Not too long ago in 2015, a Y-combinator backed company, Homejoy, with close to 150M in valuation suddenly closed its doors even after a $40M in total funding from Google Ventures and Paypal co-founder Max Lavchin, among others. Who would imagine a company with that amount of funding would just run out of all the money and would shut down within 2 years of their major funding round?
What exactly happened?
Simply put, as covered by Wired, their cost of acquiring a customer was way more than the lifetime value of each customer. In other words, the simple unit economics quietly sunk their rocket ship.
What are unit economics and lifetime value?
Unit economics is one part of your strategic plan that you cannot afford to ignore. In this article, I want to briefly walk you through the basic calculations of running your own unit economics so that you can be aware of your costs and the market value of your product or service.
The golden rule of thumb to survive is to have your market value, also called the lifetime value (LTV) of your customer, more than the cost to acquire them (CAC).
This will define how quickly you can expect to make money from each of your startup ideas…Will it be in millions, billions or pennies and will it take days, years or a lifetime to be profitable.
Essentially, you want to start a business where you know you are going to make a profit and that your break-even point is within 3 years, preferably and especially for investors.
The goal of this article is to help you answer two simple questions:
- Is your idea going to make you money or homeless?
- Will your business make a profit in days, months, years or homeless?
Based on this, you will be able to decide which of your ideas are worth pursuing and which one’s worth shelving. Also, unit economics is not a one-time calculation. As you startup grows you will start to see your actual cost of acquisition, growth rate, churn rate and overall lifetime value of your customer which you can then use to further solidify your unit economics.
How to get started
If you are just starting out as an entrepreneur and have many ideas, then for each of your ideas:
- List down a few target audiences. Like for example – high school teachers, home security companies, restaurants etc.
- Now look up how many of them are there in the region you want to launch your product.
- Consider 10% market penetration.
Let’s walk through an example.
Say you are in the education industry and sell a service to teachers. Your analysis tells you that there are 5 million teachers in the US and at 10% market penetration you are hoping to capture 500,000 of these teachers as users.
This gives you your first number – 500,000.
From here you want to know what is the lifetime value of your customer which means how much you expect to earn from your customer for the entire duration of your engagement. If you are already in business, you should know this number from your data but if not then follow the directions below…
Check your competitors for their pricing structure and apply the same pricing structure to your business. However, if you don’t have a direct competitor then pick a $$ amount you feel each of your customer will pay you for the lifetime they are with you. This is your second number. Don’t exaggerate this number.
Now, multiply the first number by the second number which is your total market potential.
In our example, say, each teacher will pay you $200 over the entire engagement and you manage to capture 500,000 teachers. This means you have a market potential of $100M, calculated by multiplying 500,000 with $200.
Calculating the rest
So far so good?
Now you want to calculate what the expected costs are to run the business. Again, you should have this number if you are already in business but if not then run quick projections based on your experience. You can also research online to find the cost of running a successful operation in your industry. I’ll walk you through some major costs to keep in mind when running your analysis.
We’ll divide our total cost into fixed costs and variable costs.
Fixed costs include building costs, admin costs and any other similar cost that do not change with change in the transaction. Let’s call it X.
Variable costs include cost of raw material, shipping and labelling costs, cost of workers and any other cost that change based on number of units. Let’s call this as Y.
To get the total cost, let’s first calculate your total variable cost by multiplying your total expected units for a year with this Y. Let’s call this total variable cost as Z.
Now, add this total variable cost, Z, to your total fixed cost to get the TOTAL EXPECTED COST.
For example – Say my fixed cost was $500,000/year and for every teacher I acquire I spend $80.
So, my X is equal to $500,000 and my Y is equal to $80. Now, say I expect to signup 2,000 teachers in the first year then my total variable cost will be 2000 times $80 equal to $160,000. My total cost for the year will be $500,000 (the fixed cost) PLUS $160,000 (my variable cost) which equals to $660,000.
So now you know your expected revenue and the Total Costs associated for a set number of customers for a particular year. Subtract costs from your revenues to get profits.
Repeat the steps for year two and three, with an expected growth rate in your industry, to see your profit numbers for those years. Do not worry if you see negative numbers in the first year or two.
After calculating with a few different scenarios, if you observe that you are constantly ending in loss or you must make up highly unlikely revenue numbers for profits then the idea might not be worth pursuing.
If the final number is close to zero in one of the three years that means you are breaking even, and your idea might work. If you see a profit, then it means that your business could be worth pursuing.
Remember, the fixed price remains the same every year and the variable price changes with the change in number of products or customers or clients you acquire.
The cost and revenue sides
Another important thing – Do not overestimate the revenues and underestimate the costs because it will break the model. You can run multiple iterations for each profit/loss calculations but try to be conservative in your calculations because as a rule of thumb it usually ends up costing twice and takes twice as long to reach the desired goals.
Here’s quick summary of the example to help you run your own rough unit economics.
Cost Side :
- Expected CAC =$80/customer
- Fixed Costs = $500K/Year
- Variable Costs = $80*2000 = $160K/Year
- Total Cost = $660K/Year (@2000 users)
- Expected LTV = $200/customer
- Estimated Yearly Users = 2000
- Churn – 10%
- Estimated Yearly Revenue = 360K (@2000 users)
Running unit economic forecast is only your first step towards acknowledging the importance of unit economics. As you jump into strategy, your goal should be to figure out how much value your product is creating per customer and how you can increase that value over time without losing direction or brand value.
Some companies try to increase their customer LTV by making them stay longer (called customer retention), some try to increase their prices to generate the cash faster, some try to up-sell other services. Whatever trick, tactic or strategy you apply make sure you keep your customers happy at the end of the day but conitnue to move towards profitability.
Now that you know the basics of unit economics, I hope you will be able to make better strategic decisions increasing the probability of success. The last thing you want to do is take someone’s money as investment, then it be an outside investor or your aunt, and not know your basic unit economics, because if you do so it will come back, haunt your startup and probably will sink it.
Set realistic expectations upfront, get your CAC and LTV numbers right so that you can predictably skyrocket and have a successful venture.