Contxto – It is not unusual for entrepreneurs to produce financial projections claiming millions of dollars in revenue for the coming year, but when investors ask them how they intend to achieve this and what their unit economics are… Crickets.
Unit economics are, in theory, quite basic. Yet in practice they could be a little bit tricky, especially if your business model is somewhat innovative, and/or your pricing strategy isn’t fixed.
Let’s take a little step back, for the newbies out there.
- CAC = Customer Acquisition Cost. It basically says how much money you have to invest in order to get someone to buy from you.
- LTV = (Customer) Lifetime Value. It represents the total amount of revenue that a customer will give you in their “lifetime”.
So in simple terms, if your CAC is bigger than your LTV over long time period: Bad business, bro. Get out!
The beauty of the LTV:CAC ratio is that in just a glance, you can tell if a business might be feasible at least at some point in the future.
So, how do you calculate these two metrics? Use average values. Since most startups have to experiment, try different marketing approaches and pivot their business model in order to find the best way to reach and provide a service to customers, their numbers might not be flat or standard. That’s why averages work in the very early stages.
- How much does x customer pay on average for one sale?
- How frequently does x customer buy from you on a daily/weekly/monthly basis.
- Multiply those two variables, and annualize it (times 360 days, 52 weeks or 12 months depending on your previous frequency).
- How long do these customers stay loyal to their brand over their life?:
- This one is tricky, but you could use an industry average to know how many years a customer keeps buying from the same company over and over again.
- Multiply step 3 and 4, and you have your LTV.
- Add up all your sales and marketing expenses. Doing this is not pretty, but you need to, otherwise you’ll be lying to yourself. These costs include:
- a. Marketing campaigns
- b. Sales and marketing salaries and commissions
- c. Other services such as software platforms, consultants, marketing, PR agencies, etc.
- Now identify all your acquired customers to date.
- Divide all your costs over your customers, and there you have it.
Now that you have those two, you can get the magic number, LTV:CAC. Most investors look for a 3:1 ratio to spot a potentially profitable company, but it all depends on the company and industry, so don’t panic (just yet).
And there you go. Keep your unit economics clear at all times, people.
You’ll thank me later.