People often say that economics is boring. So unit economics must be really boring. And yet it’s a leading cause of startup death.
Since the dawn of the industrial age, unit economics has been the underpinning of any financial model: You have something that you can make for X, and you can sell it for Y. If you’re a bakery then your unit economics are that every loaf of bread costs you X to make and you can sell that loaf for Y. If you’re a consulting firm every hour of time costs you X and a client is willing to pay Y for that hour. If you are Facebook then each targeted page-view costs you X to create, and an advertiser is willing to pay Y for that targeted page-view. Every venture distills down to unit economics. Every one.
For most companies, unit economics improve with scale. As your factory grows, your cost of producing one unit goes down, and the price you can sell that unit for goes up (as your marketing and customer retention improve).
But if your unit economics are fundamentally upside down (your cost of making a unit is hopelessly higher than you’ll ever be able to sell a unit for) then scale just makes you go broke faster (which is not usually a desired outcome).
And unit economics are the key inputs for what I think is the most important metric of all: Customer Acquisition Cost has to be less than the Lifetime Value of a Customer (CAC < LTV). Every business has to have a way of getting customers at a cost less than what it can make from them. Every one.
Example: Let’s say we make widgets — they cost us $6 to make and we can sell them for $10, so we make $4 on every unit sold. Now let’s say that our sales and marketing expenses are such that it costs us an average of $3 to get a customer, and that once we have that customer they tend to eventually buy 4 widgets from us. So our CAC is $3, and our LTV is $16. That’s an excellent business. I’d love to invest in that business.
CAC < LTV is a very simple law of economics and yet many of Silicon Valley’s worst failures have stemmed from the fact that the company (and its investors) thought that somehow the laws of economics had been suspended. An infamous example is Pets.com, which raised $180 million with their great idea of selling bags of dog food at a loss and hoping to turn that model into a winner eventually, maybe, somehow. They went bankrupt in eighteen months, sending $180 million down the toilet.
It turns out that selling dollar bills for eighty cents is really fun — and makes you really popular–but isn’t exactly sustainable.
Or take the much-hyped Y-combinator company, HomeJoy. They were a startup marketplace for connecting consumers with home cleaning services and they raised an impressive financing round of $38 million. Their cost of a house cleaning (one unit) was $35. They spent millions running a promotion offering the first cleaning for $19, figuring that customers would come back for several more cleanings. Except that people took the $19 cleaning and never came back. So fundamentally their CAC — LTV formula was flawed (see Forbes article).
Most companies start with a CAC that is much higher than the LTV (see graph above), and some (Amazon, notably) remain this way for years as they grow market share. But this requires the ability to burn through a whole lot of capital (see Amazon) and deep insight into how you are moving CAC<LTV on a winning trajectory (see Amazon).
The concept of unit economics even applies to nonprofits and social enterprises. If teaching one child to read costs you X in a pilot project, you would hope that as you scale-up your organization your impact is growing and your cost per impact unit is going down. Plus your “customers” (kids who need reading help) will be easier to attract and get into your program. Funders and donors will want to understand the unit economics of your social venture. And so should you. It’s the key to creating sustainable impact.
The reality, of course, is that most ventures are more complicated than just “we make widgets for $6 and sell them for $10”. And so many entrepreneurs just wave their hands and say “Well, unit economics doesn’t really apply to what we do, because what we do is new and different”.
History says otherwise. So avoid a leading cause of startup death by taking the time to understand the unit economics for your venture.
Some additional reading:
Sam Altman (CEO of Y-combinator) on the topic.
Omidyar Network on unit economics for social ventures.
Andreessen Horowitz on CAC < LTV.
Building a Successful Social Venture, by Eric Carlson and Jim Koch, pages 161–162