Demystifying unit economics: A deep dive into using UE as an effective tool
Cutting costs just to lower burn only delays death — cutting costs to improve unit economics buys you a great business
Many tech companies have just been through, or are still undergoing, a cost cutting exercise — but not enough of these decisions are being made with value creation in mind.
Founders may have altered their product roadmaps to kill experimental extensions, and have made plans to spend a lot less on new SaaS tools than last year. Many have scaled back on their GTM spend, both on sales heads and marketing budgets. But while cutting such costs to lower cash burn is necessary in the current environment, it is not a strategy in itself. Just making cuts to become a leaner operation does not lead to a great business model.
Today money is no longer free. Interest rates are rising and equity just became more expensive for founders, and more scarce. Growth at all costs is out and “efficient growth” is in, and many Board conversations now revolve around the question: ‘How much growth are we willing to sacrifice in order to control our burn, and have sufficient runway?’
In my experience, this approach is a blunt instrument that can do a lot of damage, and make management teams feel like they are running against a wall. Operating in this way can create a situation where, over time, money in the bank inevitably dwindles, growth is slow, and a company spirals down into mediocrity. By contrast, the best companies will take time — and use their scarce cash — to understand where in their businesses true value is created, and where they should be investing their precious “marginal dollar” to drive not just growth, but true value creation.
It can be incredibly helpful for companies facing this challenge to centre strategic conversations around unit economics.
Unit economics is one of those terms that gets thrown around all the time, and it is certainly back in vogue. In my experience, however, it tends to be calculated half-heartedly as “something that the Board asked for”, rather than used as a useful tool to steer a business. Used properly, it can help create a strategy that is laser-focused on value creation — a strategy that can show a path to both strong growth and profitability…
A brief introduction to using unit economics as an effective tool
The usual way to think about unit economics is by calculating the lifetime value (LTV) of a customer, and dividing this by the cost to acquire this customer (customer acquisition cost or CAC).
The lifetime value means the gross profit your company gets from a certain customer over that customer’s lifetime. A great LTV / CAC is >7x, an ‘OK’ one is 4–7x, and anything below 4x is sub-par for a B2B SaaS startup. This is where the lauded “scalability” of software comes from. It costs a lot of money and time to build a great B2B tech product, but once you do, the cost to ship the marginal unit is very low and the lifetime of each customer is very long. This is the only way you can start paying for the high cost of building and maintaining the product.
In this three-part series I will dive into each component of unit economics, and share some of the real-world war stories from companies that have been there before. I hope it will be helpful for technical founders as you plan strategies for the year ahead.
However, before I dive in, I have one key question for any founders reading this piece to ask themselves…
The question is: Do we really have a scalable product?
Is your B2B SaaS company actually selling the same “marginal unit” over and over again? In Enterprise Software, the answer is rarely 100% “yes”. However, if your answer is not at least an 85% “yes”, then you are probably in trouble.
If you are constantly having to customise, throw a lot of your engineering resources at a new contract just for “standard” integration, or your sales team constantly comes to your product team with an eleventh-hour product feature request that trips your product road map, then you do not currently have a product that scales. It will not be possible to come up with a reliable estimate for your unit economics, because every “unit”, or individual contract, is too different from the next.
If this is your predicament, it would be wise to retreat, and have a very honest discussion of what you can actually sell in a fairly repeatable manner. You should then re-organise your strategy around this proposition.
If your answer to the above is an honest “yes”, then please stay tuned for our next piece on a few things you should consider as you get deeper into your company’s unit economics.
NOTE: The article is written for companies that are already part-way on their scaling journey and are able to start calculating a relatively reliable set of KPIs here. Typically this would be between $3m and $10m of ARR
