In our earlier blog (Achieving Profitability) we saw the golden ring of profitability.
Unit Economics being an elementary matrix for evaluation, it is empirical to deep dive to understand unit economics and decode it right.
Not long ago,
Investors rewarded high-growth companies with less consideration to the unit economics.
These companies survived and thrived for years, at the expense of their investors, and
Normally hit a wall when attempting an IPO and or raising funds from more conservative larger investors.
Recently, VC industry has witnessed a pivot and the onset of the coronavirus and its impact, has further strengthened the result-based mindset. Those times are now passe when commercial traction could do the magic and get money . Unit economics is now in the investor’s mindset.
Unit economics
Investors are looking for entrepreneurs who understand Unit Economics. Even if the economic indicators will straighten out in a few years, they want to know that the entrepreneurs, knows where they are headed, and that they are measuring the right unit economic indicators to steer the ship in the right direction.
Besides,
Significant commercial traction
Strong team, to get funding ,
Quality of the traction ,and how that projects into the future revenues , also matter at this stage.
Investors ask questions to determine –
Economic health
Entrepreneurs understanding of the unit economics
Company’s potential for sustainable growth
To decode unit economics, investors ask question such as:
How much money is spent to get each client? – Customer Acquisition Cost (CAC)
What is each client worth to the company? – Life-Time Value (LTV) of the Client
What percentages of the clients churn? – Churn
When do you expect profitability? – Break Even Point (Value, Volume, Timeline)
CAC – Calculated by dividing all the costs spent on acquiring customers (marketing expenses) by the number of customers acquired in the period the money was spent.
LTV – Calculated as the gross profit per user in each period (Refer earlier blog), multiplied by the lifetime. Lifetime is calculated as one divided by churn over the same period.
Churn – Churn is the percentage of people who leave in a period.
Decoding the Matrices
The parameters above yield no relevant insights until put in proper metrices which enable analysis. The metrics include:
- The lifetime value (LTV) to customer acquisition cost (CAC) ratio
- LTV/CAC indicates the value multiple created by the client on the amount spent to acquire them.
- Low LTV/CAC ratio will question the scalability and growth
- High LTV/CAC ratio too may not be an advantage, as it could mean low spend on marketing and sales, hence growth will be slow and the company may lose market share to competitors.
- Benchmark LTV/CAC is 3X, but the same is subject to nature, stage of the company and the industry.
- Growth rate to churn ratio
- Investors seek to determine the real growth rate
- For the same churn needs to be subtracted from the gross growth rate
- Start-ups normally see a double-digit annual churn rate.
- A ratio of four or higher is not easy to reach
- So, a growth of 40 percent allows for a churn of 10 percent at the ratio of 4.
- Thus, gross growth rate of 40% or more indicates towards healthy scaling. Again, the benchmark is subject to industry and business.
- Break-even point
- The no of expected user determined , using the real growth rate when multiplied by the gross profit per user, one can anticipate the the expected revenues over the same time period
- Expected revenues equated with expected expenses yields the break-even point in terms of revenue, volume and timeline
Conclusion
While building the forecast and business plan, entrepreneurs should note the basic unit economic indicators and present them using relevant metrices.
- Entrepreneurs must create a culture of
- Great customer service
- Value-adding products that continuously evolve
- Good pricing strategy
- Rewarding long-term engagements
This would,
- Reduce CAC
- Increase LTV
- Reduce Churn
- Bring forward the break-even point
Adhering to the Unit Economic mentality could help companies’ commercially as well as with the fundraising.
