STARTUP STRATEGY
How to Reach Positive Unit Economics
Actionable tactics for a profitable business model
I raised the biggest check for my startup through an elevator pitch. True story. A real elevator pitch. And, the whole ride was two floors up.
It was an evening function at the home of some foreign diplomat. A handful of entrepreneurs were invited to meet a handful of investors.
The diplomat lived on the third floor of a fancy building. As I walked into the lobby, a tall, fit man walked in as well. We nodded at each other and hit the elevator button.
“Investor or entrepreneur?” I asked. “Investor,” he said. “Can I tell you about my startup?” I asked. Just then the elevator arrived and the door opened. He pointed inside, smiled, and said “Pitch me.”
I gave my quick explainer of what we do and I said, “we’re nearly at positive unit economics.”
That was enough for him to give me his card and ask me to set up a proper meeting. It turned out to be Igor Ryabenkiy of Altair capital, a very active early-stage investor. Three months later, he co-led our seed round. Over time, he became my favorite, and biggest, investor.
Positive unit economics means that your business model is working. It means you are making more money per customer than it costs you to get one.
In this article, you’ll learn tactics that can significantly improve your startup’s business model and help you reach positive unit economics.
The most impactful tactics are hiking your prices, vertically integrating, dramatically improving your onboarding, slashing your churn, establishing new traffic partnerships, nailing your targeting, and optimizing your conversion funnel.
If you want to skip straight to the tactics, click here. Otherwise, read on. We’ll get to them very soon.
Most startups start with negative unit economics. They spend more on acquiring their early customers than they make from them. Some very well-funded startups grow aggressively for a long time with negative unit economics. Amazon is an obvious example.
But all startups, at some point, must reach positive unit economics.
Sequoia Capital says:
For a product to succeed over a long period of time, several conditions must be present: product-market fit, positive unit economics, and the ability to scale and grow
Actually, reaching positive unit economics gives you the ability to scale and grow. Once you extract more value from your customers than they cost you to get, you enter a virtuous cycle of reinvesting ever-growing marketing budgets on acquiring more and more new customers. You may need funding to cover the payback period and your overheads. But investors love startups that are at positive unit economics.
Moving from negative to positive unit economics is a major milestone. But it doesn’t end there. Once you’re positive, you want your model to become more and more profitable. If your model is stronger than your competitors’, you can outspend them, outgrow them, and dominate your market.
While much has been written on the importance of reaching positive unit economics, surprisingly little has been written on how to get there.
The purpose of this article is to list tactics you can use to reach positive unit economics. Once you’ve reached positive unit economics, these tactics can help make your model more and more profitable.
The article starts by listing and explaining the drivers of unit economics. Then, high and medium impact tactics, with links for further reading, are listed for each driver.
All the tactics are available in this Google doc, which you can use as a reference.
A final note before we start — It goes without saying that you need to know where you stand first. That means you should be able to measure everything listed in this article. If you’re not measuring properly, that’s a top priority.
How to calculate unit economics
The “unit” in unit economics can be the user, customer, or product/service. We will use the most common unit, the customer.
Lifetime Value (LTV) measures how much money you make from your average customer.
Cost of Acquired Customer (CAC) measures how much it costs you to get a customer.
Unit economics compares the customer lifetime value to the cost of acquiring a customer.
Unit economics= LTV — CAC
If your LTV is bigger than your CAC, you’re making more from your customers than it costs to acquire them. It means you’ve reached positive unit economics.
Positive unit economics: LTV>CAC
Model profitability is measured by ROI. It consists of the lifetime value divided by the customer acquisition cost.
ROI= LTV/CAC
The higher the lifetime value and the lower the customer acquisition cost, the higher the ROI.
To maximize model profitability, we need to maximize LTV and minimize CAC.
How to maximize customer lifetime value
Lifetime Value (LTV) is the product of the Average Order Size (AOV), Gross Margin (GM), and the number of Transactions (T).
LTV= AOV*GM*T
The LTV formula is all multiplications. Whichever part you improve, the LTV as a whole improves by the same factor. Since you have limited resources and want maximum results, it makes sense to target the parts that have the biggest improvement potential first.
1. Maximize Average Order Value (AOV)
High impact tactics:
- A major price hike — This is possible if you change focus to higher-end services/products, or to larger companies, such as enterprise instead of SME’s. Read more on how to increase your startup’s prices here and here (SaaS).
Medium impact tactics:
- Moderate pricing increase — Do this if you can get away with a moderate price increase without losing too many potential customers. Try testing it. One way to justify a modest price increase is to add valuable features to your product.
- Scalable pricing — If you provide an ongoing service, such as SaaS, much optimization is possible around setting your plans up so that as your customers grow and get more value from your product, you charge more. Read more here.
- Upsell — Sell more of the same product/service to your customers. For example, an e-commerce site selling a chosen shirt can propose adding the same shirt in another color.
- Cross-sell — Sell complementary products/services to your customers. For instance, the e-commerce site above can propose pants, ties, socks to go with the chosen shirts.
- Bundle — Offer bundles to your customers. For instance, a shirt and tie.
2. Maximize gross margin
High impact tactics:
- Vertically integrate up — move up a level in your market- for instance, from affiliate to merchant. Note though, that you don’t capture all the additional gross margin from one level up since you need to take over the costs too. In the example above, as a merchant, you also need to cover costs such as credit cards and fulfillment.
