTV, and CAC Payback Period:
Positive Unit Economics
Positive Unit Economics is when CLTV is higher than CAC. This scenario presents a potential for the business to become profitable.
Negative Unit Economics
Negative Unit Economics is when CLTV is lower than CAC. This scenario shows that the startup is burning through resources and you have not acquired a large enough customer base in return. As a result, the startup will not be profitable.
The ideal Unit Economics
The ideal Unit Economics is when the CLTV is three times higher than CAC. In other words, startups generate three times the revenue of the money they invested to acquire those customers. This is a rule of thumb for a startup to be VC-fundable.
The ideal CAC Payback Period
The ideal CAC Payback Period is when startups take less than 12 months to earn back the money they spend in acquiring customers. This is to ensure that the selected acquisition model optimizes the particular target customer and the customers are staying long enough to recover your CAC.
Why do early-stage startups need to understand it?
As mentioned in the beginning, understanding the concept of Unit Economics is important for any early-stage startups. The advantages of being on-top of these numbers are as follows:
- It can allow startups to allocate their existing budget more effectively. Early-stage ventures of any kind need to closely monitor the cost of the whole operational process and allocate a set budget to ensure that they are running sustainably. It is to essentially reduce the risk of running out of cash.
- Unit Economics allows startups to improve their marketing strategy. Improving the efficiency of customer acquisition can help startups think of how to improve their marketing plans and add value to their customer experience to retain them.
- It allows startups to make a projection around how fast their business can grow. Unit Economics is a great predictor of long-term financial health of your business model, so it is important to determine these key metrics. It is worth noting that early-stage startups sometimes do not need a positive unit of economics from the beginning depending on their model, but they should at least be aware of where they are on their plan towards eventual profitability. This is because many early-stage startups begin with negative unit economics as they spend more money to acquire customers than what they make from them. However, as time passes and their customer base grows, they can eventually reach a point of positive unit economics.
- Investors will undoubtedly need to know your unit economics to move forward. Can you make more money from a customer than the total cost of acquiring them? When would your business reach a breakeven point and start making profit? What is your intended path going forward? Do you expect to reduce your CAC through selection or optimization of a particular customer acquisition channel? Or a plan to increase CLTV?.