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What Are Unit Economics and Why Are They Important in Early Stage Startups?

Unit Economics

As an early stage startup, data-driven decision making is the key to ensuring you have the necessary information you need to understand your company’s overall health and viability as you navigate the market.

Taking a unit economics approach helps you ensure that you’re steering your company in the right direction, and that all aspects of your SaaS are driving profit and growth.

In this article, we’ll take a closer look at unit economics and its wider implications for building a sustainable business.

What are unit economics?

what are unit economics
“Life is really simple, but we insist on making it complicated.” – Confucius

Businesses are complex systems and measuring success can feel like a complicated and challenging process. With so many different strategies to consider and a never ending list of “key metrics” to keep track of, being an owner of an early stage startup can be overwhelming. Unit economics attempts to simplify all this complexity by measuring profitability on a per unit basis.

By regularly evaluating the direct revenues and costs with your particular business model expressed on a per unit (per customer) basis, you are able to answer one of the most important questions: Can you make more profit from a customer than the total cost of acquiring them?

This method of analysis enables you to make projections around how fast you can grow your business, and how profitable it is likely to be. It helps early stage startups gain a better understanding of their growth initiatives, such as whether allocating more budget to acquire more customers is worthwhile.

All companies are driven by growth and profitability, but early stage startups especially need to pay close attention to the metrics that surround this.

How to approach unit economics as a SaaS startup

How to approach unit economics as a SaaS startup

Unit economics can be approached from two angles — looking at the ratio of customer lifetime value (LTV) to customer acquisition costs (CAC), or the payback period on CAC.

LTV to CAC ratio

As part of your unit economics analysis, you’ll be looking closely at your customer lifetime value and customer acquisition metrics, and the ratio between the two.

An ideal ratio is considered to be 3:1, where you get three times the value of acquisition from each new customer.

If your ratio is lower (e.g. 1:1), it will mean it costs you as much to acquire one customer as they spend on your product. If this is the case, you should be looking at ways to refine your sales, acquisition, and pricing models.

If your ratio is high (e.g. 6:1), it means you could be missing out on valuable opportunities. As each customer ends up being worth more to your startup than it costs to onboard them, you can afford to allocate more of your time and budget to sales and marketing. The money you spend at this stage will be made back over the lifecycle of each customer.

Payback period on CAC

This takes into account the time a company needs to pay back the cost of acquiring a customer. The average startup has a payback length of 15 months based on gross margin.

Shorter payback times are advantageous as less working capital is needed, which in turn gives companies the ability to grow faster.

Lighter Capital reached out to Ruben Gamez, Founder of BidSketch, for his thoughts on these two approaches to unit economics.

“When it comes to profitability and whether a business model will work, I prefer to focus on payback period over LTV:CAC ratio. That means, how many months does it take for us to start making money from each customer. My target is typically 2 to 4 months. It’s still important to be aware of the ratio, but the faster you can put profit back to work into growth, the faster you can scale the business. Early stage companies often have higher churn and can have an especially hard time figuring out LTV as their product changes and different customer segments start to adopt the product. Zeroing in on the more profitable customers early and testing pricing (which is often the easiest growth lever) can make the difference between a business that thrives and one that doesn’t work.”

Why you should track unit economics as an early stage startup