Note: this was originally published at https://alexoppenheimer.substack.com/
Unit economics is a term that is increasingly thrown around in the startup ecosystem, and for good reason - it is the underlying concept that makes investing in growing but unprofitable businesses worthwhile. In order to understand the unit economics of a business, you have to first identify the unit. Without a fundamental understanding of the unit, it's impossible to understand the economics of that unit. The economics portion of the term can also be confusing - it's not simply cash or GAAP metrics, but usually something in between. Then of course there are also the issues of attribution and measurability.
For most software companies, the unit is the customer, although sometimes looking at seats, nodes, volume, transactions or instances can be a more suitable or measurable option. Outside software, if we look at ecommerce, the unit can be a customer, order or individual item. For a marketplace, the unit usually needs to combine buyers, sellers and items at an observed ratio. For fintech, it can be a customer, an institution or a dollar.
So how do you figure out what is the right unit for your business?
The two key things to focus on are:
- Associated CAC and its measurability - is it possible to figure out what it costs to acquire this unit on average with a reasonable level of accuracy?
- Consistency inside the customer base - does the average of a cohort actually make sense for the business and represent the customer base as a whole?
Once you nail down your unit, you can figure out the two fundamental components of unit economics:
- How much does it cost to acquire the unit?
- How much does the unit pay you over time?
Like most things in business (and in life), this is usually an iterative process and understanding where you want to end will help you plot the path to get there.
Once you have figure this out and have data on retention or repeat rates, you can now determine if the business is unit profitable or not.
If average CAC in a SaaS business is $1,000, MRR is $100 and economic gross margin is 85%, then you need to keep your customers for 11.75 months on average to be unit profitable (assuming no upsells or add-ons). If customers are on annual contracts, you're in good shape. If they're on monthly contracts and have a track record of churning after only 6 months on average, then you're in trouble. (CAC Payback - forward looking and historical - is my favorite metric for SaaS unit economics).
The rule of thumb in ecommerce is that customers need to be unit profitable after a single purchase (this high bar is a driver behind the popularity of subscription ecommerce). If average order price is $100, average cost of goods sold is $60, then you have $40 of margin to play with for CAC.
Example: Let's say you're a SaaS company that sells 100 seat licenses and 5 seat licenses. The 100 seat package costs $10 per seat per month ($1,000 total). The 5 seat package costs $25 per seat per month ($125 total). The 100 seat customers cost $10,000 to acquire and the 5 seat customers cost $500 to acquire. Assuming gross margin is 100%, CAC payback on the 100 seat customers is 10 months while it is only 4 months on the 5 seat customers. Once you understand this, you can ask more qualitative strategic questions like which customers upsell/upgrade the most? are we pricing our product properly? is our sales method effective?
Check out a bit more on Unit Economics here (including a marketplace example): https://www.loom.com/share/aaddd4018b0a47cc80c6dd64e00846fc
Feel free to reach out with specific questions about how to figure out the right unit for your business.