What Is Unit Economics in SaaS?
- Lighter Capital
- Feb 21, 2023
- 5 min read
Updated: May 5
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 business are driving profit and growth. In this article, we explain unit economics and its wider implications for growing a startup sustainably.
Businesses are complex systems and measuring success often feels 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 definition
Unit economics attempts to simplify the analysis of complex businesses and strategies by measuring profitability on a per unit basis, minimizing the dizzying number of metrics and their corresponding acronyms that are needed to guide strategic business decisions.
With the unit economics approach, you regularly evaluate the direct revenues and costs with your particular business model expressed on a per unit (per customer) basis, so you can answer one very important question:
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 revenue growth and profitability, but early-stage startups in particular need to pay close attention to the metrics that gauge this.
How to Calculate SaaS Unit Economics
SaaS 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.
FORMULA
LTV/CAC Ratio = LTV ÷ CAC
It's a simple calculation if you're already measuring your customer lifetime value and your customer acquisitions cost. If not, you'll need to calculate those using one of the formulas below:
LTV = ARPC ÷ Customer Churn
or
LTV = ARPC x Average Customer Lifetime
CAC = Total Sales & Marketing Expenses ÷ Total Number of New Customers
Check out these articles for more detailed explanations the calculations above:
An ideal LTV/CAC ratio is 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 shows the time a company needs to pay back the cost of acquiring a customer. It's calculated using an inverted CAC ratio. Follow that link for a deeper explanation about CAC ratios.
FORMULA
CAC Payback = | Annualized Incremental Gross Margin |
Total Sales and Marketing Expenses |
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 Early-Stage Startups Should Track Unit Economics
The earlier you start tracking unit economics for your startup, the better chance you have at establishing a firm footing in your market and achieving a healthy growth curve.
Founders can be overly optimistic about the concept behind their business. A “build it and they will come” mindset is one of the biggest startup killers.
Many startups launch without putting enough thought into product-market fit, pricing strategy, cost structure associated with its business model, customer acquisition and, of course, good old-fashioned bookkeeping. All of these factors — if ignored — can sink that startup dream as money starts to run out.
Having an understanding of unit economics early on enables you to make long term financial projections that more accurately predict your revenue trajectory. At an early stage, you need a healthy growth rate, but you also need to be profitable.
Even with perfect execution, an acceleration of growth can be accompanied by a squeeze on profit margins. By keeping a close eye on key metrics, you can measure, improve, and align your marketing, product or service, and team with the direction you need to move in for sustainability.
RELATED: How to Grow a SaaS Business, Fast
A final note: Regularly evaluate your revenues and costs
Being aware of the direct revenues and costs associated with your business model is an essential, ongoing priority for startups — these are need-to-know insights about your company’s financial performance.
By taking a unit economics approach to business, early-stage SaaS startups are able to gain a better understanding of their company as it develops, scales, and grows. Paying close attention to unit economics helps identify opportunities, manage cash flow, and overcome many of the challenges that come with scaling a SaaS startup.
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