Unit economics: The core of your business (including template)

I see many startups getting the unit economics wrong. Both the Lifetime Value (LTV) as well as the cost of acquiring a customer (CAC).

There is nothing wrong with making assumptions. It’s needed. But if we make fundamentally wrong assumptions we will not be able to compare our LTV:CAC ratio to the 3:1 rule of thumb.

Read on and I will walk you through the most common mistakes I’ve seen and made myself. We will go through how to calculate our unit economics correctly. Make sure to download the template I’ve made to make your own calculations.

Lifetime Value is not the same as Lifetime Revenue

Many entrepreneurs confuse LTV with LTR (Lifetime Revenue). Don’t get me wrong. LTR is a valuable metric. But it’s far from the same as LTV. With LTR, we are not discounting the cost of capital and the cost of producing the service or product.

I understand why founders get this wrong. There are tons of blog posts confusing LTV with LTR out there.

You can make any assumptions you want when you make your financial model. But be sure not to compare apples with pears. This is what happens when we use our Lifetime Revenue to calculate the ratio with LTR instead of LTV.

So what then are the most common mistakes when calculating LTV?

Mistake 1: Gross margins need to be accounted for to find out our Unit Economics

I see tons of decks where founders have simply summed up all future revenue coming from a customer and called it LTV. But this does not account for the cost of producing the service. Lifetime Value is based on profits, not only revenue.

This is why software is so attractive as a product to sell. And maybe where this mistake comes from. Once you build it, there is little cost to scale it up. But be careful, not all software is without scalable attached costs.

Compare this with a consultancy business. Where we need to scale the workforce to increase revenue. Margins are just not as good. The same goes for e-commerce where we buy and re-sell something. If you want to dive deeper into different business models, I suggest you take a look at my article “How to spot great angel investing cases – part 3”.

Mistake 2: Not accounting for the Cost of Capital

It’s become a mantra out there in the startup ecosystem. We need to create a subscription business. Recurring revenue is king. The enterprise companies out there are moving away from perpetual licensing models. Perpetual in this case just means one-time payments for a software license.

And sure, a subscription model ensures we have an increasing recurring revenue. And for large companies with deep pockets and no cashflow problem, it makes sense. But money today is worth more than the money we might collect tomorrow. Especially if we need to give away large portions of your company to fund your operations.

This is where the Cost of Capital comes in. A startup mostly raises money in return for equity. That makes a startup’s cost of capital somewhere between 30% and 70%.

Compare this with a large public company that can finance its operations with bonds. These large companies have a Cost of Capital of maybe 8-10%.

We need to take this discount into account when summing up the LTV.

This difference in Cost of Capital is that uncertain feeling we as entrepreneurs have in our gut. Investors are reluctant to put money into our venture. And if they do, they want more potential return than when investing in more mature businesses.

The cost of Capital is equivalent to the return our investors expect from investing in us. And they will have high expectations of their returns to offset the risks of investing in startups.

A few things to consider to improve the LTV and your Unit Economics

If our LTV turns out to be too low, we need to revisit our business model. We could try to:

• Front-load with an upfront payment/installation fee – We are trying to get as much cash in as possible as early as possible. This will be cash on hand and will not be discounted by the Cost of Capital.
• Increase the gross margin of the base product – Try increasing the price. Calculate on charging the customer about 20% of the value we create. Or try lowering the cost of producing the service. Maybe negotiate with the suppliers.
• Add high-margin add-on services – Upsell with some value-adding service or product. A maintenance contract, insurance, or extra functionality.
• Increase retention – The longer the customers stay, the higher the LTV. We could tie them up with contracts, but that might hurt our CAC. The best way to increase retention is to build stickiness into the product. How to do this is a whole subject in itself.
• Decrease the Cost of Capital – Decrease the risk in our venture. Easier said than done. But more traction is the way to go here. We could also partially finance the startup with loans. If we can qualify for one. Loans have lower interest rates than the returns equity investors look for.

Customer Acquisition Cost (CAC) – the cost to get one customer

This metric should include all costs for sales and marketing. Salaries, expenses, licenses. Everything we needed to get a customer to start paying for your service.

