What is unit economics? Learn why every startup founder needs to pay attention to this measurement tool for financial success.
Nine out of ten startups will fail. If you’re a passionate founder, I know that’s not what you want to hear. And yet, it’s true.
Businesses fail for countless reasons: poor product/market fit, lack of resources, bad partnerships… the list goes on.
I know figuring out how to scale your business quickly (and profitably) is not easy.
I also know that if you want to increase your chances of becoming the one out of ten that succeed, you’ve got to work smarter — not harder. And that means paying attention to your unit economics to build a profitable growth model.
Now, if reading unit economics makes your eyes glaze over, don’t worry. I’m going to show you how easy it is to master a few calculations — even if you’re not a “numbers person.”
These tools will help you better understand the sustainability of your startup so that you can make necessary tweaks early on.
What is unit economics for startups?
Unit economics refers to an organisation’s revenues and costs relating to an individual unit. It is a valuable tool to:
- Analyse your company’s profitability and overall financial performance
- Ensure long-term market viability and sustainability
- Optimise your marketing and production
What qualifies as a unit?
For most startups, your “unit” will be the value of a single user or customer.
To understand your unit economics, there are two metrics we must consider: Customer Lifetime Value (CLTV) and Customer Acquisition Cost (CAC).
Customer Acquisition Cost (CAC)
How easily can you acquire new customers — and how much does each new customer cost you?
Your CAC calculator evaluates how efficient your marketing and sales efforts are while taking into account your overhead.
Sum up your sales and marketing expenses for a given period (i.e. salaries, CRM tools, paid ad spend) and divide this number by your total number of new customers acquired.
You now know how much you paid (on average) to acquire each new customer.
CAC = Amount spent on sales and marketing/number of new customers.
Customer Lifetime Value (CLTV)
What is the average lifetime value of a customer to your organisation?
You already know that the longer a customer buys, the greater your profits.
Take Starbucks. If a customer buys one $5 coffee, that doesn’t do much for Starbucks’ bottom line. But if that same person purchases 25 coffees a year over 20 years? That’s $2,500 — a significantly greater CLTV!
As you can see in the example above, to calculate CLTV, we must consider:
1. How much a customer spends
2. How often they buy
3. How long they buy
CLTV = Average order value x average purchase frequency x average customer lifetime
Unit Economics: The relationship between Customer Acquisition Cost (CAC) and Customer Lifetime Value (CLTV)
Now, here’s where things really get interesting…
Most startup founders immediately assume they want a low CAC and a high CLTV. At first glance, this is true.
If your CAC is less than your CLTV, your business is profitable. Conversely, if your CAC is higher than your CLTV, you are likely losing money.
That said, the ratio between these two metrics matters most. Let me explain.
Say you’re a SaaS startup with an average CLTV of $500. Your customers are loyal to your brand and have stuck with your company for years, but the cost to acquire them has gone up over the years. So, you decide to cut marketing costs and make a few changes to your campaigns. You run the numbers and realise your new CAC is only $50.
Excellent, right? Well, not necessarily. Those customers you acquired more cheaply could end up spending less.
Your CAC isn’t just an expense but an investment. We want to find that sweet spot between CLTV and CAC so that you sustainably expand your market while minimising expensive overhead.
A good rule of thumb is a 3:1 or 4:1 CLTV to CAC ratio.
How to improve your unit economics
Improving your unit economics is, in a way, simple:
1. Decrease your costs (CAC)
2. Improve your revenue (CLTV)
Exactly how we achieve those two objectives is where things get trickier. Now, a comprehensive consultation on optimising your unit economics is outside the scope of this article. For that, I’d need to get under the hood of your business to craft a custom approach for your business.
That said, I can recommend a few crucial considerations with which you can begin:
How to decrease your CAC
- Revamp your buyer personas
- Create products people actually want
- Invest in quality conversion copywriting
- Optimise your marketing strategy and flywheel
- Know your marketing metrics
- Don’t underestimate brand development
How to increase your CLTV
- Upsell to customers by including add-ons and special offers
- Leverage the power of personalisation
- Improve your customer referral program
- Encourage customer loyalty
Let’s briefly touch on that last point: encourage customer loyalty.
When I talk about customer loyalty, I don’t just mean sending out a weekly discount code or building a points program.
If you want to truly improve customer loyalty, you need to double down on enhancing the customer experience.
Remember, your customers want you to solve their problems quickly and easily. So, talk to your customers weekly to find out what they really want and need.
You’ll create a customer-centric culture that prioritises your buyers — and increase your CLTV along the way.
To sum up unit economics
If you want to assess financial health and long-term profitability, take the time to learn your CLTV to CAC ratio.
Aim for a ratio of around 3:1 or 4:1.
If your ratio is much higher, you might be missing out on opportunities to acquire new customers. And if your ratio is much lower? Then you’re spending more money than you can afford to acquire new customers; reassess your financials and strategy to avoid long-term loss.