How to test unit economics in a scaling startup

So everyone is saying that proving sustainable Unit Economics is key to startup success in 2016. But if Unit Economics inevitably change as an operation increases in scale, how can a startup test and prove unit economics BEFORE they actually scale up? Here are some ideas.

What is this Unit Economics chat all about?

In either case, there is certainly a consensus that obtaining investment will be harder and more time consuming in 2016, as investors look more closely at the operating costs of of a business. VC Mark Suster shares some evidence of this here:

Also, in a recent episode of This Week in Startups, katie benner told jason that investors may be “taking a pause” to encourage a market correction, not just in valuations, but also in founder behavior.

“[investors felt that] founders were getting too “bubbly” themselves, in terms of their expectations of their valuations… so they wanted to make it more of an investor’s market, than founders market. They saw many of their companies had unit economics that weren’t good, so wanted to enforce more discipline around what people were doing, in terms of spending and cost.”

This is again reflected from the investors themselves, with Accel Partners for example posting on medium that:

“Shoring up operating discipline and pushing towards profitable unit economics is already being addressed with greater urgency in 2016.”

Finally, this week’s episode of This Week in Startups again featured the topic within an interview with Gagan Biyani of Sprig, who seems to be really nailing the Unit Economics of on-demand food, which is possibly one of the most difficult categories to do it in.

(Side note; Gagan Biyani, you guys totally saved me last night. As someone with brutally restricting food allergies, being able to get quality food in ten minutes is a lifesaver when I arrive at a startup meetup evening to find that yet again, the only food is Pizza! Kudos and thanks!)

All of which is further evidence then, that we startup founders need to create a really solid case for our unit economics, both for our own sustainability, and especially if we are seeking investment.

So what are Startup Unit Economics, and how do we prove them?

Roger shared some excellent resources that explain the basic unit economics much better than I could, so instead I will just share them here. For anyone interested, read this excellent blog post, watch this great video and this one too:

To summarize, the most important measures in startup unit economics seem to be:

1. CAC: Cost to Acquire a Customer.

It’s the economic impact of adding one incremental customer.

To calculate your CAC cost, divide your sales and marketing costs, including overhead expenses in these departments, for a given period by the number of customers you picked up during that period. Source: KissMetrics Blog

2. Magic ratio / SaaS ratio / magic number

ARR (Annual Recurring Revenue) / CAC

If ARR / CAC = 1, this means it takes 1 year to earn back the cost of acquiring a customer. If ARR = 2, this means you get paid back twice in 1 year or 6 months to reclaim. If 0.5, means it takes 2 years to earn that money back.

Presumably, the longer it takes to earn back the CAC, the more risk for the business and the investor. Therefore if a startup can optimize it’s business model and engine of growth to payback sooner, the lower risk and more attractive that startup will be.

Sure, there are many other important measures like CAC/LTV or Net expansion revenue that are very important, but in considering the mood of the industry, it seems to me that how much it costs you to gain a new customer, and how quickly you can earn that back, is what investors should be most interested in.

3. The cost of fulfilling one customer order

So I think what we are talking about is the general sense-check that it does not cost you $10 to acquire and service a customer that makes you $8 in revenue. An important distinction, as even though a given company may be focussed on growth rather that overall profitability in certain stages, they still need to know that they can make it to a point where the unit economics do make sense eventually, and that when they are considering they have achieved Product/Market Fit, they consider Eric Ries “Law of sustainable growth”,

“A situation where new customers come from the actions of past customers.”

By which I understand — the acquisition of the new customers can be funded by the profits generated by existing customers.

But what about when your scale is accelerating?

Unit Economics are inherently tied to scale

Conversely, Lean Startup practicing companies may be learning about their business model by deliberately “doing things that don’t scale”, such as manually reproducing a task before automating it, or providing extremely high-touch customer support to a few customers before branching out to more. This is an excellent approach that I highly endorse, but it doesn’t help the startup predict what their profitability might be when they do scale.

Furthermore, the cost of acquiring users from a given channel can look relatively attractive when you are first getting started with it. But as you reach greater scale and start to saturate a channel, you can experience diminishing returns from it, which again mean that your small-scale findings can mislead your large-scale assumptions.

So what can we startup founders do now, that can give us and investors confidence that our Unit Economics WILL work at scale, BEFORE we actually scale?

Well although our startup is not yet ready for scale, I do have some relevant experience and great tricks from my prior agency and enterprise experience to share that could help, as well as some others obtained from others in the Lean Startup community.

Click here to continue reading in the second post.

Chief Marketing &Growth Officer at Topology Eyewear :: @guesto

Chief Marketing &Growth Officer at Topology Eyewear :: @guesto