Demystifying unit economics: A deep dive into using UE as an effective tool, Part 3
As outlined earlier in this series, unit economics can be used as a phenomenally helpful tool for steering a B2B software startup’s strategy, especially in today’s economic climate.
Part 2 addressed some of the questions that any leader of a growing software startup would benefit from considering, including: Do I really know what it costs my business to sell a contract? and Have I segmented my customers appropriately?
Assuming that you now know the cost of signing up a new customer, and the costs associated with expanding the revenue each customer delivers, let’s turn to look at profitably serving your customers.
What does it currently cost to serve my customers?
If you’re a founder, ask yourself: Is my business fully and transparently costing the amount spent on serving our customers? And do I have a truthful picture of our gross margin?
You may find that some customers are very profitable and, if they are coming back to renegotiate prices, your company might be able to offer steeper discounts than you had originally thought in order to retain them.
You may also find that some large customers are actually net-net losing you money, because they are so demanding on time and resources. In a world where money was free and ‘growth at all cost’ was the name of the game, it was rational to keep such large customers on board. In a world where cash is dear and scarce, does it make sense to fire them?
One company that recently conducted this exercise discovered that around half of their customers were actually gross margin negative — a shocking statistic for a SaaS startup. Many of these were flagship customers, but they had been sold at cheap “entry prices” and now commanded a steep Cloud bill that the company had just been eating up.
After making the discovery, the startup’s team could work both on the product (in a bid to reduce the Cloud compute requirements for serving these customers), and on renegotiating pricing, now armed with real data. Remarkably, none of these customers churned — a great testament to this startup’s strong product-market fit.
This discussion naturally leads us to ask:
What should I really be charging my customers?
Pricing for a B2B startup is a fascinating and lengthy topic of discussion. As there are many ways to skin this cat, here I will focus on what unit economics has to say about pricing, rather than looking at other RoI or value-based approaches to the topic.
Based on this approach, a B2B startup would want to charge its customers at least what it costs the business to sell and serve those customers, plus some margin that can (over time) defray its Product and Engineering costs.
As mentioned previously, 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. For a scaling B2B SaaS startup, a great LTV / CAC is >7x, an ‘OK’ one is 4–7x, and anything below 4x needs work.*
This type of reasoning is helpful in setting a floor to pricing conversations. If you calculate that you cannot charge a price for your product that brings your LTV / CAC within a reasonable range, you may need to pivot. You may also decide that your current LTV / CAC is actually fine for now while you build up scale, but do remember that later down the line you will need to come up with a plan to bring this measure up.
We have sometimes found that through conducting this exercise, companies discover that they don’t have true product market fit, or that their GTM approach is not well suited to the market they are serving. Companies also sometimes realise that their products are not as differentiated as their founders had imagined. If you find yourself in this situation, it is worth taking a trip back to the drawing board and examining the fundamental ways in which you are steering your startup.
The right approach for 2023
A company that dives into its unit economics, and as a result reflects and builds new, value creation-focused strategies, is setting itself up for success in a world where cash is no longer free. Today VCs want to invest in innovative companies, but need to see clear evidence that the money they deploy is being used to create true and lasting economic value.
So, as founders everywhere look to show a path to both strong growth and profitability, unit economics can be a highly useful tool. I hope this series has helped to demonstrate why this is the case, and has been insightful on how to use the tool effectively.
Thanks for taking the time to read the series!
If you want to discuss this idea in more detail, or to reach out about your latest scaling startup, please do get in touch with me on mina@dawncapital.com.
Our wider team is also always interested in hearing from founders on the topics and approaches you’re looking to read more about, so please get in touch if you have a spare moment. We’re at hello@dawncapital.com.
*Please note: The series 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