- Vertically integrate down — Develop your own traffic sources, cutting down on partners that drive traffic to your site in return for expensive commissions.
Medium impact tactics:
- Automate processes — Develop your product to require less support, training, and set up resources. Optimize for self onboarding if possible.
- Increase prices — If you can get away with it.
- Optimize sales and support resources — Find ways to improve sales and support efficiency.
- Reduce other direct costs — Break down your product/service costs and find which parts can be optimized.
3. Maximize the number of transactions
High impact tactics:
- Improve initial onboarding — If your product requires some interaction to master and receive value, and you see that you’re losing a lot of your users around the onboarding, improving it could be very impactful. Learn where the problems are by looking at the data and talking to your users. Develop improvements and test them. Read more about improving onboarding here and here.
- Reduce churn — If you have a SaaS product, minimizing churn is critical for your business. If your churn is above 10% you can dramatically improve your unit economics by focusing on cutting it. To reduce churn, try to understand the reasons for abandonment and fix them. Seek early warning signs such as falling usage, and put processes in place that preserve the customer before it’s too late. Read more about reducing churn for SaaS ventures here and here.
Medium impact tactics:
- Improve your email marketing — Most startups do some kind of email marketing. Usually, there is much room for improvement. Here are some tips on optimizing your email marketing.
- Push long-term plans — If your product is an ongoing service, optimize for annual or even bi-annual plans, with auto-renewal.
- Offer incentives/loyalty schemes/gamification for returning users — Add reasons for your customers to return.
- Build strong online communities — Engage your customers in your online communities.
- Provide great customer service — Let your customers know that they are in good hands.
In summary, the high impact tactics to increase lifetime value are a major price hike, vertical integration, improved onboarding, and reduced churn (for SaaS). These tactics are relevant in certain situations. There are also many medium impact tactics you can deploy. Improving several medium impact tactics adds up.
How to minimize customer acquisition cost
The simple way to calculate the customer acquisition cost (CAC) is to divide all marketing and direct sales costs by the number of new customers.
CAC=Total marketing & direct selling costs /# of new customers
It’s useful to further break the CAC into User Acquisition Cost and Conversion Rate. Doing so allows you to assess and optimize each part separately.
CAC=User Acquisition Cost/Conversion Rate
Note though that the two are very much intertwined. You can justify increasing your user acquisition cost if you’re getting better traffic that converts well. If you reduce your user acquisition cost by bringing in junk traffic for cheap, your conversion rate will drop.
1. Minimize user acquisition cost
High impact tactics:
- Improve your targeting — Deeply analyze your customers and understand who is your best buyer persona. Plot the buyer journey to optimize the messaging and offers in your ads. Here is a good guide on how to find your ideal buyer persona.
- Form traffic partnerships — Seek platforms that can send you large amounts of relevant traffic on a per-click or per conversion basis.
Medium impact tactics:
- Cut channels that perform badly — Analyze the performance of each channel and cut the ones that don’t convert well.
- Test new channels/platforms — Experiment with new channels.
- Optimize your campaigns — Optimize your ad text, visual, offer and bids to make your campaigns more efficient.
- Add retargeting — Retargeting usually provides a very high ROI on your marketing spend. Users that return are much more likely to convert than first-time visitors.
- Incentivize referrals — Turbocharge referrals by providing incentives for both your customers and their friends.
2. Maximize conversion rate
High impact tactics:
Optimize your conversion funnel — Optimizing your funnel may be the surest way to reach positive unit economics. If you create the optimal funnel, it’s possible to 2x, 3x, even 10x your conversion rate. That means that by optimizing your funnel, you may cut your CAC by 2x, 3x, maybe 10x.
Startups that have the most to gain are those that have innovative products, multi-step funnels, funnels that have never been challenged, or those whose conversion rate is far from relevant benchmarks. Here is an article I wrote about how doubling your funnel’s efficiency can lead to 3x growth, and here is a detailed guide on how to optimize your conversion funnel.
Medium impact tactics:
- Optimize landing pages — Reduce bounce rate and maximize conversion. Learn more here.
- Optimize forms — Minimize form abandonment. Good list here.
- Optimize checkout flow — Minimize checkout abandonment. For e-Commerce see here. For SaaS free trial, including benchmarks, see here.
Summary & takeaways
Getting to positive unit economics is a major milestone for startups. It allows you to outgrow your competition and makes you very attractive to investors.
You can improve your unit economics by increasing your customer lifetime value and decreasing your customer acquisition cost. To maximize your LTV, increase your average order size, gross margin, and the number of transactions from each customer. To minimize CAC, increase your funnel’s conversion rate and decrease your user acquisition cost.
To get the biggest gains in customer lifetime value, you need to hike your prices, vertically integrate, dramatically improve onboarding, or slash your churn.
To get the biggest cuts in CAC, you need to establish new traffic partnerships, nail your targeting, or optimize your conversion funnel.
There are a bunch of other tactics that can give you moderate gains, which add up.
A summary of these tactics, and more, is available in this Google doc.
Mapping all the relevant tactics is best done collaboratively. If you’d like to contribute by sharing additional tactics, good links, or other good ideas, please post in the comments and I’ll add to the spreadsheet.
Thank you for reading.
