When it comes to measuring subscription businesses, unit economics is crucial.
Miscalculating or misinterpreting these numbers can be really harmful to your business.
This set of metrics will tell you if you’re building a sustainable business, and that is only possible with profits. One can say that making no profits is not necessarily bad, pointing Amazon as an example.
Amazon hasn’t been profitable for years and still a very successful business. There are good reasons why one would raise capital and make investments that lead you to be unprofitable – like hiring new salespeople and accelerating sales on a SaaS business – but the key point here is the availability of capital fueling faster growth.
Despite investments, let’s see how to avoid miscalculating or misinterpreting your unit economics.
Let’s take a look at very simple math: Let’s say Amazon buys a book for $10 and spend more $5 on fulfillment, making the total cost of the book $15 (COGS). Then Amazon sells this book for $20, making $5 Gross Profit; after taxes, makes $3 Net Profit.
Now let’s say Amazon decides to invest $5 on growth, to explore new product lines or even new business such as AWS. At the end of the day, the company’s result will be $2 negative, right?
The difference between this and bad unit economics are: Amazon is not losing money on every single transaction, and therefore, they could become profitable at any moment if they slowed down growth.
I’m hypothetically analyzing Amazon as an example, but think of this on a large scale. If you make money on every single transaction, your company will certainly be profitable, unless you choose not to. That’s totally different than losing money on each transaction, making it impossible to be profitable.
Managing your unit economics is making sure you’re not selling dollar bills for ninety cents.
Certain that you know how to interpret unit economics, let’s see how not to miscalculate them.
Customer Lifetime Value
The hard thing about calculating Customer Lifetime Value is the lifetime part. We usually use churn rate to get lifetime: e.g. If your monthly churn rate is 3% then Customer Lifetime would be 1/0.03 which is 33 months.
The problem is that early stage businesses don’t have a stable churn rate (or no churn at all), and therefore they have to make assumptions around how long a typical customer will be around before churning. And that’s dangerous, especially because entrepreneurs tend to be too optimistic when making those assumptions.
The second big mistake when calculating LTV is to consider revenue. To be accurate, you should consider the profits gained by the customer, deduce COGS and use Gross Profit to calculate it, not Gross Revenue.
e.g. A customer pays you $100 (Revenue), it costs you $70 to serve them (COGS), and your acquisition costs are $50. If you consider Revenue you’d be profitable, but if you consider Gross Profit ($30) you’d be losing $20.
Customer Acquisition Costs
CAC can be measured incorrectly if it doesn’t capture the true cost of acquisition.
The default formula to calculate CAC is Sales & Marketing Expenses / # of New Customers.
The mistake here is to measure CAC by looking at the attributable marketing costs only, like paid advertising.
You should actually take your full marketing and sales spend including PR, content production, sales reps, advertising, marketing & sales software licenses (e.g. HubSpot and Salesforce) and then divided by your customers acquired to get your fully loaded CAC.
LTV:CAC Ratio and Payback Period
A smart and simple thing to do is to analyze these metrics in comparison with each other. One of the things you should do is to compare your LTV to your CAC and measure the ratio.
Even more important than that is to keep track of the CAC payback period. In SaaS, it likely makes sense to sell to customers who don’t churn yield recurring revenues for 3+ years and positive LTV/CAC ratios.
But none of this matters if you run out of money. Sustaining short-term losses is all predicated on the ability to finance the losses through venture capital or other means.