Mistake 3: Getting stuck in analysis paralysis mode when calculating Customer Acquisition Cost

It’s hard to foresee all the costs that we will incur. And how large they would be. Or how many deals we will be able to close. I often get stuck here. I start to look for more data and want to wait with calculating the estimated CAC.

But nowadays I recognize the signs. And I fight the paralysis. I know I have to embrace the uncertain world of business modeling. Make an estimate. Educated guesses. And then be prepared to explain my assumptions. Sometimes I get some help from someone with sales and marketing experience to do valid assumptions.

But what should we then include in the costs? And what rates should you apply?

Read on for some rules of thumb and common mistakes.

Mistake 4: Not using market rate salaries when calculating the cost of sales

The sales cost part of the CAC included all it takes to close a sale. From reaching out to a prospect to closing and signing the deal. Some examples are:

• Sales representatives, pre-sales people, and their manager’s salaries – All the time they spend on researching prospects, booking meetings, doing demos, making an offer, and negotiating. And we should use market rate salaries. Not the founder noodle salaries. The reason we are looking at CAC and LTV is to see how our business scales. And sales with founder salaries are not scalable.
• Commission/revenue share with partners – And don’t forget the salary cost for our people maintaining those partnerships. Larger enterprises have Partners Account Managers. These people are paid about the same as sales representatives.
• Representation dinners and travel costs – All that wine and dining will add up and needs to be accounted for.

So how do we come up with these costs then and how do we know how much cost to attribute to one customer?

Mistake 5: Not taking into account that all prospects won’t become customers

What many entrepreneurs overlook here is to factor in the costs for all sales conversations. They might map out a sales process for closing a deal. Then estimate the time it takes to complete the sales. And finally, make a rough guess on how many such processes a sales representative can handle. But then all the effort spent on deals that didn’t close is missed.

I suggest doing the following steps:

1. Map out the process we will be using to sign one customer. From finding prospects to closing the deal. Write down the activities.
2. Map who will be included in each step, and what resources they will need.
3. Estimate how much time each activity will take.
4. Estimate the conversion rate between each step in the process.
5. We now know how much effort it will take to close one customer. Now estimate how many processes our people can handle simultaneously.

The calculations can become pretty complex pretty fast. I’ve noticed I start thinking about combining channels. Digital self-service, Direct field sales, Telesales, Partner sales. And combinations of these.

The trick is to keep it as simple as possible for each stage. If you think it’s complicated to set up this Lifetime Value calculation then imagine how complicated it will be to actually operate the customer acquisition process in reality.

My advice is to stick to one channel and sales process to start out. But have a long-term plan for how we will expand. We can, if we want, make another CAC calculation for the later stages of the company where you combine the different channels to a blended rate.

Marketing

Many businesses use marketing to generate leads. These leads are then followed up and closed by the salespeople. Other businesses have a completely digital sales process. Funneling their prospects through an automated buying process until they purchase the product.

Mistake 6: Not taking marketing people’s salaries or consultancy fees into account when calculating CAC

In either case, all costs spent on gaining new customers should be included in the CAC. Be it generating leads or funnel people through a digital purchase decision. Costs that should be included could be:

• Salaries of the people working with marketing – Employees or consultants. And just as we used market rate salaries for sales reps we do the same for our marketing people. Remember, we want to know if our business scales.
• Ad spends for branding and conversion campaigns – Include all the costs you spend on google ad words, Facebook marketing, display advertising, and so on.
• Software licenses – Marketing software costs often scale with usage. So put this into the equation.
• Event and fairs – Add our budgeted costs for these ones as well.

If we are a B2B (Business to Business) sales company it’s pretty straightforward. Our marketing mainly serves to supply leads to our sales reps. We can then just add up the costs and dived it with the number of projected closed deals. Not that complicated.

If we are using a digital sales channel, like most B2C (Business to Consumer) startups, we need to create a conversion funnel and make some estimates. In these cases, our whole Customer Acquisition Cost will include a lot of marketing spend. We should do some experiments on how much it costs to get people into our funnel to have some data.

