Getting to positive unit economics is a major milestone for startups. It allows you to outgrow your competition and makes you very attractive to investors. The earlier you get to positive unit economics, the faster you can scale your startup.
I raised the biggest check for my startup through an elevator pitch. True story. A real elevator pitch. And, the whole ride was three floors up.
It was an evening function at the home of some foreign diplomat. A handful of entrepreneurs, I included, met a handful of investors. I had been bootstrapping my startup for nearly a year and a half then and getting to a point where I needed to get some funding soon.
The diplomat lived on the third floor of the building. As I walked into the lobby, an older man walked in as well. We nodded at each other and hit the elevator button. “Investor or Entrepreneur?”, I asked. “Investor”, he said. “Can I tell you about my startup?”, I asked. Just then the elevator arrived and the door opened. He pointed inside, smiled, and said “Here’s the elevator. Pitch me. “
I gave my quick explainer of what we do, “and”, I said, “we’re nearly at positive unit economics”.
That was enough for him to give me his card and ask me to set up a proper meeting. It turned out that he was a very prolific early-stage investor. We closed our seed round 3 months later, and he became my biggest, and, over time, favorite investor.
Most startups begin with negative unit economics. They spend more on acquiring customers than what they make from them. Some well-funded startups go very far exchanging rapid growth for model profitability. Amazon is an obvious example.
All startups, at one point, must reach positive unit economics.
Sequoia Capital says:
For a product to succeed over a long period of time, several conditions must be present: product-market fit, positive unit economics, and the ability to scale and grow
Actually, reaching positive unit economics gives you the ability to scale and grow. Once you extract more value from your users than they cost, you reach a virtuous cycle of reinvesting ever-growing marketing budgets on acquiring more and more new customers. You may need funding to cover the payback period and your overheads. But investors love startups that are at positive unit economics. Funding your payback period should not be an issue.
Reaching positive unit economics is a major milestone, but it doesn’t end there. Once you’re positive, you want your model to become more and more profitable. If your unit economics are better than your competitors’, you’re in a strong position to outgrow them and dominate your market.
While much has been written on how to measure unit economics and why reaching positive unit economics is important, surprisingly little has been written about how to get there.
This article lists and explains the drivers of unit economics. Each driver is broken down into tactics that you can use to drive your model into positive unit economics, and beyond, with links for further reading.
All the tactics listed in this article are available in this Google doc.
How to calculate unit economics
Unit economics and model profitability
The “unit” in unit economics can be the user, customer, or product/service. It’s similar formulas, rearranged to show the chosen metric. We will use the most common unit, the customer.
How to calculate unit economics:
Unit economics= LTV – CAC
Lifetime Value (LTV) measures how much money you make from your average customer.
The Cost of Acquired Customer (CAC) measures how much it costs you to get a customer.
When LTV is bigger than CAC you’re making more from your customers than it costs you to get them. That means you’ve reached positive unit economics.
Positive Unit Economics: LTV>CAC
How to Calculate model profitability:
Model profitability is measured by ROI.
ROI= LTV/CAC
The higher the LTV and the lower the CAC, the higher the ROI
A startup whose LTV is $300 and CAC is $200 has ROI=$300/$200= 150%. You get a $1.50 for every $1 spent.
How to calculate LTV:
LTV is composed of the Average Order Size (AOV), Gross Margin (GM), and the number of Transactions (T).
LTV= AOV*GM*T
If we have a product that sells for $100 (AOV), has a 25% gross margin (GM), and the average customer makes 12 orders (T), LTV=$100*0.25*12=$300
How to calculate CAC:
CAC=Total marketing & direct selling costs /# of customers
Numeric example = $10,000 marketing spend, 50 sales
CAC= $10,000/50=$200
How to break down CAC:
It’s useful to break CAC into User Acquisition Cost (UAC) and Conversion Rate (CVR) because it allows you to assess and optimize each part separately.
CAC= user acquisition cost (UAC) / conversion rate (CVR)
UAC=Total marketing & direct selling costs /# of users
CVR=customers/#users
Numeric example (same as above): $10,000 marketing spend, 50 sales, 20,000 users
UAC=$10,000/20,000=$0.50. It costs $0.50/user
CVR=50/20,000= 1/400= 0.25%. One in 400, or 0.25% of users become customers
CAC=$0.50/0.25%=$0.5*400=$200
How to maximize customer lifetime value (LTV)
The LTV formula is all multiplications: AOV*GM*T. This means that whichever part you improve, the LTV improves by the same factor. Since you want maximum results and have limited resources, it makes sense to target the parts that have the biggest improvement potential first.
How to maximize Average Order Value (AOV)
High impact tactics:
- A major price hike – This is possible if you change focus to higher-end services/products, or larger companies (enterprise instead of SME’s). Read more on how to increase your startup’s prices here and here (SaaS).
Medium impact tactics:
- Moderate pricing increase – Do this if you can get away with a moderate price increase without losing too many potential customers. Usually, it means that within your competitive environment, your product provides enough value to justify higher pricing. One way to get there is to add valuable features to your product.
