Unit Economics - Do you have a viable business model?

Sep 29

Unit Economics: Is Customer Lifetime Value > Cost of Customer Acquisition?

This post provides Entrepreneurs, Business Managers and Investors provides a simplified model and an introduction to Unit Economics enabling you to validate if the business model for any SaaS or subscription/recurring revenue business is viable.Unit Economics answer a key business question: Is the Lifetime Value of a customer significantly higher than the cost to acquire a customer? We also have a look at various factors, how they can impact unit economics and how you can check your unit economics in 7 steps. Why is this so relevant? Only if you get your unit economics right, you can invest funds into scaling your business.

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All subscription businesses face an initial revenue/cash flow gap. They know that the start-up period will need funding for sales and marketing to acquire customers and that recurring revenue streams and respective cash flow will only fully open up over time. As soon as the business shows that it can succeed, it should invest aggressively to grow. However not all investments make sense. Unit Economics are a tool to help you ensure that your growth initiatives/investments will pay back and you are prepared to grow your business.

Unit Economics are defined by 2 major metrics which we reference as Business Viability Metrics:

The long-term indicator “LTV/CAC ratio” also referred to as “God Metric” shows how many times the Customer Lifetime Value (LTV) exceeds the Customer-Acquisiton-Cost (CAC)
The short-term indicator “CAC Payback Period” or “Months-to-Recover-CAC” defines how fast you recover the Customer-Acquisition-Cost over the lifetime of your customer

Why understanding unit economics is so important

Customer acquisition cost is a direct reflection of the future success of your SaaS business. If you’re too cautious about your CAC, you will likely be missing out on customers and future revenue. Yet, if you spend too freely, you won’t be profitable and will likely end up in the Deadpool.

The challenge is that you want to spend the right amount of CAC to drive new customers to your service without jeopardizing the Lifetime Value (LTV) and revenue from that customer. A great measure to gauge this balancing act is the LTV/CAC ratio, which is sometimes even referred to as the “god metric” of many successful SaaS companies.

Experiencing Unit Economics

Inputs

To experience Unit Economics hands-on, we created a simplified, interactive model for you below. You can play with the model to understand how Cost-of-Customer-Acquisition, Customer Lifetime in Months, Monthly Recurring Revenues per Customer and Gross Margin relate and how they impact the CAC Payback Period and the LTV/CAC Ratio. You can enter

the estimated Customer Lifetime in Months
the Average Monthly Recurring Revenues (MRR)
the Gross Margin of your Service in % (reduces revenues with direct costs associated with producing the goods and services sold by your company)
the Cost of Customer Acquisition (CAC)

Output				Input
Lifetime in Months	MRR in $	Growth Margin in %	CAC in $	Payback in Months	LTV/CAC Ratio
				10.00	3.60

Impact

The model shows you two lines

the blue line which represents Cumulated Customer Lifetime Value (= Customer Life Time in Months * MRR * Gross Margin) at a given point in time (reaching its final value at the end of customer lifetime)
the red line representing the Cost of Customer Acquisition (which actually occurs at or even before the customer sign up)

The customer starts to pay monthly for your subscription service and you eventually break even (where the two lines intersect) and make your money back on the initial CAC investment. This is the Payback Period in Months. From then on is a magical period where you’re rolling in the dough and netting a profit from that customer to optimize your LTV/CAC ratio. Lifetime Value increases until the customer decides to churn and its lifetime ends.

When you change any of the input factors, the model re-calculates the two lines and the viability metrics

Payback Period = MRR * 12 * Gross Margin / CAC
LTV/CAC Ratio = Lifetime Value / CAC

Based on the calculated values for Payback Period and the LTV/CAC Ratio, the model give you a red/green-traffic-light-indication of the viability metrics.

Traffic Light Guidelines of Viability Metrics

David Skok in his blog post SaaS Metrics explained set up a few traffic light guidelines for B2B companies:

the Payback Period should ideally be less than 12 months and
the LTV/CAC ratio should ideally be higher than 3 meaning that for every dollar you put in your SaaS machine you’re getting three dollars out (in this case, both output parameters will turn green).

This exercise should help you to understand and tune your subscription business input thresholds to enable a viable business. The thresholds do not apply to all SaaS businesses in the same way. For example, a business without a salesforce that has a touchless conversion usually has a far lower investment in sales and marketing expenses, and becomes cash flow positive far earlier. On the other hand, a business with a lower gross margin might require a longer time to break even. You should be able to adjust these thresholds to your specific expected business.

Understanding sensitivies

Playing with the model, you can now draw a few conclusions and ask how sensible the Payback Period and LTV/CAC Ratio react upon a change of any of the input variables. Specifically, you can test how the viability metrics change upon a change of an input variable. Check it out:

If you increase the Lifetime value, short-term Payback Period remains unchanged, but the long-term LTV/CAC ratio increases.
If you increase MRR per customer, the Payback Period decreases (that's a positive result and the LTV/CAC ratio increases.
If you increase the Gross Margin, the Payback Period decreases and the LTV/CAC ratio increases.
If you increase the CAC, the Payback Period increases and the LTV/CAC ratio decreases

The table below summarizes the positive or negative impact of an increase of any of the input variables.

Increase of ...	Impact on CAC Payback	Impact on LTV/CAC Ratio
Customer Lifetime in Months	-
Monthly Recurring Revenue
Gross Margin
Cost of Customer Acquisition

Is it all that easy?

As simple as the above model, is the answer this question: "NO!" There are many more variables which impact the Viability Metrics such as

Churn
Revenue Expansion
Sales Team Compensation
Sales Team Quotas
Cost per Lead
Lead-to-Deal Conversion Rates

The impact of a change of one of any of the input parameters on any of the Viability Metrics can differ dramatically. This is what is called a Sensitivity Analysis. The image below shows results of a Sensitivity Analysis from one our Lean-Case projects. For example, check out the green line which shows the impact of a change of churn on the LTV/CAC Ratio

A 20% reduction of Churn increases the LTV/CAC Ratio from 5.8 to 7.3 (that is an increase of almost 30%) whereas
a 20% increase of Churn decreases the LTV/CAC Ratio from 5.8 to 4.8 (that is an decrease of almost 20%)

Your Unit Economics in 7 steps

If you want to get more hands-on, check out the 1-min video below. By selecting your revenue model, defining your average customer contract, defining a forecast, adding Cost-of-Goods-Sold, Cost-of-Selling and Cost of Marketing, you can check your unit Economics in 7 steps.

If you want to get more background on the key metrics of a SaaS business are and how to calculate them, we would like to refer you Lean SaaS Metrics – The Definitive Guide to create business impact and the associated InfoGraphic.

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About the Author

CEO and Founder Lean-Case - Eckhard is a Serial Entrepreneur co-founding cyber-security startup accells acquired by Ping Identity and m-payment startup paybox acquired by Sybase/SAP. As a Business Angel, VC Partner and Investment Advisor, he has realized that turning business models into numbers is a major challenge and must professionalize.

Unit Economics – Do you have a viable business model ?

Unit Economics: Is Customer Lifetime Value > Cost of Customer Acquisition?