Just remember that our CAC has more factors than the direct ad spends even if our channel is fully digital. Like the salaries to set up, maintain and follow up on the campaigns.

I think we covered most of the factors that are needed to take into account when calculating our Unit Economics. Let’s now have a look at some costs we should not include.

Costs that are not included in the Unit Economics

There are some costs you should not include when finding out your Unit Economics. As a rule of thumb, these are all the costs that are not directly attributed to acquiring a customer or delivering the service to them.

Also, costs that don’t scale in any meaningful way with more customers. This could be things like:

• Mgmt and overhead – If our CEO works mostly with investor relations and running the company, or building the product, their salary is not included in the Unit economics cost. Or costs for accounting and legal fees that are not part of closing a deal. The HR department, once we get to a place where we need one, is also an overhead. Same with recruitment costs of all people.
• Product Development – Building the next version of the product is not part of the unit economics costs. So our developers, designers, and product managers’ salaries do not go into the costs when calculating LTV. But customer support and maintenance do. We should make an educated guess about how much of our developers/product managers will need to do bug fixes and handle incidents.
• Software licenses – As long as the cost does not scale with the number of customers, we can exclude it. Licenses like Slack, design software, developer licenses, and so on.
• Negligible costs – I run into these over and over again. Maybe we have server costs that scale with the number of users. But the costs are so small it does not really matter for the case. For simplicity’s sake, I recommend we exclude these costs and make a note of why if some picky investor asks why it’s not there.

And there you have it! What to include and not to include in our Unit Economics calculation.

Now get crunching with your own spreadsheet. Feel free to use my template to get started. Download it from the banner at the top of the article. But make sure you understand all parts of your unit economics fully. And are able to explain all calculations to your investors.

But before we conclude the article, let’s briefly touch on how our Lifetime Value and Customer Acquisition Cost relate to our long-term financial plan.

How Unit Economics relates to your financial plan

Our Unit Economics proves to investors that our company has a scalable business model. Or, prove might be a strong word. But it at least indicates it. If our assumptions hold up.

But there is also another spreadsheet we will be asked for. It’s the Pro-forma financial plan to get to break even. Pro forma means “for the sake of form”. And in this case, it’s just fancy wording for “Our best guess on how to get to a state when we can stand on our own legs”.

Basically, the financial plan will show how we will go about scaling the company.

Usually, this is a 5 or so years plan showing costs and revenue. Preferably with a focus on the cash flow of the startup. As liquidity is one of our main problems. From this plan, an investor will be able to deduce how we will go about scaling our team, and where the important inflection points are for the venture.

Numbers don’t lie. We can’t spin a financial plan with fancy pitching. If our sales or conversion rates take a huge leap a year from now we better have a good rationale for how this will be achieved.

But what about the Unit Economics we spent so much time calculating? Where will we use these numbers in our financial plan? Here are some pointers and common mistakes.

Mistake 7: Using Lifetime value as revenue/cash flow in

Lifetime Value is not the same as the money we will get into our account. LTV is actually lower than the sum of all the revenue streams from a customer. At least if our margin is decent. Don’t put the LTV for closed deals during a year as income for that year. Put the actual cash we will be able to invoice during each year as our revenue.

And we should not discount our revenue in upcoming years with the cost of capital. We might even put in an increase in price per unit further ahead in the plan as our product matures and the value provided by it increases.

When it comes to the cost of goods / delivering the product of the Unit Economics, these will have a relationship with our financial plan. All the salaries, supplier fees, and so on should be laid out. Including all the costs we didn’t include in the Unit Economics. Like overhead and product development. All these go into the financial plan.

Conclusion about how to calculate Unit Economics

Here is a quick summary.

• Account for the cost of capital and the cost of delivering the product when calculating LTV.
• Include market rate salaries and factor in that all deals won’t go to a close when we calculate CAC.
• Aim for an LTV:CAC ratio of about 3. Lower means it’s not a scalable business model, and higher means we are not scaling aggressively enough.
• Keep it as simple as possible!