- Scalable pricing – If you provide an ongoing service, such as SaaS, much optimization is possible around setting your plans up so that as your customers grow and get more value from your product, you charge more. Read more here
- Upsell – Sell more of the same product/service to your customers. For example, an e-commerce site selling a chosen shirt can propose adding the same shirt in another color.
- Cross-sell – Sell complementary products/services to your customers. For instance, the e-commerce site above can propose pants, ties, socks to go with the chosen shirts.
- Bundle – Offer bundles to your customers. For instance, a shirt and tie.
How to maximize gross margin
High impact tactics:
- Vertically integrate up – move up a level in your market- for instance, from affiliate to merchant. Note though, that you don’t capture all the additional gross margin from one level up since you need to take over the costs too. In the example above, as a merchant, you also need to cover costs such as credit cards and fulfillment.
- Vertically integrate down – Develop your own traffic sources, cutting down on sources that drive traffic to your site in return for expensive commissions (eg. affiliates).
Medium impact tactics:
- Automate processes – Develop your product to require less support, training, and set up resources. Optimize for self onboarding if possible.
- Increase prices – If you can get away with it
- Optimize sales and support resources – Find ways to improve sales and support efficiency to reduce costs
- Reduce other direct costs – Breakdown your product/service costs and find which parts can be optimized
How to maximize the number of transactions
High impact tactics:
- Improve initial onboarding – If your product requires some interaction to master and receive value, and you see that you’re losing a lot of your users around the onboarding, improving it could be a good opportunity. Learn where the problems are by looking at the data and talking to your users. Develop improvements and test them. Read more about improving onboarding here and here.
- Reduce churn – If you have a SaaS product, churn is critical to your business. If your churn is above 10% you can dramatically improve your unit economics by focusing on reducing it. To reduce churn, try to understand the reasons for abandonment and fix them. Seek early warning signs such as falling usage, and put in place processes that preserve the customer before it’s too late. Read more about reducing churn for SaaS ventures here and here.
Medium impact tactics:
- Improve your email marketing – Most startups do some kind of email marketing. Usually, there is much room for improvement. Here are some tips on optimizing your email marketing.
- Offer incentives/loyalty schemes/gamification for returning users – Add reasons for your customers to return
- Build strong online communities – Engage your customers in your online communities
- Provide great customer service – Let your customers know that they are in good hands
The high impact tactics for your LTV are a major price hike, vertical integration, improved onboarding, and reduced churn (for SaaS). These tactics are relevant in certain situations. In addition, there are many medium impact tactics you can deploy. Improving several medium-impact tactics adds up.
How to minimize CAC
CAC is composed of the user acquisition cost and conversion rate. By separating them, we can try to optimize each one. Note though that the two are very much intertwined. If you reduce your user acquisition cost by bringing in cheap junk traffic, you’ll have difficulties converting. It’s often worthwhile to increase your user acquisition cost by acquiring more expensive traffic that converts well.
How to minimize user acquisition cost
High impact tactics:
- Improve your targeting – Deeply analyze your customers and understand who is your best buyer persona. Plot the buyer journey to optimize the messaging and offers in your ads. Here is a good guide on how to find your ideal buyer persona.
- Form traffic partnerships – Seek platforms that can send you large amounts of relevant traffic on a per-click or per conversion basis.
Medium impact tactics:
- Cut channels that perform badly – Analyze the performance of each channel and cut the ones that don’t convert well.
- Test new channels/platforms – Experiment with new channels
- Optimize your campaigns – Optimize your ad text, visual, offer and bids to make your campaigns more efficient
- Add retargeting – Retargetting usually provides a very high ROI on your marketing spend. Users that return are much more likely to convert than first-time visitors.
How to maximize conversion rate
High impact tactics:
- Optimize your conversion funnel – Optimizing your funnel may be the fastest way to reach positive unit economics. If you create the optimal funnel, it’s possible to 2x, 3x, even 10x your conversion rate. That means cutting your CAC by 2x, 3x, maybe 10x. Startups that have the most to gain are those that have innovative products, multi-step funnels, funnels that have never been challenged, and those whose conversion rate is far from relevant benchmarks. Here is an article I wrote about how optimizing your funnel can lead to scaling and here is a detailed article on how to optimize your funnel.
Medium impact tactics:
- Optimize landing pages – reduce bounce rate and maximize conversion. Learn more here.
- Optimize forms – minimize form abandonment. Good list here
- Optimize checkout flow – minimize checkout abandonment. For e-Commerce see here. For SaaS free trial, including benchmarks, see here.
Summary
You can improve your unit economics by focusing on increasing your average order size, gross margin, the number of transactions from each customer, conversion rate, and by decreasing your user acquisition cost.
To get the biggest gains in lifetime value, you need to hike your prices, vertically integrate, dramatically improve onboarding or slash your churn.
To get the biggest cuts in CAC, you need to establish new traffic partnerships, nail your targeting, or optimize your conversion funnel.
There are a bunch of other tactics that give you moderate gains that add up.
A summary of these tactics, and more, is available in this google doc. Mapping all the relevant tactics is best done collaboratively. If you’d like to share additional tactics or good links, please post in the comments and I will add them to the spreadsheet.
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