When writing about business models and sustainability we often mention unit economics, as it is such a key element to assess the financial health of a company. But what does ‘unit economics’ actually mean?
Unit Economics is broadly defined as the sum total of all economic activities related to one unit of any product or service. Companies providing services such as SaaS usually calculate this as Lifetime Value (LTV) of a customer divided by Customer Acquisition Costs (CAC). It is basically the ratio between the gross profits you expect to receive over the duration of a business relationship and the costs incurred in an effort to get a new customer. Obviously, you want this ratio to be considerably higher than 1, so you can use the excess to cover overheads and eventually make a profit.
Software, cloud-based and subscription-based businesses have a particularly hard time estimating unit economics. This is because lifetime values are so volatile and there is no accredited accounting system for valuing development costs, which in turn makes it tricky to estimate both LTV and CAC.
Estimating LTV for a SaaS company
The Lifetime Value of a customer is defined as the gross profit generated by a single customer over the duration of their business relationship with a company. Broadly*, for a SaaS, that is calculated as follows:
(Average Revenue per Account – Average Cost of Service) / Churn Rate
Let’s look more closely at the three elements of this formula:
- Average Revenue per Account (ARPA) is a very common metric for SaaS. It indicates the average revenue generated by a subscription in a single period (month/year, according to the terms of your subscription). This is arguably the easiest to estimate out of these three.
- Average Cost of Service is the average cost incurred to provide the service to a single user. The reason why this is hard to estimate is that to calculate it you need to sum all the components required for you to provide your services and divide by the total number of users. As an early stage company, it is extremely easy to over- or underestimate both, especially if you are dealing with projected data.
- Churn Rate is defined as the percentage of your users that unsubscribe from your service in each single period. This value adds another degree of uncertainty as it is influenced by a variety of largely unpredictable factors such as more affordable alternatives, users’ disposable income and media attention towards a certain sector.
There is no accredited standard to calculate any of these three elements which, once combined, result in an even looser estimate of a key metric such as LTV.
As a result, this is too often overestimated by projecting revenues from a customer into an unfeasibly long future, or by exaggerating the value of intellectual property which, in turn, reduces the Average Cost of Service. User growth is also often overestimated, which means that the Average Cost of Service is usually much higher than anticipated.
Estimating CAC for a SaaS company
The maths behind Customer Acquisition Cost is much simpler: it’s the total marketing and sales spend over a time period divided by the number of new users over the same period.
As easy as it can seem, Founders are often tempted to underestimate this metric by basing projections on reduced CAC, which implied inferior costs achieved through progressive automation of sales and marketing processes.
The bottom line
The harsh truth is that your LTV needs to be at least twice your CAC before you can hope to turn a profit. Of course, Founders and investors are usually willing to wait for a company to gain traction before its unit economics become sustainable. However, it is important to always make sure that all estimates are conservative and data-driven. It is always better to tweak the business model from the start, always keeping in mind a clear path towards profitability.
Blindly chasing user growth might work sometimes, but its certainly not advisable: retaining users gets harder and harder, as soon as a service launches there are tens of alternatives that offer a similar service at a lower rate and digital-native, informed users are less and less loyal.
If you are interested to learn more about SaaS businesses and how they are valued, check out this report we published a while ago!